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CHAPTER 1
Introduction
Definition of Derivatives
One of the most significant events in the securities markets has been the development and
expansion of financial derivatives. The term ³derivatives´ is used to refer to financial
instruments which derive their value from some underlying assets. The underlying assets
could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of
these various assets, such as the Nifty 50 Index. Derivatives derive their names from their
respective underlying asset. Thus if a derivative¶s underlying asset is equity, it is called
equity derivative and so on. Derivatives can be traded either on a regulated exchange, such as
the NSE or off the exchanges, i.e., directly between the different parties, which is called
³over-the-counter´ (OTC) trading. (In India only exchange traded equity derivatives are
permitted under the law.) The basic purpose of derivatives is to transfer the price risk
(inherent in fluctuations of the asset prices) from one party to another; they facilitate the
allocation of risk to those who are willing to take it. In so doing, derivatives help mitigate the
risk arising from the future uncertainty of prices. For example, on November 1, 2010 a rice
farmer may wish to sell his harvest at a future date (say January 1, 2011) for a pre-determined
fixed price to eliminate the risk of change in prices by that date. Such a transaction is an
example of a derivatives contract. The price of this derivative is driven by the spot price of
rice which is the "underlying".
Origin of derivatives
While trading in derivatives products has grown tremendously in recent times,
earliest evidence of these types of instruments can be traced back to ancient Greec
Even though derivatives have been in existence in some form or the other since ancient times,
the advent of modern day derivatives contracts is attributed to farmers¶ need to protect
themselves against a decline in crop prices due to various economic and environmental
factors. Thus, derivatives contracts initially developed in commodities. The first ³futures´
contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650. The
farmers were afraid of rice prices falling in the future at the time of harvesting. To lock in a
price (that is, to sell the rice at a predetermined fixed price in the future), the farmers
entered into contracts with the buyers. These were evidently standardized contracts, much
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like today¶s futures contracts.
In 1848, the Chicago Board of Trade (CBOT) was established to facilitate trading of
forward contracts on various commodities. From then on, futures contracts on commodities
have remained more or less in the same form, as we know them today.
While the basics of derivatives are the same for all assets such as equities, bonds,
currencies, and commodities, we will focus on derivatives in the equity markets and all
examples that we discuss will use stocks and index (basket of stocks).
Derivatives in India
In India, derivatives markets have been functioning since the nineteenth cen
with organized trading in cotton through the establishment of the Cotton Trade Association in
1875. Derivatives, as exchange traded financial instruments were introduced in India in
June 2000. The National Stock Exchange (NSE) is the largest exchange in India in
derivatives, trading in various derivatives contracts. The first contract to be launched on
NSE was the Nifty 50 index futures contract. In a span of one and a half years after the
introduction of index futures, index options, stock options and stock futures were also
introduced in the derivatives segment for trading. NSE¶s equity derivatives segment is called
the Futures & Options Segment or F&O Segment. NSE also trades in Currency and Interest
Rate Futures contracts under a separate segment.
A series of reforms in the financial markets paved way for the development of exchange-
traded equity derivatives markets in India. In 1993, the NSE was established as an electronic,
national exchange and it started operations in 1994. It improved the efficiency and
transparency of the stock markets by offering a fully automated screen-based trading
system with real-time price dissemination. A report on exchange traded derivatives, by the
L.C. Gupta Committee, set up by the Securities and Exchange Board of India (SEBI),
recommended a phased introduction of derivatives instruments with bi-level regulation
(i.e., self-regulation by exchanges, with SEBI providing the overall regulatory and
supervisory role). Another report, by the J.R. Varma Committee in 1998, worked out the
various operational details such as margining and risk management systems for these
instruments. In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was
amended so that derivatives could be declared as ³securities .́ This allowed the regulatory
framework for trading securities, to be extended to derivatives. The Act considers
derivatives on equities to be legal and valid, but only if they are traded on exchanges.
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The Securities Contracts (Regulation) Act, 1956 defines "derivatives" to include:
i. 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.
ii. A contract which derives its value from the prices, or index of pr
underlying securities.
At present, the equity derivatives market is the most active derivatives market in India.
Trading volumes in equity derivatives are, on an average, more than three and a half times the
trading volumes in the cash equity markets.
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CHAPTER 2
NEED AND USE OF DERIVATIVES
A. NEED FOR DERIVATIVES
Diverse situations in the market make the need for derivatives in the investment ring. Before
investing one has to analyze the situation and look for the reason for choosing derivatives as
an investment option. This is an important step to be taken and hence requires attention.
i. FUND MANAGEMENT
The question of effective utilization of funds is foremost in the mind of various investors.
This is because there is a certain cost attached to the funds that are worth something for
people. This cost has to be borne by the person who is using the funds and hence the main
mantra in the financial markets is to free up the funds as fast as possible and use them to earn
a higher rate of return. This will ensure that the funds have a better use which in turn makes
the entire assets available with the investor effective.
A similar situation in a spot market can be costly, where payment has to be made for
everything bought and sold for those looking at a quick turnover and movement. Derivatives
on the other hand provide an option where one is able to take the required position using the
same amount of funds. This can meet a larger objective but at the same time the risk involved
in the investment will also increase. The investment is also highly liquid and the position can
be changed quickly as the need arises.
ii. LEVERAGING
One of the biggest benefits of using derivatives is that one can leverage on the existing
resources available with a person. If earlier a person could buy just a certain amount of
investments with the given funds, now the amount can be multiplied by a few times by use of
derivatives.
This enables a person to ensure that he is able to take a larger position in the markets even
with the same amount of funds. This can be a factor that can help scale up the operation of
the person or entity and result in a much larger activity. If these were not present then the
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derivative instruments that provide the additional choices for the players in order to achieve
their financial objectives.
These objectives can be very wide and they can be spread across a large number of areas but
while this is being achieved it is important to look at the route that is being used in the
process. This is the reason why the role of derivatives assumes importance, as they are able to
ensure that a lot of the targets that people have set before their investments are achieved in a
manner that they feel comfortable with. Derivatives provide the necessary additional choices
for people and hence a route that is needed under these circumstances.
vi. DYNAMIC NATURE
The entire area of derivatives is dynamic in nature and this is probably one of the main points
that separate the route from all others that are present in the market. With various other
investment routes there are only a certain objectives that can be achieved in terms of the
investment and the manner of the investment being conducted.
This is not the case of derivative where the canvas is very wide. Due to this feature there are a
lot more options that can be achieved using the route of derivatives. The most important thing
is that when derivatives are used there is also the choice for a person to create a structure that
will be completely different from what is on offer in the menu. By using various strategies
there can be a lot of dynamic positions that will come into play depending upon the situation.
This increases the need for such an instrument because it is the route that will help in
achieving the dynamism that is expected.
vii. CREATIVITY
Derivatives are a route to increase the creativity in a team or among members because this
leaves a wide arena for people in order to ensure that they are able to make the best out of the
situation. With the instruments in front of them people are encouraged to create structures as
well as positions that will result in an overall improvement of the financial situation. People
in the area consider this best as it enables a lot of them to be creative in their efforts and make
the best use of the situation.
This kind of creativity is also very good from the point of view of keeping employees happy
and using them effectively. This also provides a lot of financial benefits in terms of either
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savings or additional earnings for the entity and also enables people to realize the potential
that they have.
B. USE OF DERIVATIVES
There are various uses of derivatives depending upon the conditions under which they
operate. Hence, there has to be a clear objective about the way in which these instruments are
used. While there is a need for derivatives in several conditions the use of the derivatives will
look at a more practical aspect of how these instruments are actually put to use by the people
in their daily work.
i. NORMAL INVESTING
Many people think that the derivatives are just another route for investment and hence are
often used as a normal way of investing. Many of them consider derivatives as a means in
which they can achieve their investment objective.
The impact of such a move can have varied results depending upon the use of the instrument.
But people have different needs and hence they will be comfortable with a certain way of
working. There are people who consider derivatives to be a normal way of taking the required
risk and hence it becomes a simple way in which the investment can take place. This
becomes a comfortable way to invest and complete the investment requirements.
ii. USE AR BITRAGE OPPORTUNITIES
Often there are opportunities in the form of arbitrage or some other gain that looks very
evident. The best way to benefit from such a situation is to take a certain position that will
result in a larger gain occurring to the person if the situation develops as per the expectation.
Derivatives are the route that will help in making use of such opportunities and making a nice
handsome gain out of the situation. This is crucial because the window of opportunity in
several cases will not remain outstanding for a long point of time and hence it has to be
exploited quickly. This will be done using the route of derivatives, which will also push upthe risk in the transaction because the loss can be as severe.
iii. DEPLOY EXTRA FUNDS
There are several people who have a large portfolio but do not know what to do with the
funds. There is a large amount available with them and hence they are always on the lookout
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for several opportunities or areas where they can deploy the necessary funds and make
investments just to keep the funds moving around.
For this category of people the route of derivatives is a very good option because it meets
several of the requirements that they have. There is some action that always takes place in the
derivatives market and hence money is always rolling with returns coming at regular
intervals. While many would disagree with this kind of expectation, this method of investing
is very useful for those who love making some extra money and hence a loss in the area will
also have not much impact. Though the loss might be inevitable, extra funds will find a good
alternative use, which is considered as an asset by several people.
iv. ADDITIONAL POSITIONS
Often the route of derivatives is used for the purpose of taking additional position in the
market. There are always some investments that are lying around and if these are used in
conjunction with derivative investments then it can result in an additional position that is
possible using the available sum of money. If this is done in the right manner then the impact
of this can be contained.
Such additional positions might not always be a good option but their use can be very
effective under certain conditions. Keeping the risk factor in mind at all times is very
important when derivatives are used in different arenas.
v. SPECULATION
This is probably the biggest use of derivatives present in various markets across the world.
For a normal investor this is not the way to use derivatives because it can result in a large
impact if things do not work out as expected. Those who can afford to lose money can use
derivatives in this manner and satisfy their requirements.
Speculation is done in order to garner large gains from a certain expectation but this pushes
up the risk element quite high. Due to this factor it might not be effective for everyone in themanner that was expected. However, a very large percentage of those using derivatives have
speculation at the top of their list as the purpose for using this route.
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Any investor can trade into the derivatives based on equities and hence they are quite popular
across the world. A lot of trading takes place on various exchanges across the world in equity
derivatives and this allows for higher risk but also often higher returns for investors.
ii. DEBT
There are various types of debt instruments that are present in the world of finance. More and
more variants are entering the market depending upon the requirement of various customers.
For various companies the need for funds from the debt route is one of the ways in which
they can meet their requirement of finance.
The more complicated version of the entire capital structure is created using debt derivatives
and hence there are various ways in which new instruments are created using the derivatives
route. The presence of derivatives on the debt side means that here the instruments are
created where the needs of funds are met for the required time duration and then the resulting
money is raised. However, the repayment and other details often related to the conversion of
the instruments in other forms takes place through the working of the derivatives.
Funds are required at specific point of time and these can then be utilized for the purpose of
business and is possible by using debt derivatives. There are various additional conditions
that have to be met including maintenance of the strength of the capital structure of the
enterprise and so on. All this can be done with the help of derivatives.
iii. FOREIGN EXCHANGE
The foreign exchange area has a well-developed market and there is a lot of trading that takes
place in the foreign exchange markets across the world. The most developed part of the
foreign exchange market relates to derivatives because of the fact that a lot of demand for the
exchange takes place in the future.
There is the spot market where the transaction takes place at this point of time and the entiretransaction is completed at this stage itself. However, a lot of demand for foreign exchange
arises at a stage in the future because a lot of demand takes place at some time that is there in
the future.
This gives the rise for derivatives in order to protect the position of the entity that is
undertaking the transaction. In the world of international business where large deals
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regarding trade as well as purchase and sale of goods and products take place there will be
large settlement in the future. When the transactions are across countries the factor of foreign
exchange comes into the picture and this can be a very disruptive force. If the exchange rate
moves against the expectations then there can be a financial situation that is completely
opposite to what has been expected and this can result in financial difficulties.
Here is where derivatives help protect the position of a party with regard to the entire
transaction and hence they are extremely popular. By undertaking a certain exercise one can
know the extent of the risk that is being taken and what will be the cost for the entire
transaction. This has to be considered because the entire world of foreign exchange moves
through the use of derivatives.
The foreign exchange market is such that a very small change can have a very large impact
because the transaction value is extremely high. The use of derivatives in the nature of
options, forwards, futures and swaps, which are the most preferred routes ensure that the
objective of the entire exercise is met. This makes the use of derivatives one of the most
common routes to be adopted in this field.
iv. COMMODITIES
There is the route of various commodities that are traded on the commodity exchanges across
the world. The commodities are varied in nature and can range from something like oil to
sugar and from wheat to even oilseeds. This kind of variation means that there are a lot of
factors that are at play in the entire thing.
The first is that there are different players in each of the segment and hence a lot of factors
come into play. On one hand are the various farmers who produce the various commodities
who would want a good price for the product. If the derivatives market was not available then
they would be subject to the market position and this can mean serious trouble because in
case of an oversupply, the price fall can prove to be disastrous. In addition, there are several
areas where there are middlemen who pocket a large part of the entire earnings from thecommodity which can leave the original farmers bankrupt.
On the other side are the various dealers who also supply same things to the market and often
to the end consumer. They are interested in ensuring that there is a continuous supply of the
product especially when they are required. Due to this there is the situation where they have
to ensure that there is some reliability in the system that they have created and this will be
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possible only through the route of derivatives.
The position of supply and demand is met through the route of derivatives and they are the
best way available for the purpose of ensuring that the needs across the world are met. There
are several commodities that are used in the production of various other items and hence if
there has to be some activity then there is a need to lock into the supply of these items at the
specified prices. In such a situation it is the derivatives that come in the picture.
The derivatives are also a route that gives an indication about the position in a particular
commodity and hence they would look at the position on this front and then take the
necessary decision about the way they should approach the issue accordingly.
v. MUTUAL FUNDS
One of the best areas where derivatives are used is in case of mutual funds that can be based
on a large number of things. Mutual funds are a derivative product because the value of the
fund depends upon the value of a particular asset. While there are mutual funds in areas
related to equity, debt and various commodities there is also an additional area to be
considered.
This is the area of real estate and there are a lot of funds whose value depends upon the
position of the real estate and the various movements of the price. Due to this reason this also
becomes an area that will be covered by derivatives. Often it is impossible for an investor toinvest small amounts in the real estate sector, however, there are a lot of people who would
like to ensure that they are able to get the best returns out of the area.
This is possible when there are mutual funds that are related to the area of real estate. The
funds will be invested in real estate and then the change in the value will be reflected in the
returns of the fund. This is a good opportunity for investors to ensure that they are able to get
the maximum benefit from the entire route.
If there were no derivatives that were present in this area then it would not be possible for aninvestor to ensure that they are able to benefit from the gain that would occur for investments
in this area. There are specific features of such funds and hence they have to be treated in a
separate manner. This is the reason why different types of funds have to be considered in a
different manner. There has to be a mode of operation of these funds and hence they have to
be treated differently.
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In addition, mutual funds themselves use derivative instruments for a whole host of purposes
and across various schemes. Now there are specific schemes present in the market that will
invest in derivative instruments to achieve the desired objectives.
vi. STOCK AND INDEX DERIVATIVES
Derivatives in the equity markets have really taken off and there are a lot of investors who are
looking at trading through these instruments. The derivatives that are present in the equity
markets of the country are mainly of two types and hence they signify the importance that is
given to the different types of derivatives. The investors and those who trade are also now
familiar with these derivatives and it makes it easy for them to actually understand how this
operates and what they actually mean for them as an investor. The derivatives in the market
are based upon these two areas.
a) Stock derivatives
Here the derivatives are based upon individual stocks and due to this factor they are linked to
the prices of the stock. There can thus be futures related to individual stocks like Reliance or
Infosys. Similarly, there can also be options on the same stocks and hence their movement
will be linked to the movement of the stock in the cash market. Stock derivatives enables a
person to undertake activity based on individual stocks and hence the view of the person on
the particular stock can then be played out using the various options and due to this reason
they are also quite popular. The main advantage of these instruments are that they enable a
person to gain from their view regarding a particular share in a higher manner than what they
would have experience in normal terms.
b) Index derivatives
These are opposite to what stock derivatives stand for because here a specified index can be
at the center of the entire range of activities of the derivatives trading. Instead of a particular
stock here the person takes a view on the index as a whole and in many cases this refers to the
market as a whole. Here the items covered are much wider and hence there is a need to
exercise due diligence and care in the entire matter.
Index derivatives are very popular with all those people who would like to take a broader
view of the market and thus are able to predict overall trends in a better manner. Due to this
reason there is also an element of a general overview that is taken by those who deal in index
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derivatives. Again index derivatives can be related to the futures or options on the various
indices present in the market. The two main indices, which are at the center of attention in the
Indian market, are the Sensex and the Nifty.
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CHAPTER 4
TERMS USED IN THE DERIVATIVES TRADING
Introduction
There are various terms that are used in the derivatives segment and one must be aware of
what they mean and how they can be used for the purpose of various types of analysis as well
as dealings. Each of them has their own separate meaning along with the use. This is a vast
field that is also developing quite fast and so one also has to be alert to the new developments
occurring in the field.
1. DERIVATIVES
Most people get confused with the main term derivatives as they are not aware about the clear
meaning of this and get confused about the operation of various instruments. Derivative in
simple words is a product whose value is derived from some other product. The basic
variable, which is the underlying can include a wide variety of areas like equity, foreign
exchange or some commodity too. There are various types of derivatives and there will be
different factors that are driving their prices. However, the way in which the underlying asset
is being impacted will also play a role in the price of the derivative
2. FORWARD CONTRACT
A forward contract is a type of derivative that is present in various markets across the world.
One of the most important features of a forward contract is that it is a customized contract
between two entities. This means that there will be a difference in the way in which different
parties will be creating the forward contract because this will be done according to the
convenience of both of them and the way in which they would like to deal. The other feature
of the contract is that the settlement will take place some day in the future and hence it isknown as a forward contract. The price for this purpose will be determined at this point of
time and the specified and pre agreed price would be applicable. Thus it provides the benefit
of undertaking transactions in the future with the details being decided at this point of time.
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3. FUTURES
There are different terminologies used in the derivatives market and often can create a lot of
confusion between the features of various items. Forwards and futures are two such terms
that lead to a lot of confusion. A futures contract is different from a forward contract. This is
also a contract that falls into the category of derivatives. A future is an agreement between
two parties to buy or sell a specific asset at a specific price at a specific time in the future. In
such a contract, the details of the transaction are determined at the present time and here there
will be a decision to buy or sell the asset at the price that is determined but at a time that will
come sometime in the future. For several people this might seem to be just like a forward
contract but here there will be the additional feature of the contracts being standardized and
that they are also exchange traded in nature. These are traded on the exchange and the various
details regarding the composition and the construction of the contract are fixed.
4. OPTIONS
An option is another type of derivative contract that is very popular in the investment world.
An option gives the right but not the obligation to do a certain thing as laid out in the contract
and this is a great benefit because the person can complete the transaction only when they
feel that this is beneficial to them. If they feel that the situation is not in their favour then
there is no need for them to put through the transaction. There are two types of options- call
option and put option. The former gives the right but not an obligation to buy a certain assetand the latter gives a right but not the obligation to sell a certain asset.
5. WARRANTS
In the markets there are several types of instruments that are present and floating all around.
A warrant is one such offering, which is in the nature of an option. A warrant in simple words
is an instrument that gives the right to a person to buy some assets at a certain price within a
specified time limit. A lot of investors will have witnessed warrants that come along with
some share offerings and they offer additional shares at a certain price within a specified time
period. These are often very useful in providing the required benefit for the targeted group
where the benefit comes at a date in the future. Again based upon the actual situation the
person holding the warrant will decide upon exercising the warrant.
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6. SWAPS
Swaps are a common derivative instrument used in the debt market. These are agreements
between two parties and is mostly a private agreement. The agreement is to exchange cash
flows at some time in the future according to a decided calculation or a formula. There are
various types of swaps that are used in the market. Under an interest rate swap the cash flow
from two interest flows are swapped while in currency swap both the principal as well as the
interest are swapped. Thus here there is a different currency that can also come into the
picture.
7. EXCHANGE TRADED DERIVATIVES
As the name suggests these are derivative products that are traded on an exchange. There are
various exchanges related to different assets and on these exchanges when there are
derivatives traded they are known as exchange traded derivatives. One of the most important
features that will distinguish a derivative as an exchange traded one is the fact that these will
be of a specific size and will be conducted in a specific manner. Thus everything related to
the construction and the trading of the derivative is known and fixed and this makes them
standard in several respects. Within this category there can be several types of derivatives
that are created and traded.
8. OTC DERIVATIVES
OTC derivatives are known as over the counter derivatives. The most important feature of
this derivative is that they are not traded on any exchange but are traded over the counter.
This means that one does not have to go through the exchange mechanism to deal with the
derivatives but two parties can by themselves sit down and decide to deal in the transaction
without any additional presence or the completion of any more details. The most important
factor here is that there is a large amount of flexibility in creating and dealing in the
instruments and hence this is a big advantage as far as the various parties who are involved
are concerned.
9. INDEX
There are various indices that are present in the market for various areas. An index is a
number that will measure and reflect the change in a set of values over a period of time. This
is a very easy way of looking at the various areas and then knowing the kind of change that
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has occurred in the area. When there is an index one can also compare the change in the
values witnessed over a period of time.
10. INDEX BASED DERIVATIVES
Each derivative requires an underlying asset to be covered and based on which the existing
prices will be determined. When a particular derivate is based on an index then it is known as
an index based derivative. The movement of the index that is taking place will determine the
price of such a derivative and hence it is linked to the performance of the index. Since an
index is often the best way in which a person can track what is happening in a particular area
this becomes a good way to ensure that the investor can also get the best out of the situation.
11. EXCHANGE TRADED FUNDS
When an index is mentioned exchange traded funds cannot be far behind. These are
instruments that are mutual funds but the only point of difference is that they are also traded
during the day on the exchanges. These funds are usually based on a particular index and
hence they will track the movement of the index and perform accordingly. The advantage
here is that the investor is able to track the investment better and it also gives them a good
way of exiting the investment when required. The features of both a mutual fund as well as a
stock makes it an interesting concept for a lot of investors.
12. COST OF CARRY
The spot price and the futures price shows a difference at different points of time and this can
be explained by the cost of carry. The cost of carry is nothing but the storage cost plus the
interest cost that is required to be paid for the purpose of financing the asset. The figure will
also have to account for the income earned on the asset and this will be reduced from the cost
so arrived at. This will give an indication of the extent of the expense that is incurred in
holding the futures position on account of these two aspects.
13. IMPLIED VOLATILITY
This is a measure of how volatile the particular stock or asset is and it is useful in the process
of finding out the cost of derivative instruments. The logic is that the higher the volatility, the
larger is the chance that the various targets would be achieved and hence there has to be a
careful watch on this figure for the kind of indications and signals that it sends out because
proper interpretation is very important.
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CHAPTER 5
FORWARDS, FUTURES AND OPTIONS
There are various types of derivatives traded on exchanges across the world. They range
from the very simple to the most complex products. The following are the three basic forms of
derivatives, which are the building blocks for many complex derivatives instruments:
1. Forwards
2. Futures
3. Options
1. FORWARDS
A forward contract or simply a forward is a contract between two parties to buy or sell an
asset at a certain future date for a certain price that is pre-decided on the date of the contract.
The future date is referred to as expiry date and the pre-decided price is referred to as
Forward Price. It may be noted that Forwards are private contracts and their terms are
determined by the parties involved.
A forward is thus an agreement between two parties in which one party, the buyer, enters
into an agreement with the other party, the seller that he would buy from the seller an
underlying asset on the expiry date at the forward price. Therefore, it is a commitment by
both the parties to engage in a transaction at a later date with the price set in advance. This
is different from a spot market contract, which involves immediate payment and
immediate transfer of asset.
The party that agrees to buy the asset on a future date is referred to as a long investor and
is said to have a long position. Similarly the party that agrees to sell the asset in a future
date is referred to as a short investor and is said to have a short position. The price agreed
upon is called the delivery price or the Forward Price.
Forward contracts are traded only in Over the Counter (OTC) market and not
exchanges. OTC market is a private market where individuals/institutions can trade
through negotiations on a one to one basis.
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There are several features that are present in the construction of a forward contract and each
of these will vary with each of the forward contracts being constructed. Here is a look at
several of the factors that will vary with respect to a forward contract.
CONTRACT SIZE
The contract size refers to the amount or the extent of the asset that make up each contract for
a particular asset. This is a prerequisite for every derivative contract because only when the
contract size is known will the agreement be completed. For example, if one is looking to
trade in a contract size in shares then it might be 500 shares or 1000 shares or so on. When a
particular contract is built on a customized basis then it will include the underlying asset in
the quantity that is required for the purpose of the transaction and no more. This also gives
the required amount of flexibility in putting together the transaction. Thus, for example, if there is a requirement for 12 kg of gold for a particular entity and a forward contract is to be
entered into then it will be undertaken for this specific contract size and hence will form the
base of the entire transaction.
EXPIRY DATE
The forward contract has to expire on a particular date because this is the time when the
settlement between the two parties will take place. However the good part is that the expiry
date can be fixed as the one where both the parties are comfortable with the confirmation and
the completion of the contract. There is no compulsion by some outside party in the fixing of
a particular date as the expiry date. The expiry date can be fixed as a particular day even
when it might not be possible in some other ways because there are no restrictions that will
be applicable. The key part of the entire transaction is that both the parties to the contract
have to agree upon the fix the necessary expiry date. As a matter of convenience this can also
be taken to be a round figure like 3 months or 6 months or so on.
ASSET TYPE
If there is a derivative contract that is taking place through the route of an exchange then one
of the major things that will seem like a restriction is the type of assets. A forward contract
does not take place through the exchange and this creates another benefit in terms of the asset
that can be selected for the purpose. In case of a forward contract as this restriction of only
specific types of assets is not present the two parties may decide to trade in an asset where
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they want to make a deal. This increases the scope of the various transactions that can take
place through this medium. The good part of this type of benefit is that a person will be able
to select the asset that they want to trade in or enter into a forward contract and then be able
to execute it in an effective manner.
ASSET QUALITY
One of the major factors that often create a situation of low liquidity is that the quality of the
asset being traded does not match with the specifications laid down in the exchange or at
some other place. In case of a forward even if the asset quality is of a slightly different type
then this can be traded because the contract will be created in such a manner that the asset
quality is taken care of by the other details in the contract. This is a very good way of
ensuring that the right method is adopted in conducting the transaction. It also ensure that the
right value is available for the contract and the person who are transacting in the contract
know precisely what they are doing and the manner in which they will be able to deal with
the situation.
SETTLEMENT OF FORWARD CONTRACTS
When a forward contract expires, there are two alternate arrangements possible to settle
the obligation of the parties: physical settlement and cash settlement. Both types of
settlements happen on the expiry date and are given below.
Physical Settlement
A forward contract can be settled by the physical delivery of the underlying asset by a
short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the
agreed forward price by the buyer to the seller on the agreed settlement date. The
following example will help us understand the physical settlement process.
Illustration
Consider two parties (A and B) enter into a forward contract on 1 August, 2009 where, Aagrees to deliver 1000 stocks of Unitech to B, at a price of Rs. 100 per share, on 29
thAugust,
2009 (the expiry date). In this contract, A, who has committed to sell 1000 stocks of
Unitech at Rs. 100 per share on 29th
August, 2009 has a short position and B, who has
committed to buy 1000 stocks at Rs. 100 per share is said to have a long position.
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In case of physical settlement, on 29th August, 2009 (expiry date), A has to actually deliver
1000 Unitech shares to B and B has to pay the price (1000 * Rs. 100 = Rs. 10,000) to A.
In case A does not have 1000 shares to deliver on 29th August, 2009, he has to purchase it
from the spot market and then deliver the stocks to B.
On the expiry date the profit/loss for each party depends on the settlement price, that is, the
closing price in the spot market on 29th
August, 2009. The closing price on any given day is
the weighted average price of the underlying during the last half an hour of trading in
that day. Depending on the closing price, three different scenarios of profit/loss
possible for each party. They are as follows:
Scenario I. Closing spot price on 29 August, 2009 (S T) is greater than the Forward price (FT)
Assume that the closing price of Unitech on the settlement date 29 August, 2009 is Rs.
105. Since the short investor has sold Unitech at Rs. 100 in the Forward market on 1
August, 2009, he can buy 1000 Unitech shares at Rs.105 from the market and deliver
them to the long investor. Therefore the person who has a short position makes a loss of
(100 - 105) X 1000 = Rs. 5000. If the long investor sells the shares in the spot market
immediately after receiving them, he would make an equivalent profit of (105 - 100) X
1000 = Rs. 5000.
Scenario II. Closing Spot price on 29 August (S T), 2009 is the same as the Forward price
(FT)
The short seller will buy the stock from the market at Rs.100 and give it to the long
investor. As the settlement price is same as the Forward price, neither party will gain or
lose anything.
Scenario III. Closing Spot price (ST) on 29 August is less than the futures price (FT)
Assume that the closing price of Unitech on 29 August, 2009 is Rs. 95. The short investor,
who has sold Unitech at Rs. 100 in the Forward market on 1 August, 2009, will buy thestock from the market at Rs. 95 and deliver it to the long investor. Therefore the person
who has a short position would make a profit of (100 - 95) X 1000 = Rs. 5000 and the
person who has long position in the contract will lose an equivalent amount (Rs. 5000), if
he sells the shares in the spot market immediately after receiving them.
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The main disadvantage of physical settlement is that it results in huge transactio
in terms of actual purchase of securities by the party holding a short position (in this case
A) and transfer of the security to the party in the long position (in this case B). Further, if
the party in the long position is actually not interested in holding the security, then she
will have to incur further transaction cost in disposing off the security. An alternative way
of settlement, which helps in minimizing this cost, is through cash settlement.
Cash Settlement
Cash settlement does not involve actual delivery or receipt of the security. Each party
either pays (receives) cash equal to the net loss (profit) arising out of their respective position
in the contract. So, in case of Scenario I mentioned above, where the spot price at the
expiry date (ST) was greater than the forward price (FT), the party with the short position
will have to pay an amount equivalent to the net loss to the part y at the long position. In
our example, A will simply pay Rs. 5000 to B on the expiry date. The opposite is the case in
Scenario (III), when ST < FT. The long party will be at a loss and have to pay an amount
equivalent to the net loss to the short party. In our example, B will have to pay Rs. 5000 to A
on the expiry date. In case of Scenario (II) where ST = FT, there is no need for any party to
pay anything to the other party.
Please note that the profit and loss position in case of physical settlement and cash
settlement is the same except for the transaction costs which is involved in the physicalsettlement.
DEFAULT RISK IN FORWARD CONTRACTS
A drawback of forward contracts is that they are subject to default risk. Regardless of
whether the contract is for physical or cash settlement, there exists a potential for one party
to default, i.e. not honor the contract. It could be either the buyer or the seller. This results
in the other party suffering a loss. This risk of making losses due to any of the two parties
defaulting is known as counter party risk. The main reason behind such risk is the absence
of any mediator between the parties, who could have undertaken the task of ensu
that both the parties fulfill their obligations arising out of the contract. Default risk is
also referred to as counter party risk or credit risk.
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2. FUTURES
Like a forward contract, a futures contract is an agreement between two parties in which
the buyer agrees to buy an underlying asset from the seller, at a future date at
that is agreed upon today. However, unlike a forward contract, a futures contract i
a private transaction but gets traded on a recognized stock exchange. In addition, a futures
contract is standardized by the exchange. All the terms, other than the price, are set by the
stock exchange (rather than by individual parties as in the case of a forward contract).
Also, both buyer and seller of the futures contracts are protected against the counter
party risk by an entity called the Clearing Corporation. The Clearing Corporation provides
this guarantee to ensure that the buyer or the seller of a futures contract does not suffer as a
result of the counter party defaulting on its obligation. In case one of the parties defaults, the
Clearing Corporation steps in to fulfill the obligation of this party, so that the other party does
not suffer due to non-fulfillment of the contract. To be able to guarantee the fulfillment of
the obligations under the contract, the Clearing Corporation holds an amount as a security from
both the parties. This amount is called theMargin money and can be in the form o
cash or other financial assets. Also, since the futures contracts are traded on the stock
exchanges, the parties have the flexibility of closing out the contract prior to the maturity by
squaring off the transactions in the market.
The basic flow of a transaction between three parties, namely Buyer, Seller
Clearing Corporation is depicted in the diagram below:
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DATE OF EXPIRY
The futures contract which looks at buying or selling an asset at a certain time in the future
also ensures that the date of expiry is specified and this is fixed on the exchange. Thus this
eliminates any disputes or confusion that often arises when a direct deal is made between two
parties as in this case the date of expiry is clearly outlined and hence is the date, which has to
be followed. In case of derivatives in stocks on the Indian exchange, the date of expiry is the
last Thursday of the month.
MONTH OF DELIVERY
There are also specified months in which the entire transaction will take place hence the date
of expiry will also be accompanied by the details of the month of making the delivery. This is
a significant factor because with this detail the entire working of the contract is very clear and
eliminates any chance of making a wrong estimate or creating any confusion.
PRICE QUOTATION
The price quotation is also specified so that the various price changes that occur in the futures
contract will take place as per the expectations. The details will be laid out regarding the
quantum of the price change that will be permitted along with the units of the price. This will
ensure that anyone dealing with the futures contract will know very clearly the kind of price
change that is possible.
SETTLEMENT
The settlement of the entire transaction is very important because the method and the manner
of settlement hold an important place in derivatives trading. There are two ways of settlement
that are possible. The first is a cash settlement and the second one is a settlement by delivery.
Under the cash settlement the entire transaction is closed on the specific day considering the
decided price and the position is settled by cash. On the other hand when it comes to delivery
there will be actual delivery of the asset at the time of settlement and hence this will requirethe presence of several other aspects of infrastructure that will have to be present.
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DIFFERENCE BETWEEN FORWARDS AND FUTURES
Forwards Futures
1. Privately negotiated contracts 1. Traded on exchange
2. Not standardized 2. Standardized
3. Settlement date can be fixed by the
parties
3. Fixed settlement dates are declared by
the exchanges
4. High counter party risk 4. Almost no counter party risk.
TERMINOLOGY IN FUTURES
There are several terminologies that will be used when dealings in futures are to be
considered and in such a situation the meaning of these terms will be useful in getting a
proper idea of the way in which the futures market operates
Spot price
There is a spot market present for the trading of various asset classes. In the spot market the
transaction is completed on the spot itself without waiting for a future time period and this
gives rise to the spot price. The spot price in such a situation is the price at which an asset
trades in the spot market, giving an immediate effect to the transaction.
Future contract
Whenever there is some trading in the future market then the nature of the trading is in the
form of contracts. Each contract represents a certain quantity of the underlying asset. The size
of the contract and what it represents is fixed and due to this there is an element of certainty
as far as the futures market is concerned and this is known as a futures contract. The futures
contract also gives rise to the term futures price because this is the price at which the futures
contract trades.
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Expiry date
This is the date on which the futures contract expires. It is specified in the futures contract
and it denotes the last date till which the particular contract will be traded. After the expiry
date there will be no further trading in the contract and this contract itself will cease to exist.
Due to this reason the expiry date is important as it seeks to highlight the extent of the life of
the contract
Futures contract cycle
The period for which the futures contract is in existence is called the contract cycle. There
can be different time periods for which a contract cycle may be on. This can be a month or it
can be three months or also as per the situation. However the contract cycle in existence from
a particular day will also be considered important because of the fact that it will give an idea
as to when the contract cycle expires.
Basis
When it comes to the area of financial futures the term basis refers to the futures price less the
spot price. The basis will be different for various situations and it will also keep changing
however, the general trend of the basis has to be noted because this is an important factor. In
most cases the futures price exceeds the spot price and hence the basis will be positive
however the situation can be different too and hence this would also have to be tackled whenthe situation arises
Cost of carry
There is a reason why there is a difference between the futures price and the spot price and
this can be understood using the concept of cost of carry. The cost here measures the storage
cost plus the interest that will be incurred in order to finance the asset. In this calculation the
amount earned would be reduced from this figure to arrive at the actual cost of carry. One has
to understand that due to the fact that there is some storage cost plus interest the futures pricehas to be higher than the spot one
Initial margin
There are different types of margin that are present in the process of investing in futures.
These margins are useful for the purpose of ensuring that the risk in the entire transaction is
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covered. Due to this reason the amounts are collected under various heads known as margins.
One of them is called the initial margin. This is the figure that has to be deposited in the
futures account on entering the transaction and is hence known as the initial margin.
Mark to market margin
This is the margin requirement that most people would be familiar with. In the futures
process every day the outstanding position of the investor is marked to the market price and
depending upon the movement the investor either has to pay more margin or their margin
requirement is reduced. Due to this factor there is the mark to market margin, which will take
care of the fact that the changes in the price in the asset will be reflected regularly on a daily
basis.
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3. OPTIONS
Like forwards and futures, options are derivative instruments that provide the opportunity
to buy or sell an underlying asset on a future date. An option is a derivative contract
between a buyer and a seller, where one party (say First Party) gives to the other (say
Second Party) the right, but not the obligation, to buy from (or sell to) the First Party the
underlying asset on or before a specific day at an agreed -upon price. In return for granting
the option, the party granting the option collects a payment from the other party. This
payment collected is called the ³premium´ or price of the option.
The right to buy or sell is held by the ³option buyer´ (also called the option holder); the
party granting the right is t he ³option seller´ or ³option writer´. Unlike forwards and futures
contracts, options require a cash payment (called the premium) upfront from the option buyer
to the option seller. This payment is called option premium or option price. Options can be
traded either on the stock exchange or in over the counter (OTC) markets. Options
traded on the exchanges are backed by the Clearing Corporation thereby minimizing the
risk arising due to default by the counter parties involved. Options traded in the OTC
market however are not backed by the Clearing Corporation.
TYPES OF OPTIONS
There are various types of options that are present in the market and the investor has a choice
to select from what is put in front of them. Depending upon the circumstances and the
manner of their operation, the right type of option can be chosen for the desired transaction.
a. Call option
A call option is the right but not the obligation to buy a particular asset at a specified price on
a specified date. When such an option is purchased then it will be very clearly mentioned that
the person can buy a specified quantity of the asset at the given price on the particular day.
The idea behind buying a call option is that the person expects the price of the asset to rise in
the future. In order to profit from this price rise the person is locking himself into the cost of
the asset from this time period itself and hence the person knows that from this stage itself
that their cost will be the specific amount fixed.
If the price actually rises as expectated, the investor will gain because they have already
locked into the cost from this time period itself. In such a situation on the specified day the
person will exercise the option and enjoy the gains. However if the expected situation does
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not develop then the person who has bought the option cannot exercise the option and thus
restrict the losses that would have occurred.
A good example of this is when a person buys a call option for Indian Hotels that entitles him
to 1000 shares of the company at Rs 140 at share at the end of January 2007. In this case the
investor will wait till the end of the specified period and then depending upon the share price
in the market will decide about exercising or not exercising the option. If the price is above
his cost then there is a gain available to the investor and hence they will exercise the option
however there is no obligation to actually exercise the option and hence if the price is say Rs
125 then nothing will be done and the required shares will not be bought.
b. Put option
A put option is opposite to a call option. Here the option gives the right but not the obligation
to sell a particular asset at a specified price at a specified date in the future. The put option is
a very useful tool because this can protect the gains of the investor and hence assure them a
specific price for the assets that they hold. Here on the specified date the person who has sold
the asset can complete the transaction at the specified price if they feel that this is beneficial
to them. On the other hand if they feel that they will make a loss in the process then they are
under no obligation to complete the transaction.
A put option is extremely useful in order to get a particular price for the assets that a person
has. It protects against the downside of the market because if one has bought a put option and
the market price falls after that then the buyer of the option has little cause to worry because
they are assured of the price that has been fixed under the put option. At the same time if the
situation does not work out as expected and the price actually rises then they can walk away
after letting go of the premium paid on the transaction. This is useful when one has an
expectation of a fall in the prices of an asset so that they will be able to gain from the
situation by ensuring that their sale is at a higher price.
A good example of this is the put option of Satyam Computers at Rs 550 one month down the
line. If the price of the company is Rs 650 on the particular day then the option will not be
exercised because it will result in a loss for the investor. On the other hand if the price has
dipped to say Rs 380 then the option will be exercised and hence the person will gain due to
the locking in of the sale price of the shares at that point of time.
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c. American option
This is another variation of the option as here the key feature is the timing of the exercise of
the option. An American option is one that can be exercised at anytime during the tenure of
the option. This feature is very important because it can help the investor make use of any
intermediate price changes that occur in the market and get the best out of the situation.
The price changes on a daily basis while the specified date in the option is at some time in the
future. Now assume that a person has bought a call option on a share for Rs 50 that would be
exercised after a period of 1 month. However after 15 days the person finds that the price of
the company has already reached Rs 75 and there is no certainty that it would stay at that
level. In such a situation the person would like to exercise the option get the shares and sell
them off so that they are able to make the difference in the transaction. This will be possible
only when the option is an American option because that enables a person to exercise it at
any time during the tenure. Here there is more flexibility for the investor because it gets them
to act according to the changing situation that will be beneficial for them.
d. European option
This is another type of option that is present in the market where the option cannot be
exercised at any time before the specified date. This takes away the benefit of exercising it if
the situation turns favourable and hence the person will have to wait till the date specified in
the option for the purpose of completing the transaction. This often acts as a disadvantage
because the person is not able to take the benefit of any situation that arises in the
intermediate period.
This is suitable for areas where there is not much intermediate activity and changes that
impact the prices significantly. Due to this factor there is no need for constant monitoring or
intervention and hence the European option will be suitable for the situation that has
developed here.
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TERMS USED IN OPTIONS
There are various terms that are used for the purpose of dealing in options and one needs to
be familiar with them in order to be able to understand the complete nature of the activities
that are conducted in this area.
Option holder
The person who buys the option is known as the option holder. This is the person who has
bought either a call or a put option and is the one who has the right but not the obligation to
undertake the entire transaction. It is in the hands of the option holder as to what has to be
done with respect to the option and how this is to be tackled. Hence there is an important role
to be played by the option holder when it comes to dealing in options
Option writer
The option writer is at the other end of the option transaction. For every option that is bought
by a person and this can be a put option or a call option there has to be someone else who has
to write the option. Writing an option means meeting the conditions of the option. For
example writing a call option means having to buy a particular share at a particular price and
writing a put option means having to sell a share at a certain price.
The difference between an option holder and an option writer is quite huge because of the
very basic nature of the activity. There is no right for an option writer to move away from the
requirements of the option. Thus unlike a holder they cannot say that the option will not be
honoured and completed. If they have written a call option and this is exercised then they will
have to buy the asset at the specified price. In order to compensate for this feature that they
face the option writer earns money from writing option while the option holder has to pay
money for the purpose of getting the benefit of the options.
Exercise price
The option has a price that is fixed for the purpose of the particular option. The price at which
the option will be carried out is known as the exercise price. This is the price at which the
option holder can buy or sell the asset involved in the option. It is an integral part of an option
transaction because the price for the option is a very important component that has to be
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present. The exercise price is mentioned clearly at the time of entering in to the option
contract.
Expiry date
An option has a date on which the option holder has a right to buy or sell a particular asset.
This date is the time when the decision has to be taken on the option and when the option will
expiry. This date is known as the expiry date and is a very important role to play because it
determines the time period for the option. After this expiry date the option will cease to be in
operation and hence it has to be exercised by or on the expiry date.
Option exercise
When the option process leads to buying or selling of the asset as per the terms of the option
then it is said that the option has been exercised. The exercise of the option will result in a
situation where the transaction is completed. In case the option is not exercised then the
option will lapse and there will be no transaction however this does not mean that there will
be no earnings for everyone. When an option expires the option writer will get to keep the
option premium that has been collected on the writing of the option
Option premium
A lot has been said about options and the kind of benefits that they provide. The entire
transaction of getting a right but not the obligation to undertake several activities would be
there in consideration for a cost. In this situation the cost is in the form of option premium
that has to be paid by the person buying the option to the option writer. This is the cost for the
entire transaction and even if the option is not exercised there will not be the return of the
option premium
For example if a person goes to buy a call option on Infosys at Rs 2300 then there will be an
option premium that has to be paid on this transaction. In this case the figure might be Rs 50.
This results in the actual cost for the option holder to be RS 2350. If the price is above thisfigure then only will the exercise of the option become favourable. In case the option is not
exercised and the option holder walks away from the situation then the Rs 50 paid for each
share in the option contract will be the loss for the person and this on the other side of the
transaction is the income for the option writer.
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At the money option
In case of options there has to be a constant lookout for the position of the market price as
compared to the exercise price. This is to check for the position in case the option has to be
exercised at any point of time. In such a situation when the market price is equal to the
exercise price then in this case the option is said to be at the money. At this stage of the
option there is no loss or no profit being made by the option holder. Thus this is actually a
neutral stage for both a call as well as a put option
In the money option
An option where the option holder is making money is said to be in the money option. The
important thing is that the situation when this will happen will differ according to the nature
of the option. Again the market price and the exercise price are to be considered in
determining the position. In case of a call option when the market price is greater than the
exercise price then the option is said to be in the money. In case of a put option the situation
is reversed because when the market price is lower than the exercise price the option becomes
in the money. This means a profitable situation for the investor holding the option.
Out of the money option
There are also times when things are not going the way of the investor and the situation is
opposite to what was expected. In such a case the option becomes an out of the money
option. In this case too the nature of the position will depend upon the type of the option. In
case of a call option if the market price is less than the exercise price then the option is said to
be out of the money while in case of a put option if the market price is higher than the
exercise price then the option is said to be out of the money. For the option holder if the
option remains out of the money then at the time of expiry this will not be exercised.
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For example, an investor holding Reliance shares may be worried about adverse future price
movements and may want to hedge the price risk. He can do so by holding a short position
in the derivatives market. The investor can go short in Reliance futures at the NSE. This
protects him from price movements in Reliance stock. In case the price of Reliance
shares falls, the investor will lose money in the shares but will make up for this loss by the
gain made in Reliance Futures. Note that a short position holder in a futures contract
makes a profit if the price of the underlying asset falls in the future. In this way, futures
contract allows an investor to manage his price risk.
Similarly, a sugar manufacturing company could hedge against any probable loss in the
future due to a fall in the prices of sugar by holding a short position in the futures/ forwards
market. If the prices of sugar fall, the company may lose on the sugar sale but the loss will
be offset by profit made in the futures contract.
Long Hedge
A long hedge involves holding a long position in the futures market. A Long
holder agrees to buy the underlying asset at the expiry date by paying the agreed futures/
forward price. This strategy is used by those who will need to acquire the underlying asset
in the future.
For example, a chocolate manufacturer who needs to acquire sugar in the future will be
worried about any loss that may arise if the price of sugar increases in the future. To hedge
against this risk, the chocolate manufacturer can hold a long position in the sugar futures.
If the price of sugar rises, the chocolate manufacture may have to pay more to acquire
sugar in the normal market, but he will be compensated against this loss through
profit that will arise in the futures market. Note that a long position holder in a futures
contract makes a profit if the price of the underlying asset increases in the future.
Long hedge strategy can also be used by those investors who desire to purchase the
underlying asset at a future date (that is, when he acquires the cash to purchase the asset)
but wants to lock the prevailing price in the market. This may be because he thinks that the
prevailing price is very low.
For example, suppose the current spot price of Wipro Ltd. is Rs.250 per stock. An investor
is expecting to have Rs. 250 at the end of the month. The investor feels that Wipro Ltd. is
at a very attractive level and he may miss the opportunity to buy the stock if he waits till the
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end of the month. In such a case, he can buy Wipro Ltd. in the futures market. By doing
so, he can lock in the price of the stock. Assuming that he buys Wipro Ltd. in the futures
market at Rs. 250 (this becomes his locked-in price), there can be three probable
scenarios:
Scenario I: Price of Wipro Ltd. in the cash market on expiry date is Rs. 300.
As futures price is equal to the spot price on the expiry day, the futures price of Wipro would
be at Rs. 300 on expiry day. The investor can sell Wipro Ltd in the futures market at Rs.
300. By doing this, he has made a profit of 300 - 250= Rs.50 in the futures trade. He can
now buy Wipro Ltd in the spot market at Rs.300. Therefore, his total investment cost for
buying one share of Wipro Ltd equals Rs.300 (price in spot market) - 50 (profit
futures market) = Rs.250. This is the amount of money he was expecting to have at the end
of the month. If the investor had not bought Wipro Ltd futures, he would have had only
Rs. 250 and would have been unable to buy Wipro Ltd shares in the cash market. The
futures contract helped him to lock in a price for the shares at Rs. 250.
Scenario II: Price of Wipro Ltd in the cash market on expiry day is Rs. 250.
As futures price tracks spot price, futures price would also be at Rs. 250 on expiry day.
The investor will sell Wipro Ltd in the futures market at Rs. 250. By doing this, he has made
Rs. 0 in the futures trade. He can buy Wipro Ltd in the spot market at Rs. 250. His total
investment cost for buying one share of Wipro will be = Rs. 250 (price in spot market) + 0 (loss
in futures market) = Rs. 250.
Scenario III: Price of Wipro Ltd in the cash market on expiry day is Rs. 200.
As futures price tracks spot price, futures price would also be at Rs. 200 on expiry day.
The investor will sell Wipro Ltd in the futures market at Rs. 200. By doing this, he has
made a loss of 200 - 250 = Rs. 50 in the futures trade. He can buy Wipro in the spot market at
Rs. 200. Therefore, his total investment cost for buying one share of Wipro Ltd will be =
200 (price in spot market) + 50 (loss in futures market) = Rs. 250. Thus, in all the three
scenarios, he has to pay only Rs. 250. This is an example of a Long Hedge.
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2. SPECULATORS
A Speculator is one who bets on the derivatives market based on his views on the
potential movement of the underlying stock price. Speculators take large, calculated risks
as they trade based on anticipated future price movements. They hope to make quick, large
gains; but may not always be successful. They normally have shorter holding time for their
positions as compared to hedgers. If the price of the underlying moves as per their
expectation they can make large profits. However, if the price moves in the opposite
direction of their assessment, the losses can also be enormous.
Illustration
Currently ICICI Bank Ltd (ICICI) is trading at, say, Rs. 500 in the cash market and also at
Rs. 500 in the futures market (assumed values for the example only). A speculator feels that
post the RBI¶s policy announcement, the share price of ICICI will go up. The speculator
can buy the stock in the spot market or in the derivatives market. If the derivatives contract
size of ICICI is 1000 and if the speculator buys one futures contract of ICICI, he is buying
ICICI futures worth Rs 500 X 1000 = Rs. 5,00,000. For this he will have to pay a margin of
say 20% of the contract value to the exchange. The margin that the speculator needs to pay to
the exchange is 20% of Rs.5,00,000 = Rs. 1,00,000. This Rs.1,00,000 is his total investment
for the futures contract. If the speculator would have invested Rs.1,00,000 in the spot
market, he could purchase only 1,00,000 / 500 = 200 shares.
Let us assume that post RBI announcement price of ICICI share moves to Rs. 520. With
one lakh investment each in the futures and the cash market, the profits would be:
(520 - 500) X 1,000 = Rs. 20,000 in case of futures market and
(520 - 500) X 200 = Rs. 4000 in the case of cash market.
It should be noted that the opposite will result in case of adverse movement in stock
prices, wherein the speculator will be losing more in the futures market than in the spotmarket. T his is because the speculator can hold a larger position in the futures market
where he has to pay only the margin money.
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3. AR BITRAGEURS
Arbitrageurs attempt to profit from pricing inefficiencies in the market by making
simultaneous trades that offset each other and capture a risk-free profit. An arbitrageur may
also seek to make profit in case there is price discrepancy between the stock pr
the cash and the derivatives markets.
For example, if on 1st
August, 2009 the SBI share is trading at Rs. 1780 in the cash market
and the futures contract of SBI is trading at Rs. 1790, the arbitrageur would buy the SBI
shares (i.e. make an investment of Rs. 1780) in the spot market and sell the same
number of SBI futures contracts. On expiry day (say 24 August, 2009), the price of SBI
futures contracts will close at the price at which SBI closes in the spot market. In other
words, the settlement of the futures contract will happen at the closing price of the SBI
shares and that is why the futures and spot pr ices are said to converge on the expiry day.
On expiry day, the arbitrageur will sell the SBI stock in the spot market and buy the futures
contract, both of which will happen at the closing price of SBI in the spot market. Since the
arbitrageur has entered into off-setting positions, he will be able to earn Rs. 10 irrespective of
the prevailing market price on the expiry date.
There are three possible price scenarios at which SBI can close on expiry day. Let us
calculate the profit/ loss of the arbitrageur in each of the scenarios where he had initially (1
August) purchased SBI shares in the spot market at Rs 1780 and sold the futures contract of SBI at Rs. 1790:
Scenario I: SBI shares closes at a price greater than 1780 (say Rs. 2000) in the spot
market on expiry day (24 August 2009)
SBI futures will close at the same price as SBI in spot market on the expiry day i.e., SBI
futures will also close at Rs. 2000. The arbitrageur reverses his previous transaction entered
into on 1 August 2009.
Profit/ Loss (- ) in spot market = 2000 - 1780 = Rs. 220
Profit/ Loss (- ) in futures market = 1790 - 2000 = Rs. ( - ) 210
Net profit/ Loss (- ) on both transactions combined = 220 - 210 = Rs. 10 profit.
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Scenario II: SBI shares close at Rs 1780 in the spot market on expiry day (24 August 2009)
SBI futures will close at the same price as SBI in spot market on expiry day i.e., SBI futures
will also close at Rs 1780. The arbitrageur reverses his previous transaction entered into on 1
August 2009.
Profit/ Loss (- ) in spot market = 1780 - 1780 = Rs 0
Profit/ Loss (- ) in futures market = 1790 - 1780 = Rs. 10
Net profit/ Loss (- ) on both transactions combined = 0 + 10 = Rs. 10 profit.
Scenario III: SBI shares close at Rs. 1500 in the spot market on expiry day (24 August 2009)
Here also, SBI futures will close at Rs. 1500. The arbitrageur reverses his previous
transaction entered into on 1 August 2009.
Profit/ Loss (- ) in spot market = 1500 - 1780 = Rs. (- ) 2 8 0
Profit/ Loss (- ) in futures market = 1790 - 1500 = Rs. 290
Net profit/ Loss (- ) on both transactions combined = ( - ) 280 + 290 = Rs. 10 profit.
Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, wh
the difference between the spot price of SBI and futures price of SBI, when the
transaction was entered into. This is called a ³risk less profit´ since once the transaction
is entered into on 1 August, 2009 (due to the price difference between spot
futures), the profit is locked.
Irrespective of where the underlying share price closes on the expiry date of the contract,
a profit of Rs. 10 is assured. The investment made by the arbitrageur is Rs. 1780 (when he
buys SBI in the spot market). He makes this investment on 1 August 2009 and gets a return
of Rs. 10 on this investment in 23 days (24 August). This means a return of 0.56% in 23
days. If we annualize this, it is a return of nearly 9% per annum. One should also note that
this opportunity to make a risk-less return of 9% per annum will not always remain. The
difference between the spot and futures price arose due to some inefficiency (in the market),
which was exploited by the arbitrageur by buying shares in spot and selling futures. As
more and more such arbitrage trades take place, the difference between spot and future
prices would narrow thereby reducing the attractiveness of further arbitrage.
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CHAPTER 7
CONCLUSION
Derivative market in India is growing every year very rapidly in Indian Economy. The
turnover has increased every year ever since it was established. This clearly demonstrates its
popularity and hence one has to quite clearly take a look at the way in which these
instruments operate and how an investor can actually go around investing their money. More
people are now confident to use derivatives to hedge against the risk. Hence it encourages
investor to take more risk and generate more return in this type of market. Derivative market
is well regulated by the SEBI so that there is controlled environment for investors. By using
financial derivatives wisely an investor can maximize his value as shareholder. Derivatives
are an instrument, which help a person in taking a certain view about the market or the
position about a particular item in the market. It can either be a debt or an equity market.
Derivatives are becoming quite popular across the world and newer derivatives are
introduced in the market place, which cover a wide variety of areas.
For the economy, a collapse of large derivative user or dealer may create systematic risks.
The regulators have to make sure to monitor that derivatives are used properly. The market
should be regularly scrutinized so that no party is trading against the law. The investors have
to measure and understand the derivative positions so as to take gain from the derivativemarket.
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