Derivatives in India

DERIVATIVES IN INDIA
CHAPTER I: - BASICS OF DERIVATIVES

1. INTRODUCTION TO DERIVATIVES A lot of people have heard a lot about derivatives, though most people are ignorant to know or understand what derivatives is all about. Most people will say it is some form of financial instrument. But the actual meaning is often lost. In an economy which has recently been booming, understanding derivatives has become important for any person interested in the stock market and the economy as a whole. Derivatives essentially are financial securities whose values are derived from another underlying financial security. Let us look further into the same. he term !Derivative! indicates that it has no independent value, i.e. its value is entirely !derived! from the value of the underlying asset. he underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fi"ed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an inde" of securities. Derivatives are all about risk. #o we need to clarify the meaning of the word $risk%. $&isk% has a speciali'ed meaning in an insurance conte"t( it refers to the chance that a future event might happen with bad conse)uences for somebody * for e"ample an airline might loose someone+s baggage. his event is uncertain in that it may or may not happen. If it does not happen, you are no worse off but if it does, there is an adverse conse)uence that could involve an economic loss or something else untoward. he more usual meaning of $risk% has positive as well as negative undertones. In business and investment decisions, risk involves both the prospects of gains as well as the chances of loss. ,hen there is a
wide variation in the range of outcomes we say that a pro-ect $carries a lot of risk%. If there is little variation in the range of outcomes we say that it $carries very little risk%. .irms take up risk, with a hope to increase their profits. commodity. #imilar are Derivatives. Derivatives are financial tools used to transfer these risks. hey can used to reduce risk and they can be used to hey are similar to increase risk. It depends on how they are used. &isk can be bought or sold like any other
insurance contracts, which are used to reduce risk on one hand and increase risk on other. Derivatives are widely used by corporations and financial institutions to reduce risk but are used by traders to increase risk. .or the derivative market to flourish, we need both risk takers and sellers i.e. agents willing to these derivatives and also agents willing to sell them. Derivatives are financial contracts whose value/price depends on the behaviour of the price of one or more basic underlying assets 0often simply know as the underlying1. sell an asset in future. hese contracts are legally binding agreements, made on the trading screen of stock e"changes, to buy or he asset can be a share, inde", interest rate, bond, rupee dollar e"change rate, sugar, crude oil, soybean, cotton, coffee and any other asset. In case of inde" futures, the B#2 #ense" or 3#2 3ifty becomes the underlying asset. Derivatives are contracts for future delivery of assets at prices agreed at the time of the contract. specified in the contract. he )uantity and )uality of the asset is he buyer of the asset will make the cash
payment at the time of delivery. Derivative product s initially emerged as hedging devices against fluctuations in commodity prices and commodity4linked derivatives remained the sole form of such products for almost three hundred years. he financial derivatives, derivatives for future delivery of stocks, debt instruments and foreign currencies,
came into spot light in post45678 period due to the introduction of floating e"change rates. .or e"ample, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. #uch a transaction is an e"ample of a derivative. he price of this derivative is driven by the spot price of wheat which is the $underlying%. Derivative is a security whose value is derived from the value of the underlying asset in a contractual manner. It can be defined as follows. 5. 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. 9. A contract, which derives its value from the prices, or inde" of prices, of underlying securities. 2. EMERGENCE AND GROWTH OF DERIVATIVES :olatility in the market has been present for several decades and has been a prime factor in the development and growth of derivatives. .undamentally, institutions enter into derivatives transactions to protect against, or take advantage of, market volatility( this is accomplished by establishing simple/compound derivative hedge or speculative positions in a particular market. he e"plosive growth in derivatives began during the 5678s when certain key financial variables became more volatile and new types of derivatives were introduced to manage the increased risk. In the early 5678s, the increased volatility in financial variables such as interest rates and e"change rates e"posed corporations more risks and increased the demand for vehicles to reduce these risks. During the last )uarter of the 98th century there was also a large increase in international trade and foreign direct investment in real assets, associations with a huge e"pansion of cross4border capital market
flows. Derivatives provided investors with efficient instruments for investing in the global economy, and dramatic advances in information technology lowered the cost of sorting and transmitting information. his made the rapid development of global markets possible. .inally, fundamental advances in financial theory gave rise to the basic models that provide the foundation for the pricing and risk management of derivatives. .oreign e"change risk, which had not been a ma-or concern during the previous ;8 years, became an important factor in the early 5678s. his added a new dimension of uncertainties to international trade. volatility in interest rates and a sharp increase in oil prices. could protect firms against these risks. hrough the use of derivative products, it is possible to partially or fully transfer price risks by locking4in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. <owever, by locking4in asset prices, derivative products minimi'e the impact of fluctuations in asset prices on the profitability and cash flow situation of risk4averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity4linked derivatives remained the sole form of such products for almost three hundred years. he financial derivatives came into spotlight in post45678 period due to growing instability in the financial markets. <owever, since their emergence, these products have become very popular and by 5668s, they accounted for about two4thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their comple"ity and also turnover. In the class of e)uity derivatives, futures and options on stock indices have gained he advent of floating e"change rates coincided with the increased he stage was set for the development of new derivatives * instruments that
more
popularity
than
on
individual
stocks,
especially
among
institutional investors, who are ma-or users of inde"4linked derivatives. 2ven small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. he lower costs associated with inde" derivatives vis4vis derivative products based on individual securities is another reason for their growing use.
he following factors have been driving the growth of financial derivatives( 5. Increased volatility in asset prices in financial markets, 9. Increased integration of national financial markets with the international markets, ;. Marked improvement in communication facilities and sharp decline in their costs, =. Development strategies, and >. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as trans4actions costs as compared to individual financial assets. of more sophisticated risk management tools, providing economic agents a wider choice of risk management
3. FUNCTIONS OF DERIVATIVES IN THE ECONOMY
he roles of the derivatives market with respect to the spot market are ? Risk Ma a!"#" $ * Because derivative prices are related to the prices of the underlying spot market, they can be used to reduce or increase the risk of owning the spot items. 2"ample( Mutual funds maintain a portfolio of stocks, which are e"posed to ups and downs of
the market. Instead of dynamically change the portfolio they can buy derivatives against the stocks to hedge the portfolio. transactions are called hedging. ? P%i&" Dis&'("%) * .utures and forward markets are an important means of obtaining information about investor+s e"pectations of future prices. In a crude way, the future price can be substituted for e"pected spot price in future. prices. hough this might not be completely true, the futures prices contain some valuable information about future spot hough @ptions market does not directly provide forecasts of herefore the future spot prices, it provides valuable information about the volatility and the associated risk of the underlying spot asset. the functioning of the overall financial market. he derivative market performs a number of economic functions. .irst, prices in an organi'ed derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. he prices of derivatives converge with the prices of the underlying at the e"piration of derivative contract. hus derivatives help in discovery of future as well as current prices. #econd, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them. hird, derivatives, due to their inherent nature, are linked to the underlying cash markets. ,ith the introduction of derivatives, the underlying market witnesses higher trading volumes because, of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. .ourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organi'ed derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become e"tremely difficult in these kinds of mi"ed markets. .ifth, an important incidental benefit that efficiency of the functioning of the derivatives market is very vital for hese types of
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flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. attitude. he derivatives have a history of attracting many bright, creative, well4educated people with an entrepreneurial hey often energi'e others to create new businesses, new products and new employment opportunities, the benefit of which are immense. #i"th, derivatives markets help increase savings and investment in the long run. ransfer of risk enables market participants to e"pand their volume of activity. Derivatives thus promote economic development to the e"tent the later depends on the rate of savings and investment.
*. USERS OF DERIVATIVES
Before going forward let us see who the participants in the derivative market are. T+" ,a%$i&i,a $s i &/assi0i"i $' $+%"" A%.i$%a!"1%s. -"%i(a$i("s #a%k"$s a%" .%'a-/) H"-!"%s2 S,"&1/a$'%s2 a !%'1,s:
H"-!"%s : #pecific e"posures 3eutrali'e adverse market movements Decisions based on fear of market movements @b-ective is to stabili'e cash flows and reduce cost of capital.
S,"&1/a$'%s : @pportunists Aapture market movements Increase profitability.
A%.i$%a!"1%s: 2arning profit without taking risk.
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<edgers have a position in the underlying asset or interested to buy the asset in the future. .or e"ample, the hedger could be an investor who has a portfolio of stocks worth &s.9 &%'%" a - 3+' is 3'%%i"$+a$ $+" s$'&k #a%k"$ #a) !' -'3 +"-!"% &'1/- ." a i $+" s$'&ks. T+") ,a%$i&i,a$" i s+'%$/). A/$"% a$i("/)2 a i ("s$'% 3+' +as !'$ 01 -s $' ." i ("s$"$+" -"%i(a$i("s #a%k"$ $' /'&k i $+"
$+" ,%i&"s a$ 3+i&+ $+") 3i// ." a./" $' -' $+" $%a sa&$i' risk associated with the price of an asset. markets to reduce or eliminate this risk.
01$1%". T+1s $+") a%" $%)i ! $' a('i- $+" ,%i&" %isk. Hedgers face hey use futures or options
#peculators participate in the futures market to take up the price risk being avoided by the hedgers. Speculators wish Bto bet on future movements in the price of an asset. .utures and options contracts can give them an e"tra leverageC that is, they can increase both the potential gains and potential losses in a speculative venture. #peculators provide the necessary li)uidity and depth to the market. Arbitrageurs watch the spot and futures markets and whenever they spot mispricing between the two markets they enter to get the e"tra profit in a risk4free transaction. Arbitrageurs force spot and futures prices to have a difference which is e)ual to the cost of carrying the assets bought in the spot market for delivery in the future market on the stipulated day of delivery in the contract. Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for e"ample, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. Arbitrageurs strive to make risk4less profit by simultaneously transacting in two markets to capitali'e on the price differential between them.
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CHAPTER II: - TYPES OF DERIVATIVES
he most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. <ere we take a brief look at broad classification of derivatives contracts that have come to be used. Derivatives fall broadly into two groups, in terms of structure of trading, settlement systems and characteristics of the contracts( @ver4 the4counter and 2"change4traded derivatives. he distinction is important because each market carries distinct legal and credit4risk
Derivatives
Exchangetraded Derivatives
Over-thecounter Derivatives For ards
Futures
Options
! aps
Futures Options
Options
negotiated by banks and
implications. @ A contracts are privately
investments banks and their clients, and specifically tailored to customer needs, whereas e"change4traded derivatives are traded on a recognised e"change such as the #ydney .uture 2"change or the
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Australian #tock 2"change+s derivative market 0A#DD1, typically using a standard contract specification. Aounterparty risk is much less of a concern for e"change4traded instruments because of the role of the clearing house 0each trader+s e"posure is to the clearing house, not to another market participant1 whereas with @ A derivatives counterparty risk is an important feature.
1. E4CHANGE-TRADED DERIVATIVES Derivatives have probably been around for as long as people have been trading with one another. .orward contracting dates back at least to the 59th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Although early forward contracts in the E# addressed merchants+ concerns about ensuring that there were buyers and sellers for commodities, $credit risk% remained a serious problem. B'a%- '0 T%a-" 0AB@ 1 in 5F=F. o deal with this problem, a group of Ahicago businessmen formed the C+i&a!' he primary intention of the AB@ went one was to provide a centrali'ed location known in advance for buyers and sellers to negotiate forward contracts. In 5FG>, the AB@ step further and listed the first $e"change traded% derivatives contract in the E#C these contracts were called $futures contracts%. In 5656, Ahicago Butter and 2gg Board, a spin4off of AB@ , was reorgani'ed to allow futures trading. Its name was changed to C+i&a!' M"%&a $i/" E5&+a !" 0AM21. he AB@ and the AM2 remain the two largest organi'ed futures e"changes, indeed the two largest $financial% e"changes of any kind in the world today.
1"
he first stock inde" futures contract was traded at 6a sas Ci$) B'a%- '0 T%a-e. Aurrently the most popular inde" futures contract in the world is based on #HI >88 inde", traded on Ahicago Mercantile 2"change. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Inde" futures, futures on 4bills and 2uro4Dollar futures are the three most popular futures contracts traded today. @ther popular international e"changes that trade derivatives are LI..2 in 2ngland, D B in Jermany, #JD in #ingapore, I..2 in Kapan, MA I. in .rance, etc.
2. OTC DERIVATIVES MAR6ETS 2"change traded derivatives dominated the 5678s and 56F8s, but in the last decade the @ver the Aounter or @ A market grew so )uickly that it is now much larger than the e"change4traded market. he @ A derivatives markets have witnessed rather sharp growth over the last few years, which have accompanied the moderni'ation of commercial and investment banking and globalisation of financial activities. he recent developments in information technology have contributed to a great e"tent to these developments. ,hile both e"change4traded and @ A derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their @ A derivative positions were the main cause of turbulence in financial markets in 566F. originating in features of @ A derivative instruments and markets. he @ A derivatives markets have the following features compared to e"change4traded derivatives( hese episodes of turbulence revealed the risks posed to market stability
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5. 9. ;. =.
he management of counter4party 0credit1 risk is decentrali'ed and here are no formal centrali'ed limits on individual positions, here are no formal rules for risk and burden4sharing, here are no formal rules or mechanisms for ensuring market
located within individual institutions, leverage, or margining,
stability and integrity, and for safeguarding the collective interests of market participants, and >. he @ A contracts are generally not regulated by a regulatory authority and the e"change+s self4regulatory organi'ation, although they are affected indirectly by national legal systems, banking supervision and market surveillance. #ome of the features of @ A derivatives markets embody risks to financial market stability. he following features of @ A derivatives markets can give rise to instability in institutions, markets, and the international financial system( 0i1 the dynamic nature of gross credit e"posuresC 0ii1 information asymmetriesC 0iii1 the effects of @ A derivative activities on available aggregate creditC 0iv1 the high concentration of @ A derivative activities in ma-or institutionsC and 0v1 the central role of @ A derivatives markets in the global financial system. Instability arises when shocks, such as counter4party credit events and sharp movements in asset prices that underlie derivative contracts, occur, which significantly alter the perceptions of current and potential future credit e"posures. ,hen asset prices change rapidly, the si'e and configuration of counter4party e"posures can become unsustainably large and provoke a rapid unwinding of positions. here has been some progress in addressing these risks and perceptions. <owever, the progress has been limited in implementing
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reforms in risk management, including counter4party, li)uidity and operational risks, and @ A derivatives markets continue to pose a threat to international financial stability. he problem is more acute as heavy reliance on @ A derivatives creates the possibility of systemic financial events, which fall outside the more formal clearing house structures. Moreover, those who provide @ A derivative products, hedge their risks through the use of e"change traded derivatives. In view of the inherent risks associated with @ A derivatives, and their dependence on e"change traded derivatives, Indian law considers them illegal.
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CHAPTER III: - FORWARDS
1. FORWARDS E4P7AINED Derivatives in the form of forward contracts have been used for centuries. .orward trading by written contract is recorded as early as the si"th century BA in Jreece. .orward contracts, as well as being one of the earliest forms of derivatives, are also one of the simplest. A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. It is an agreement, made today, to buy something in the future for a fi"ed price. @ne of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. he other party assumes a short position and agrees to sell the asset on the same date for the same price. @ther contract details like delivery date, price and )uantity are negotiated bilaterally by the parties to the contract. outside the e"changes. he forward contracts are normally traded he owner of the forward contract has the he price to be paid for the asset is he price is fi"ed at
obligation to buy the underlying asset 0or commodity1 at a fi"ed date in the future for a fi"ed price. termed the delivery price or the contract price.
inception and does not change over the period of the contract. A forward contract is a customi'ed contract between two entities, where settlement takes place on a specific date in the future at today+s pre4agreed price.
An e"ample of a .orward Aontract( Aonsider the e"ample of buying a house. 3ormally there is a period between the signing of purchase contract and my taking the possession of the property. his contract to purchase the house is an
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e"ample of a forward contract. In other words, I agree now to buy the house in three months time and to pay the agreed purchase price at that time. he seller also agrees now to sell me the house in three months time. I am the long forward contract here in this case.
2. SA7IENT FEATURES hey are bilateral contracts and hence e"posed to counter*party risk. 2ach contract is custom designed, and hence is uni)ue in terms of contract si'e, e"piration date and the asset type and )uality. he contract price is generally not available in public domain. @n the e"piration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter4party, which often results in high prices being charged. <owever forward contracts in certain markets have become very standardi'ed, as in the case of foreign e"change, thereby reducing transaction costs and increasing transactions volume. his process of standardi'ation reaches its limit in the organi'ed futures market. .orward contracts are very useful in hedging and speculation. he
classic hedging application would be that of an e"porter who e"pects to receive payment in dollars three months later. <e is e"posed to the risk of e"change rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. #imilarly an importer who is re)uired to make a payment in dollars two months hence can reduce his e"posure to e"change rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the
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cash market. he speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. #peculators may well be re)uired to deposit a margin upfront. <owever, this is generally a relatively small proportion of the value of the assets underlying the forward contract. markets here supplies leverage to the speculator. he use of forward
3. PROB7EMS IN FORWARD MAR6ET .orward markets world4wide are afflicted by several problems( Lack of centrali'ation of trading Illi)uidity, and Aounter party risk In the first two of these, the basic problem is that of too much fle"ibility and generality. he forward market is like a real estate market in that any two consenting adults can form contracts against each other. his often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non4tradable. Aounterparty risk arises from the possibility of default by any one party to the transaction. ,hen one of the two sides to the transaction declares bankruptcy, the other suffers. 2ven when for4ward markets trade standardi'ed contracts, and hence avoid the problem of illi)uidity, still the counterparty risk remains a very serious issue.
*. PRICING FORWARD CONTRACTS he no4arbitrage principle can be used to estimate the contract price. ,e do this by constructing a portfolio that has e"actly the same payoff as the forward contract on the delivery date. his portfolio is known as the replicating portfolio. he portfolio that replicates the forward contract consists of positions in the underlying asset and a risk4free
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security.
he
reasury bill is an e"ample of a riskless security. It pays
a fi"ed amount of money at a fi"ed date in the future without any risk. o make matters simple, we assume that the underlying asset makes no cash payments such as dividends. ,e will show that the replicating portfolio consists of a long position in the underlying asset and a short position in a risk4free bond. his risk4 free bond matures at the delivery date of the forward contract and it pays an amount e)ual to the contract price. It should be noted that at this point we do not know the value of the contract price 4 this is what we are looking for. ,e can regard the contract price as a )uantity that will be determined later. ,e now check what this portfolio is worth on the delivery date of the forward contract. he value of the portfolio, at contract maturity, will be the market value of the asset at the delivery date less the amount of the contract price. <owever, this value corresponds e"actly to the market value of a long forward position. he market value of the long he forward position at delivery is e)ual to the market price of the asset minus the amount that has to be paid, namely the contract price. replicated the forward contract at the delivery date. ,e now show that this approach enables us to find the contract price. .rom the no4arbitrage rule we know that the initial market price of the replicating portfolio must be e)ual to the initial market value of the forward contract. <owever, we know the initial market value of the forward contract. ,hen a forward contract is set up it is designed so that it does not favour either party, there is no cash transferred at inception and the initial market value of the contract is 'ero. By the no4arbitrage rule, the initial market value of the portfolio that replicates the forward contract is also 'ero. the contract price. ,e are now able to find it. he initial market value of the replicating portfolio -ust contains one thing that we do not know( replicating portfolio has therefore lived up to its name( it has
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A numerical e"ample may help to clarify this point. Aonsider a newly initiated forward contract with a delivery date one year from today. he current market price of the underlying asset is &#.588. Assume the riskfree interest rate is >L. he contract price can be computed using the above argument. ,e have e"plained that the market value of the replicating portfolio is 'ero. <owever, this means that the current market value of the asset 0&#.5881 is e)ual to the current market value of a risk4free bond that pays the contract price in one year. hey are both e)ual to &#.588 and therefore the current value of a bond that pays the contract price is also e)ual to &#.588. he risk4 free interest rate in this market is >L so the maturity value of the one4year bond is &#.58>. <ence the contract price under the forward contract is &#.58>. he contract price is e)ual to the accumulated amount obtained by investing the initial asset price over the term of the contract at the risk4free rate. ,e can compute it from the initial price of the asset and the risk4free interest rate. works )uite well in practice. his simple formula
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CHAPTER IV: - FUTURES

1. INTRODUCTION TO FUTURES .utures markets were designed to solve the problems that e"ist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardi'ed and e"change traded. o facilitate li)uidity in the futures contracts, the e"change specifies certain standard features of the contract. It is a standardi'ed contract with standard underlying instrument, a standard )uantity and )uality of the underlying instrument that can be delivered, 0or which can be used for reference purposes in settlement1 and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an e)ual and opposite transaction. More than 66L of futures transactions are offset this way. .utures are contracts to buy or sell a specified )uantity of the underlying assets at a price agreed upon by the buyer H seller, on a specified date. Both the buyer and the seller are obligated to buy/sell the underlying asset. #o if Mr. D bought &eliance futures at &s. >68 and if the market price on e"piry is say >>8, even then Mr. D will have to purchase the stock at >68. <e loses &s. 9=888 0&s. =8 " G881 from this transaction as the &eliance futures are traded in lots of G88 shares. Also, on the upside if the market prices on e"piry would have been G;8, he would gain &s. 9=888. A future contract is a binding obligation, enforceable at law, re)uiring delivery of a specific )uantity of a specific type of good, at an agreed price, place and time. A future contract can be terminated at any time before it is due for delivery by selling 0if trader were holding a bought contract1 or buying 0if trader were holding a sold contract1.
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he standardi'ed items in a futures contract are( 4 Muantity of the underlying Muality of the underlying he date and the month of delivery he units of price )uotation and minimum price change Location of settlement
#uccessive increase in the prices of oil, fluctuating interest rates, rising inflation and switch from fi"ed to floating e"change rates focused attention on the need to protect against unforeseen movements in interest rates and currencies and, more recently, share prices. And .inancial futures came forward as a product of these global economic upheavals of the 5678s. .inancial futures have been the source of growth in the futures industry over the last two decades. he chief users of financial futures are( Institutions which generate financial instruments 0e.g. Bills of e"change. Bonds and shares1 hose who trade the financial instruments0banks, investment banks, investment institutions and some individuals1 Borrowers and lenders, fund managers, importers, e"porters and manufacturers Investors and speculators.
2. FUTURES TERMINO7OGY
2"
S,'$ ,%i&": he price at which an asset trades in the spot market. F1$1%"s ,%i&": futures market. C' $%a&$ &)&/": he period over which a contract trades. he inde" he price at which the futures contract trades in the
futures contracts on the 3#2 have one4month, two4months and three4 months e"piry cycles, which e"pire on the last hursday of the month. hursday of hus a Kanuary e"piration contract e"pires on the last
Kanuary and a .ebruary e"piration contract ceases trading on the last hursday of .ebruary. @n the .riday following the last hursday, a new contract having a three4month e"piry is introduced for trading. E5,i%) -a$": It is the date specified in the futures contract. will cease to e"ist. C' $%a&$ si8": is 988 3ifties. Basis: In the conte"t of financial futures, basis can be defined as the futures price minus the spot price. be positive. prices. C's$ '0 &a%%): carry. he relationship between futures prices and spot here will be a different basis for each delivery month for each contract. In a normal market, basis will his reflects that futures prices normally e"ceed spot he amount of asset that has to be delivered under his is
the last day on which the contract will be traded, at the end of which it
one contract. .or in4stance, the contract si'e on 3#2+s futures market
prices can be summari'ed in terms of what is known as the cost of his measures the storage cost plus the interest that is paid to he amount that must be deposited in the margin finance the asset less the income earned on the asset. I i$ia/ #a%!i : initial margin. Ma%ki !-$'-#a%k"$: In the futures market, at the end of each trading day, the margin ac4count is ad-usted to reflect the investor+s gain or loss depending upon the futures closing price. marking*to*market. his is called
account at the time a futures contract is first entered into is known as
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Mai $" a &" #a%!i : margin.
his is somewhat lower than the initial
his is set to ensure that the balance in the margin account
never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is e"pected to top up the margin account to the initial margin level before trading commences on the ne"t day. B"$a: Beta is a concept to be used in using futures and options for hedging. Beta measures the sensitivity of a share or a portfolio to that of the inde". Beta of a share is found out by relating the daily price changes of a share to the daily changes in a stock price inde". If a graph is drawn with daily changes of the share price on y a"is and daily changes in the inde" on " a"is the slope of the straight line fitted will be the value of beta. Mathematically it is found by regression method. If the beta of company A is found to be5.9;, it implies if the inde" increases by 58L in a period, price of company A will increase by 59.;L. Beta of the portfolios is found by weighted average of the betas of the shares in the portfolio. .or e"ample, an investor+s portfolio has e)ual value in company A and company B. Aompany A has a beta of 5.9; and company B has a beta 5.;7. of beta for a large number of shares. he portfolio beta is the average of 5.9; and 5.;7 which is 5.;. 3#2 website is providing values
3. PAYOFF FOR FUTURES
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.utures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. hese linear payoffs are fascinating as they can be combined with options and the underlying to generate various comple" payoffs. Pa)'00 0'% .1)"% '0 01$1%"s: 7' ! 01$1%"s he payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. <e has a potentially unlimited upside as well as a potentially unlimited downside. ake the case of a speculator who buys a two4month 3ifty inde" futures contract when the 3ifty stands at 5998. he underlying asset in this case is the 3ifty portfolio. ,hen the inde" moves up, the long futures position starts making profits, and when the inde" moves down it starts making losses. Pa)'00 0'% s"//"% '0 01$1%"s: S+'%$ 01$1%"s he payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. <e has a potentially unlimited upside as well as a potentially unlimited downside. the 3ifty stands at 5998. ake the case of a speculator who sells a two4month 3ifty inde" futures contract when he underlying asset in this case is the 3ifty portfolio. ,hen the inde" moves down, the short futures position starts making profits, and when the inde" moves up, it starts making losses.
*. STOC6 INDE4 FUTURES
27
In the case of stock inde" futures contract the underlying asset is the specified stock inde". A futures contract on the stock market inde" gives its owner the right and obligation to buy or sell the portfolio of stocks characteri'ed by the inde". contract. o facilitate li)uidity in the futures contracts, the e"change specifies certain standard features of the he standard contracts once bought can be sold at any time to s)uare off the position till the date of e"piry of the contract. #imilarly, once a futures contract is sold, it can be bought back at any time to s)uare off the position. hus a futures contract may be offset prior to maturity by entering into an e)ual and opposite transaction. More than 66L of futures transactions are offset this way. #tock inde" futures are cash settledC there is no delivery of the underlying stocks. In their short history of trading, inde" futures have had a great impact on the world+s securities markets. Indeed, inde" futures trading have been accused of making the world+s stock markets more volatile than ever before. he critics claim that individual investors have been driven out to the e)uity markets because the actions of institutional traders in both the spot and futures markets cause stock values to gyrate with no links to their fundamental values. ,hether stock inde" futures trading is a blessing or a curse is debatable. It is certainly true, however, that its e"istence has revolutioni'ed the art and science of institutional e)uity portfolio management. he main differences between commodity and e)uity inde" futures are that( N here are no costs of storage involved in holding e)uity. 2)uity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock. herefore, Aost of carry O .inancing cost 4 Dividends hus, a crucial aspect of dealing with e)uity futures as opposed to commodity futures is an accurate forecasting of dividends. he better
28
the forecast of dividend offered by a security, the better is the estimate of the futures price.
9. USING INDE4 FUTURES H"-!i !: I//1s$%a$i' ,'%$0'/i' #ometimes, you may have a view that the market will fall in the future. At other times, you may feel that the market is going to have a few days of massive volatility, and you do not want to bear that amount of volatility. he union budget, and period of onset of monsoon etc. are such events. Many investors do not want to speculate on such events. ,hen investors have such an"ieties, stock inde" futures provides a convenient alternative to remove e"posure to the stock market for a short time. Investors having a portfolio can sell the stock inde" futures and have an hedged position. Wa% i !: <edging does not always make money. If the inde" has gone up in stead of going down futures position will show a loss and the investor has to fund it if re)uired by reducing his portfolio. he best that can be achieved using hedging is the removal of unwanted e"posure. he hedged position will make less profits than the un4hedged position, half the time. he investor should adopt this strategy for the short periods of time where the market volatility that he anticipates makes him uncomfortable, or when he plans to sell his holdings in the near future. I//1s$%a$i' 2: B1) s$'&k i -"5 01$1%"s $' +"-!" ,/a $+" 01$1%" "1: S"//i ! s$'&k i -"5 01$1%"s $' ,%'$"&$ $+"
,1%&+as" '0 ":1i$) s+a%"s i
29
A mutual fund has received large amount of funds which are to be invested in the stock market. he fund managers need time to research stocks and carefully pick stocks that are e"pected to do well. After selecting the stocks, they cannot rush to the market and place orders to buy as it would generate large Pimpact costs+. he e"ecution would be improved substantially if they could instead place limit orders and accumulate the shares at favorable places. But all this effort takes time, and during this time the market may go up. Inde" futures offer a convenient way of ac)uiring e"posure to the stock market. he mutual fund can buy futures contracts for the value of the funds to be invested immediately. As and when its buys the shares it wants it can sell contracts e)ual to that amount. his hedging ensures that the fund will buy the shares it wants close to their current prices. Any increase in the market would be compensated by the profits it makes on the futures position. @nce again it is to be noted that if market goes down in price, the mutual fund does not benefit. he hedge locks in the prices. <edger does not lose if prices go up. <e does not gain if prices come down. @ptions provide an opportunity to the hedger to en-oy profits if the market moves in a favorable position and protect him if the market moves in an unfavorable position.
I//1s$%a$i'
3:
H"-!"-
/' !
,'si$i'
s+a%"
;7' !
S$'&k<S+'%$ F1$1%"s=
30
A stock picker picks a share to outperform the market due to reasons specific to the stock. A position in that stock may not provide profit to him if the general market goes down. 2very buy position on a stock is simultaneously a buy position on the general market. he e"posure to hen the general market can be removed by selling an inde" future.
the position becomes a focused play on the performance of the stock. he earliest hedge funds were involved in similar hedging strategies only. 2"ample( 1. An investor wants to ac)uire a long position of &s. 5million in isco. he current market price of &s.59>. he beta of isco is 5.9; according the 3#2 site. 2. <ence he re)uires a short position of &s.5.9; million on the 3ifty futures market to totally remove his 3ifty e"posure. 3. 3ifty futures with August maturity are available at 5866. 2ach contract will have a value of &s. 9,56,688. > contracts of 3ifty futures need to be sold. 0 he actual value is >.>6. &ounding was done on the lower side1. *. ,ith this hedge if 3ifty goes down, investor will not suffer as his short position in futures will earn him the profit. <e will have the benefit of relative performance of isco to the market.
I//1s$%a$i' 01$1%"s=
*:
H"-!"-
s+'%$
,'si$i'
;S+'%$
s$'&k<7' !
31
#tock pickers may be good in identifying shares likely to have a bad performance in the market. heir short positions in such shares may not yield them profits because of a rise in the general market. #tock pickers can create hedged short positions by combining the short position in the stock with a long position in the inde" future. hedged long position in the stock. S,"&1/a$i' #peculators buy and sell derivatives to make profit, while hedgers buy and sell derivatives to reduce risk. #peculators are vital to derivatives markets. hey facilitate hedging and provide li)uidity. It is highly unlikely that hedger wishing to buy futures will precisely match hedgers selling futures in terms of contracts to be traded. If hedgers are net sellers there will be tendency for futures prices to fall. #peculators will buy such under priced futures. #uch purchases by speculators allow net sales on the part of hedgers. In so doing, they tend to maintain price stability since they are buying into a falling market. Iroper speculation thus provides stability to prices in markets. In a li)uid market, hedgers can make their transactions with ease and with little impact costs. #peculative transactions add to market li)uidity. #peculators by definition do a lot of information search and processing to forecast future behavior of prices. herefore they make markets more informationally efficient. In the stock inde" futures markets speculators have two alternative strategies. If they are bullish on the inde" they can go long on inde" futures. If the spot prices go up, future prices follow them along with their carry premiums and the speculators make the profits. he mechanics of this strategy are e"actly similar to the creating of a
32
If the speculator is bearish he can go short on the inde" futures. If the spot inde" goes down, futures price also will go down and speculator makes a profit. he two speculative strategies can be summari'ed as( B1//is+ Ma%k"$ - 7' ! i -"5 01$1%"s B"a%is+ Ma%k"$ - S+'%$ i -"5 01$1%"s
A%.i$%a!" i
01$1%" a - s,'$ #a%k"$s
.uture prices and spot prices are tightly linked by the fair price formula. Also on the day of the e"piry, the final settlement price of the future is made e)ual to the spot inde" price. hus at the end, the spot and futures prices converge. Any deviation between the fair price and actual price of a future can be utili'ed for earning risk less profits by agents who are willing to buy in the spot market and deliver in the future market at e"piry. #uch operations are called as arbitrage operations. Buying in the spot and delivering in the future market is resorted to when the actual futures price in the market is higher than the fair price. If the actual futures price is lower than the fair price, then futures are bought and shares are sold in the spot market to carry out the arbitrage operation. hese arbitrage operations can also be viewed as lending money to the market and borrowing money from the market using one+s holding of shares. >. SUMMING UP STOC6 INDE4 FUTURES In many countries stock inde" futures is a very popular contract with trading volumes being e)ual to the volume of the entire cash market in shares. #tock market participants have to study the stock inde" futures so that they can use the market appropriately when they find an opportunity to make use of it for hedging, speculating or arbitraging.
33
?. DIFFERENCE BETWEEN FUTURES AND OPTIONS .orward contracts are often confused with futures contracts. he
confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. .uture and forward are similar in nature but are not same as they appear. .utures are nothing but a form of forward contract. It is a standardised contract, traded on an organi'ed e"change. <owever futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more li)uidity. .ollowing are some key factors which show how they are different( .utures are traded on 2"change while .orwards are @ A in nature .uture contract are #tandardised and forward are customised, tailor made contracts. erms of .uture contract are decided by e"change on which they are traded but terms of a forward contract are negotiated between buyer and seller In .uture contracts the e"change becomes the counter party to each trade and guarantees settlement, while in .orward contracts there is risk of counter party default. .utures are more li)uid compared to forwards, and their price is transparent as their price and volumes are reported in the media. A future contract can be reversed on the screen of the e"change as the latter is the counter party to all futures trades but a forward contract can be reversed with only the same counter party with whom it was entered into. .utures re)uire margin payments while forwards don+t.
CHAPTER V: - OPTIONS
3"
1. INTRODUCTION TO OPTIONS An @ption is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. ,hile a buyer of an option pays the premium and buys the right to e"ercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer e"ercises it on him. @ptions are of two types 4 Aalls and Iuts options( $Aalls% give the buyer the right but not the obligation to buy a given )uantity of the underlying asset, at a given price on or before a given future date. E5a#,/": Mr. Q is bullish on Infosys and buys one call option of strike price of &s. >>88 after paying a premium of &s. ;888 0say &s G8 " lot si'e of Infosys i.e.>8 shares1. If the stock price on the e"piry day is more than the break even point of &s >>G8 0&s. >>88 R &s. G81, he will make a total profit of ST0#pot price * #trike price1 * IremiumU " lot si'eV. <owever if the price falls below >>88, e"ercising this option does not make sense and the whole premium is lost. $Iuts% give the buyer the right, but not the obligation to sell a given )uantity of underlying asset at a given price on or before a given future date. E5a#,/": Mr. Q feels <LL is overvalued and buys one put option of strike price of &s. 5>8 after paying a premium of &s. =;>8 0say &s =.;> " Lot si'e of <LL i.e. 58881. If the stock price on the e"piry day is less than the break4even point of &s 5=>.G> 0&s. 5>8 4 &s. =.;>1, he will make a profit of ST0#trike price * #pot Irice1 * IremiumU " Lot si'eV. <owever, if the price rises above 5>8, e"ercising this option does not make sense and the whole premium is lost.
35
Iresently #HI A3D 3ifty @ptions and options on certain specified securities are available for trading at 3#2. All the options contracts are settled in cash. @ptions are fundamentally different from forward and futures hus on
contracts. An option gives the holder of the option the right to do something. he holder does not have to e"ercise this right. the e"piry of day of the contract the option may or may not be e"ercised by the buyer. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. ,hereas it costs nothing 0e"cept margin re)uirements1 to enter into a futures contract, the purchase of an option re)uires an up*front payment.
2. OPTION TERMINO7OGY I -"5 ',$i' s: hese options have the inde" as the underlying.
#ome options are 2uropean while others are American. Like inde" futures contracts, inde" options contracts are also cash settled. S$'&k ',$i' s: #tock options are options on individual stocks. @ptions currently trade on over >88 stocks in the Enited #tates. A contract gives the holder the right to buy or sell shares at the specified price. B1)"% '0 a ',$i' : he buyer of an option is the one who by
paying the option premium buys the right but not the obligation to e"ercise his option on the seller/writer. W%i$"% '0 a ',$i' : he writer of a call/put option is the one who
receives the option premium and is thereby obliged to sell/buy the asset if the buyer e"ercises on him. here are two basic types of options, call options and put options. Call option( A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option( A put option gives the holder the
36
right but not the obligation to sell an asset by a certain date for a certain price. O,$i' ,%i&": @ption price is the price which the option buyer pays
to the option seller. E5,i%a$i' maturity. S$%ik" ,%i&": A#"%i&a he price specified in the options contract is known as -a$": he date specified in the options contract is known
as the e"piration date, the e"ercise date, the strike date or the
the strike price or the e"ercise price. ',$i' s: American options are options that can be
e"ercised at any time upto the e"piration date. Most e"change4traded options are American. E1%',"a ',$i' s: 2uropean options are options that can be
e"ercised only on the e"piration date itself. 2uropean options are easier to analy'e than American options, and properties of an American option are fre)uently deduced from those of its 2uropean counterpart. I -$+"-#' ") ',$i' : An in4the4money 0I M1 option is an option that would lead to a positive cash flow to the holder if it were e"ercised immediately. A call option on the inde" is said to be in4the4 money when the current inde" stands at a level higher than the strike price 0i.e. spot price W strike price1. If the inde" is much higher than the strike price, the call is said to be deep I M. In the case of a put, the put is I M if the inde" is below the strike price. A$-$+"-#' ") ',$i' : An at4the4money 0A M1 option is an option that would lead to 'ero cash flow if it were e"ercised immediately. An option on the inde" is at4the4money when the current inde" e)uals the strike price 0i.e. spot price O strike price1. O1$-'0-$+"-#' ") ',$i' : An out4of4the4money 0@ M1 option is an option that would lead to a negative cash flow it was e"ercised immediately. A call option on the inde" is out4of4 the4money when the current inde" stands at a level which is less than the strike price 0i.e.
37
spot price X strike price1. If the inde" is much lower than the strike price, the call is said to be deep @ M. In the case of a put, the put is @ M if the inde" is above the strike price. Ti#" (a/1" '0 a ',$i' : he time value of an option is the
difference between its premium and its intrinsic value. A call that is @ M or A M has only time value. Esually, the ma"imum time value e"ists when the option is A M. have no time value. he longer the time to e"piration, the greater is a call+s time value, all else e)ual. At e"piration, a call should
3. USES OF OPTIONS Like futures options are also used for hedging and speculation. Arbitrageurs can look for mispricing between spot, option and futures markets and do transactions whenever they find mispricing. H"-!i ! Buying a call option can be seen as a means of ensuring a ma"imum purchase price. .rom the table on premiums on inde" options it can be seen that a person buying a Kuly call at a strike price of 5588 by paying a premium of 96.78 inde" points is ensuring a ma"imum cost of 5596.78 for ac)uiring shares in Kuly. Buying a put option provides a minimum selling price for the e"isting stock portfolio. A person buying a Kuly put on 3ifty inde" at a strike price of 5588 by paying a premium of 96 inde" points is ensuring a minimum recovery of 5875 points at the end of Kuly as against a current spot market price of 586G.;>. ,hy is this investor buying a put by paying a premiumY <e is e"pecting a rise in the inde". But he is taking precaution on the side by agreeing to sell the inde" at 5588 after paying a premium of 96 inde" points. his is e)uivalent to a future price of 5875 points 055884961. But the difference is that in the
38
case of a futures contract, if the market rises the investor will not get any benefit. @n the contrary he has to pay everyday mark4to4market payments. ,ith options he is assured of his downside income and can be very happy if there is an upside. It is clear that options will be used only when there is uncertainty as to the direction of price movement. .utures are preferable if the hedgers believe that the balance of probabilities is that the stock price will fall. he option becomes a possible choice if the hedger either has no view as to future movements or believes a rise to be more likely. hus a hedger will use options only in the event of believing that the stock price movement is uncertain, but more likely to be favorable than unfavorable. #ome investors can sell call options when they are mildly bearish. .or e"ample, an inde" fund can sell Kune 3ifty call options at a strike price of 5598 and take in a premium of G.9> inde" points. If the view taken is correct when the 3ifty goes down from the current level the fund has an income of G.9> inde" points to compensate the slide in inde". A hedging strategy using options may involve buying an option paying premium and also selling an option receiving premium. As a part of hedging operation an investor can buy a Kune call on 3ifty inde" at 5588 by buying a premium of 59.;>. <e can sell a Kune call at 55G8 and receive a premium of 9.88 inde" points. In this case, the investor is reducing his cost of hedging by showing willingness to forego the benefit of upside at 55G8. Actually investor+s view is that inde" may go above 5588 but it may not go above 55G8.
T%a-i ! '% S,"&1/a$i ! 3i$+ ',$i' s
39
@ptions provide multiple opportunities for trading. @ptions premiums are determined by volatility of the underlying asset, time to e"piration of the option and the risk free interest rate. Ahanges in any of these variables changes option premiums even though the price of the underlying asset remains constant. hus a speculator who analyses multiple dimensions has a lot more opportunity in options to strategi'e and act. #ome of these possible trading strategies are presented below.
A%.i$%a!" 3i$+ O,$i' s Arbitrage involves making risk less profits from mispricingC relatively under priced options are bought and relatively overpriced are sold. Iure arbitrage re)uires that none of the arbitragers+ own capital is used. <e should be able to borrow all the capital re)uired. If the arbitrager uses his own capital, the process is called )uasi4arbitrage. here will be number of situations providing arbitrage opportunity as three markets, spot, futures and options are involved. @ne of the simple arbitrage opportunities which arises when options premium is beyond its lower bound is described here.
*. OPTION TRADING STRATEGIES
"0
Vi"3 :ery bullish :ery bearish Mildly bullish H sure of no
T%a-i ! s$%a$"!) Buy Aall Buy Iut #ell Iut Buy a Aall with #trike Irice D and #ell a Aall with #trike Irice higher than D0Bull #pread1 Buy a Iut and buy a Aall at the same #trike Irice0Buy a #traddle1 #ell a Iut and #ell a Aall at the same #trike Irice 0#ell a #traddle1 #ell 3ear Month Aall, Buy Longer4 Month out4of4the4money Aall #ell Aall #ell a Aall with #trike Irice D and Buy a Aall with #trike Irice higher than D 0Bear #pread1 in near4 #ell 3ear4Month Iut and Buy Longer4 month out4of4the4money Iut Buy Iut 0<edge1 #ell a Iut at lower level of the band and #ell a Aall at the higher level of the band 0#ell #trangle1 only moderately #ell two Aalls at #trike Irice D. Buy
downtrend Mildly bullish Hfairly sure of no downtrend there1 Market movements to be big in either way Market movements to be narrow Bearish in near4term 0weeks1 but bullish in longer term 0months1 Market will not rise, mildly bearish Moderately bearish H fairly sure that the market will not rise 0uncertainty e"ists1 Moderately term0months1 Bearish and holding the stock 3eutral, but prices might fluctuate in a small band 3eutral, but bullish 0but uncertainty is
term0weeks1 and bearish in longer
"1
certain that prices will not fluctuate much 0uncertainty is there1 3eutral H short4term weakness but longer term rally e"pected 3o significant movement e"pected, but holds stock
one Aall at #trike Irice lower than D. Buy one Aall at #trike Irice higher than D.0Long Butterfly1 #ell 3ear4month Aall and Buy Longer4 month Aall with the same #trike #ell Aall 0Aovered Aall1 Buy an out4of4the4money Aall
2"pects prices to be very volatile
Buy an out4of4the4money Iut Buy #trangle1 Buy wo Aalls #ell a Aall with #trike
Market will be volatile within a range
Irice at the bottom of the range. #ell a Aall with #trike Irice at top of the range. #hort Butterfly1
9. OPTION PAYOFFS AND POSITIONS
Besides offering fle"ibility to the buyer in form of right to buy or sell, the ma-or advantages of options is their versatility. hey can be as conservative or as speculative as oneZs investment strategy dictates. #ome of the benefits of @ptions are as under(
"2
<igh leverage as by investing small amount of capital 0in form of premium1, one can take e"posure in the underlying asset of much greater value.
Ire4known ma"imum risk for an option buyer. Large profit potential and limited risk for option buyer. @ne can protect his e)uity portfolio from a decline in the market by way of buying a protective put wherein one buys puts against an e"isting stock position. his option position can supply the insurance needed to overcome the uncertainty of the market place. <ence, by paying a relatively small premium 0compared to the market value of the stock1, an investor knows that no matter how far the stock drops, it can be sold at the strike price of the put option anytime until the put e"pires.
2.g. An investor holding 5 share of Infosys at a market price of &s. ;F88/4 thinks that the stock is overpriced and decides to buy a put option at a strike of &s. ;F88/4 by paying a premium of &s. 988/4. If the market price of Infosys comes down to &s. ;888/4, he can still sell it at ;F88/4 by e"ercising his put option. hus, by paying premium of &s. 988, his position is insured in the underlying stock.
,hile using options there are basically four options a investor can take. hese are known as option payoffs. hese four options are e"plained with the help of graphs. hese four payoffs are
Buying a call option
"3
<ere @A 4 @ption Iremium 2 4 2"ercise Irice # 4 #hare Irice he investor must understand that the potential loss associated with buying a call option is limited to the cost of the option, but the potential gain is unlimited.
,rite a call @ption
""
<ere @A 4 @ption Iremium 2 4 2"ercise Irice # 4 #hare Irice he potential gain to the writer of a call option is limited to the premium received, but the potential losses in unlimited
"5
Buy a put option
,rite a put @ption
"6
<ere @A 4 @ption Iremium 2 4 2"ercise Irice # 4 #hare Irice

Jains and losses on put options are limited because the price of the underlying stock can not fall below 'ero. he gain of the option buyer is the loss of the option writer and vice versa.
>. HOW DO FUTURES DIFFER FROM OPTIONS@
.utures 2"change defines the
@ptions #ame as futures. #trike price is fi"ed, price moves. Irice is always positive. 3onlinear payoff. @nly short at risk.
product Irice is 'ero, strike price moves Irice is 'ero Linear payoff Both long and short at risk
An interesting )uestion to ask at this stage is 4 when would one use options instead of futuresY @ptions are different from futures in several interesting senses. At a practical level, the option buyer faces an interesting situation. <e pays for the option in full at the time it is purchased. After this, he only has an upside. paid for the option1. here is no possibility of the options position his is different from futures, which is free to generating any further losses to him 0other than the funds already
"7
enter into, but can generate very large losses.
his characteristic
makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions. Buying put options is buying insurance. o buy a put option on 3ifty is to buy insurance, which reimburses the full e"tent to which 3ifty drops below the strike price of the put option. his is attractive to many people, and to mutual funds creating $guaranteed return products%. he 3ifty inde" fund industry will find it very useful to make a bundle of a 3ifty inde" fund and a 3ifty put option to create a new kind of a 3ifty inde" fund, which gives the investor protection against e"treme drops in 3ifty.
CHAPTER VI - SWAPS
#waps are private agreements between two parties to e"change cash flows in the future according to a prearranged formula. hey can be
"8
regarded as portfolios of forward contracts. swaps are( Interest rate swaps( Currency swaps(
he two commonly used
hese entail swapping only the interest
related cash flows between the parties in the same currency. hese entail swapping both principal and interest
between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. A contract between two parties, referred to as counter parties, to e"change two streams of payments for agreed period of time. he payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. #waps contracts also include other provisional specified by the counter parties. #waps are not debt instrument to raise capital, but a tool used for financial management. A swap is an over4the4counter 0@ A1 contract between two parties, with each agreeing to e"change his or her respective obligations. #waps are arranged in many different currencies and different periods of time. E#[ swaps are most common followed by Kapanese yen, sterling and Deutsche marks. transacted has ranged from 9 to 9> years. he length of past swaps
1. DEVE7OPMENT AND GROWTH Before the advent of swaps, a lender providing fi"ed4rate term funds was locked into the conditions of the loan for the specified term. Many
"9
suffered when market rates rose 0if market risk had not been covered in some way1 because they were unable to vary their charges. Aredit4 tiering resulted in rigidities. .or e"ample, governments would have access to fi"ed4interest markets where, as long4term borrowers, they preferred predictable interest costs. At the other end of the spectrum would be companies which, with the e"ception of top4class credits, could not raise fi"ed4term funds because those lending to them preferred to provide floating, rate finance. In between were the banks, which by and large lent at floating rates because this matched the mostly floating4rate nature of their borrowings, and the institutions, which borrowed long4term fi"ed4rate funds as a counterpart to their long4term investments. #waps brought a way to manage these cash flows more fle"ibly. #waps enable a state government borrower, for e"ample, to raise floating4rate debt at a cheaper rate than through traditional sourcesC at the same time they provide companies with access to fi"ed4rate finance4if that is what better suits each partyZs cash flow. he determining factor is that traders and company treasurers4anyone managing cash flows4cannot afford to ignore the risks associated with funding fi"ed assets with floating4rate liabilities, or [A liabilities with yen assets. #uch practices could involve opportunity costs, or worse. #wap techni)ues have been used increasingly in Australia since the mid456F8s. he two main categories are interest4rate swaps and he currency swaps, with interest4rate swaps by far the larger.
development of the swaps market was a response to restrictions on international capital flows 0and was also fuelled by arguments about comparative advantage, domestically and internationally1. currency swaps. Aurrency swaps Zevolved from the parallel and back4to4back loans popular in the late 56G8s and 5678s. In the case of parallel loans, he search for a mechanism to bypass these restrictions led to the emergence of
50
these were structured through, say, a E\ company lending sterling, for a fi"ed term and at a fi"ed rate, to theZ E\ subsidiary of, say, a E# company. Across the Atlantic, the E# company would lend an e)uivalent amount of [E# for the same maturity to the E# subsidiary of the E\ company. his transaction avoided any cross4border movement of funds and so avoided e"change controls. According to #atya-it Das in Swap Financing, this led to the first currency swap in 567G, arranged by Aontinental Illinois and Joldman #achs for a Dutch company and a British company and involving guilders and sterling. he ,orld Bank gave a boost to the use of swaps when it entered into a swap agreement in 56F5 with IBM which enabled IBM to pay the ,orld BankZs [E# obligations while the ,orld Bank serviced IBMZs obligations in #wiss francs and deutschmarks. In Swap Financing, Das writes that the first interest4rate swaps were also arranged in 56F5, initially between Aitibank and Aontinental Illinois. he first swap in Australia was transacted in 56F; between the Aommonwealth Bank and AIDe. Kust over a decade later, in the year to Kune 566=, the total volume of swaps dealt was [A97= billion, =5L higher than last year+s [A56> billion In the late 5678Zs, the first currency swap was engineered to circumvent the currency control imposed in the E\. A ta" was levied on overseas investments to discourage capital outflows. herefore, a British company could not transfer funds overseas in order to e"pand its foreign operations without paying si'eable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. o overcome such a predicament, back4to4back loans were used to e"change debts in different currencies. .or e"ample, a British company wanting to raise capital in the .rance would raise the capital in the E\ and e"change its obligations with a .rench company, which was in a reciprocal position. hough this type of arrangement was providing relief from e"isting protections, one could imagine, the task of locating
51
companies with matching needs was )uite difficult in as much as the cost of such transactions was high. In addition, back4to4back loans re)uired drafting multiple loan agreements to state respective loan obligations with clarity. <owever this type of arrangement leads to development of more sophisticated swap market of today.
2. FACI7ITATORS he problem of locating potential counter parties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counterparty. Dealers work for investment, commercial or merchant banks. !By positioning the swap!, dealers earn bid4ask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer is a counterparty paying fi"ed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fi"ed payments and paying floating rate payments in another swap. A perfectly netted position as -ust described is not necessary. Dealers have the fle"ibility to cover their e"posure by matching multiple parties and by using other tools such as futures to cover an e"posed position until the book is complete. #wap brokers, unlike a dealer do not take on a swap position themselves but simply locate counter parties with matching needs. herefore, brokers are free of any risks involved with the transactions. After the counter parties are located, the brokers negotiate on behalf of the counter parties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counter parties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.
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3. DIFFERENT FORMS OR TYPES OF SWAPS F'%3a%- Ra$" A!%""#" $ A F'%3a%- Ra$" A!%""#" $ ;FRA= is a financial contract between two parties e"changing or swapping a stream of interest payments for a notional principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract 0fi"ed1 and the settlement rate, are made by the parties to one another. he settlement rate is the agreed benchmark/reference rate prevailing on the settlement date. I $"%"s$ Ra$" S3a, Interest4rate swaps form the largest category, accounting for [577 billion out of a total of [97= billion in [A interest4rate and cross4 currency swaps e"ecuted in the year to Kune 566=. An interest4rate swap is a contract between two parties under which they agree to e"change interest payments. Jenerally, this involves the e"change of fi"ed4interest payments for floating4interest payments, or vice versa. An important distinction is that there is no e"change of principal amounts under an interest4rate swap because they are e)ual and in the same currency. Iayments of fi"ed and floating4rate obligations are generally made on the same day and are settled by calculating and paying the cash difference, which reduces the credit e"posure between counterparties and simplifies administration. An I $"%"s$ Ra$" S3a, ;IRS= is a financial contract between two parties e"changing or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap
53
period4Aash payments based on fi"ed/floating and floating rates are made by the parties to one another. Interest4rate swaps he driving feature that makes a swap worthwhile is one partyZs relative credit advantage in a particular market, i.e., it can borrow fairly easily in a number of markets but at especially favourable rates in one. he swap techni)ue enables each party to the transaction to borrow in the market where it achieves the best terms and then e"change the conditions of its borrowings to achieve a lower cost and the desired interest4rate profile. Aompanies usually approach the swaps market to pay fi"ed and receive floating, to generate synthetic fi"ed4rate funding, while state borrowers, which mostly issue fi"ed4interest debt, use swaps to receive fi"ed and pay floating, to raise synthetic floating4rate funding more cheaply than would be available from traditional sources. #waps involving an e"change of fi"ed for floating rates, with interest calculated in arrears, usually pay interest )uarterly or semi4annually. ,hen the interest payment on a swap is calculated using the formula for a discounted bill of e"change, i.e., the discount or Zup4frontZ method, the swap is known as a discounted swap. forward4rate agreement. #waps transacted on an e"change4for4physical 02.I1 basis now accounts for around 68 per cent of inter bank trading. An EFP is the simultaneous purchase and sale of a physical instrument 0including swaps1 with a corresponding opposite futures contract taken out. eachZs discretion. his leaves both parties with a hedged position which can be managed at he formula used when settling a discounted swap is the same as that used for a
P%i&i ! IRS
5"
Interest4rate swaps are generally priced relative to an underlying physical instrument, usually a commonwealth Nor state bond or a 2urobond, or, in the case of shorter swaps4say, up to two years in maturity4off a bond/bill futures strip 0a continuous string of se)uential contracts created by buying or selling futures1. A considerable volume of swaps during the 56F8s was based on the then popular euro4[A bonds, or euro4Aussies. As with other interest rates and prices, swap prices are influenced by supply and demand in the market, with the demand for, and supply of, fi"ed4rate money determining the swap rate. Indicative rates for swaps are displayed on screens and are also published in the daily press. TYPES OF INTEREST RATE SWAP he following are variations of the interest4rate swap. Aomple" versions can be achieved by addingZ e"oticsZ to a standard or ZvanillaZ product. Forward swaps start from a date set in, the future. .or e"ample, a borrower with a debt due to start in three monthsZ time can lock in a fi"ed rate now, instead of waiting until the borrowing is drawn down. .orward swaps could go out as far as a bankZs credit risk and policy will allow, say planning a si"4year swap to start four years hence. Zero-coupon swaps are those in, whichU the fi"ed4interest payment due is paid out as a lump sum, in the form of a ZbulletZ payment, when the swap matures. Amortised and escalating swaps involve a swap where a single swap rate applies to a principal which increases 0with an escalating swap, also known as accreting swap1 or decreases 0with an amortised swap1 over time. asis swaps differ from regular swaps in that they involve an e"change of two different floating interest rates, or fi"ed4rate for fi"ed4rate funds instead of the conventional fi"ed4rate for floating4rate funds. A
55
basis swap involves different time periodsC for e"ample, a company might want to receive floating4rate payments structured on a 684day rollover and make floating4rate payments on a 5F84day rollover. .
!on-par swaps are swaps where the fi"ed and floating rates are based on a non4market interest rate with appropriate cash ad-ustments. "ollercoaster swaps involve a variation of the principal or the coupon during the life of the swap. CURRENCY SWAPS Aross4currency4and4interest4rate swaps, known as currency swaps, where each side is denominated in a different currency, involve an e"change of interest payments in the two different currencies. 0 his differs from the generic Z.DZ swap which is purely a purchase and sale, and, at a pre4agreed rate, a subse)uent sale and repurchase of currency on maturity. he interest differential in this case is handled by adding the forward points to, or subtracting them from, the contract price on maturity.1 .,ith currency swaps the interest differential is handled through mutual e"change of interest flows and. not through the forward points. Aredit risk is a greater issue with currency swaps because principal amounts are swapped and a foreign4 e"change e"posure incurred. Many currency swaps are structured usingN euro4[A bonds and Nother 2uromarkets issues. hese swaps may be on a fi"ed4to4fi"ed, fi"ed4to4floating, or floating4to4floating interest4rate basis. hey are also known, as currency4and4interest4rate swaps. Aurrency swaps can be defined as a legal agreement between two or more parties to e"change interest obligation or interest receipts between two different currencies. It involves three steps( Initial e"change of principal between the counter parties at an agreed upon rate of e"change which is usually based on spot e"change
56
rate. his e"change is optional and its sole ob-ective is to establish the )uantum of the respective principal amounts for the purpose for calculating the ongoing payments of interest and to establish the principal amount to be re4e"changed at the maturity of the swap. @ngoing e"change of interest at the rates agreed upon at the outset of the transaction. &e4e"change of principal amount on maturity at the initial rate of e"change. his straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency.
C1%%" &) S3a,s i
I -ia
&BI in its slack season credit policy Z67 allowed the authori'ed dealers to arrange currency swap without its prior approval. his was to enable those re)uiring long4term forward cover to hedge themselves without altering the e"ternal liability of the country. Irior to this policy &BI had been approving rupee foreign currency swaps between corporates on a case basis, but no such swaps were taking place. &BI in its process of making the Indian corporates globally competitive has simplified their access to this instrument by making changes in its credit policy. But despite an easing regulation, swaps have not hit the market in a big way. India has a strong dollar4rupee forward market with contracts being traded for one, two, and si"4month e"piration. Daily trading volume on this forward market is around [>88 million a day. Indian users of hedging services are also allowed to buy derivatives involving other currencies on foreign markets. @utside India, there is a small market
57
for cash *settled forward contracts on the dollar *rupee e"change rate. ,hile studying swaps in the Indian conte"t, the counter parties involved are Indian corporates and the swap dealers are the Authori'ed dealers of foreign e"change, i.e., the banks allowed by &BI to carry out the swaps. hese banks form the counterparty to the corporates on both sides of the swap and keep a spread between the interest rates to be received and offered. @ne of the currencies involved is the Indian rupee and the other could be any foreign currency. he interest rate on the rupee is most likely to be fi"ed, and on foreign currency it could be either fi"ed or floating.
COMMODITY SWAPS Aommodity swaps have emerged as risk4management tools for the 5668s, propelled by the same factors that drove the popularity of currency and interest4rate swapsC volatility and uncertainty4this time, volatility and uncertainty in the price of, say( oil, gold, wool, .wheat or cotton. #o far, most Australian activity has been in oil swapsC gold, aluminum and copper tend to be traded forward rather than swapped. he bulk of commodity swaps volume is handled overseas, although Australian consumers 0refiners and those with big transport costs1, do hedge their oil costs. Airlines have been ma-or users of oil swaps. A commodity swap enables a producer to fi" future revenues at a specified level and, on the other side, enables a consumer to set future costs. 2ach gives up any increased income or reduced costs should prices move in his or her favour. Aommodity swaps are similar in, structure to the earlier financial swap. Jiven that the two parties to a commodity swap, produceC and consumer, through an intermediary, e"change a stream of payments 0fi"ed for floating cash flow1 with no, e"change of principal, a commodity swap is more like an interest4rate
58
swap than a currency swap. A bank or investment bank acts as intermediary, bringing the two parties together and taking a spread between payments for bearing the credit risk of each.
EAUITY SWAPS 2)uity swaps would typically be used by a fund manager, institutional e)uity manager or a company to protect the price risk of an e)uity portfolio. An organisation with a diversified share portfolio could use an e)uity swap to convert an unpredictable return on shares into a fi"ed income or a return based on a floating interest4rate indicator. 2)uity swaps, discussed in chapter G, are more common in the E# and 2urope but increasing in use in Australia. hey share the characteristics of a conventional swap such as notional principal, specified term, predetermined payments made at intervals, a fi"ed rate 0swap coupon1 and an e"change of income streams by the parties to the swap.
MACROECONOMIC SWAPS Macroeconomic swaps are designed to hedge against macroeconomic risk, i.e., whereas an, interest4rate swap provides protection against a specific risk4interest4rate risk4a macroeconomic swap provides protection against general business risk such as a downturn in economic activity. Macroeconomic swaps were first proposed in 5665 in the E# by Marshall, Bansal, <erbst and ucker as tools for wo essential companies wishing to hedge against business4cycle risk.
ingredients are a suitable macroeconomic inde", such as the AII 0consumer price inde"1 or JDI 0gross domestic product1 and an ade)uate degree of correlation between the inde" and the hedging companyZs earnings. An e"ample of a macroeconomic swap would be a
59
fi"ed4for4floating swap where the floating4leg payment is based on a macroeconomic inde" or a floating4for4floating swap in which one leg is pegged to a macroeconomic inde" and the other to a floating rate of interest. Macroeconomic swaps are like conventional swaps in that they comprise a notional principal, swap coupon 0fi"ed rate1, regular payments and specified term.
*. SWAPS PRICING here are four ma-or components of a swap price. Benchmark price Li)uidity 0availability of counter parties to offset the swap1. ransaction cost Aredit risk #wap rates are based on a series of benchmark instruments. hey
may be )uoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIB@&, 5=, 65, 5F9 H ;G= day 4bills, AI rates and IL& rates. Li)uidity, which is function of supply and demand, plays an important role in swaps pricing. especially so in India his is also affected by the swap duration. It ransaction costs include the cost of hedging a . may be difficult to have counter parties for long duration swaps, swap. #ay in case of a bank, which has a floating obligation of 65 days . Bill. 3ow in order to hedge the bank would go long on a 65 day Bill. .or doing so the bank must obtain funds. would thus involve such a difference. Qield on 65 day . Bill 4 6.>L Aost of fund 0e.g. 4 &epo rate1 * 58L he transaction cost
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he transaction cost in this case would involve 8.>L Aredit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. #ay for e.g. it would be 8.>L for an AAA rating.
9. SWAP MAR6ET PARTICIPATIONBS #ince swaps are privately negotiated products, there is no restriction on who can use the market. <owever, parties with low credit )uality have difficulty entering the market. his is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the E.#. many parties re)uire their counter parties to have minimum assets of [58 million. his re)uirement has become a standardi'ed representation of !eligible swap participants!. Derivatives such as swaps, options and .&As involve two main categories of participants4sellers of, or dealers in, the products 0intermediaries such as banks and investment banks1 and end4users, which covers a wide range including overseas investors, companies, fund managers and state government borrowers. Banks and investment banks market swaps to corporate clients who want to improve their risk4management techni)ues. hese intermediaries play an active role in organising swaps, identifying organisations with offsetting needs, arranging the different forms of financing, negotiating terms, organising documentation and watching market movements to find the right moment at which to e"ecute a deal. Jood timing is important in swaps transactions because even a small movement in a currency or interest rate can make a difference to the fi"ed swap rate, which is the important number in the transaction.
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he intermediaries, usually banks, also have a ZclientZ in their own internal asset and liability management needs. Much business, though, centers on structuring swaps to suit clients. Banks use swaps and other derivatives to manage the interest4rate risks in their own products, for e"ample the offer of a capped or fi"ed housing loan to a retail borrower. Entil recently, retail customers had virtually no access to derivatives but they can benefit from them because derivatives enable the bank to package products and to manage its liabilities more efficiently and to provide a wider choice to customers. By using swaps, an end4user transfers performance 0market1 risk 0but not the underlying position1 to the provider 0intermediary1 who, in return, earns a spread or margin. 2nd4users enter the swaps market for a number of reasons( to achieve a lower cost of funds or higher returns, to hedge an interest4rate or currency e"posure or to improve asset or liability management. In addition, there is an active hroker market in swaps, with brokers acting as agent and earning brokerage for finding the best price. Brokers handle a si'eable volume of interbank businessC however, a bank would not see a corporate deal through a broker because that would involve a weakening of the bank client relationship on which the bank wants to build.
>. THE P7AYERS #waps are instruments, which allow the user to hedge 4 that are to offset risk or to take risk deliberately in the e"pectation of making
62
profit.
he user in this case would be any corporate having a foreign he
e"change e"posure/ a risk. A foreign e"change e"posure will arise out of the mismatch between the currency of inflow and outflow. outflow being considered here is the interest and the principal payment on the borrowings of the corporates. Aorporates having such currency mismatches would be of the following types C'%,'%a$"s 3i$+ %1,"" /'a a - 0'%"5 %"(" 1"
Mainly the e"porters would fall in this category. Aorporates with foreign subsidiaries would also be having fore" revenues but due to cheaper availability of funds abroad, it is unlikely that these hus the main players he main players in the subsidiaries would be funded by a rupee loan. meeting this criterion would be the e"porters. Indian market are 3estle Indian Ltd. among the others. C'%,'%a$"s 3i$+ 0'%"5 /'a a - %1,"" %"(" 1"
ata 2"ports, <industan Levers Ltd., I A Ltd., and
he corporates having foreign currency loan could further be classified into two groups. @ne which have net imports and thus may have raised loans to meet their import re)uirements, for e"ample Bharat <eavy 2lectricals Ltd., Apollo yres Ltd., ata Iower Ao. Ltd. wo, which do not have net imports but have raised foreign currency loan for funding re)uirements, for e"ample Arvind Mills Ltd., Ballarpur Industries etc.
C'%,'%a$"s 3i$+
' 0'%"i!
"5,'s1%"
here may be corporates with no e"isting e"posure but willing to take up an e"posure in an e"pectation of making profit out of this transaction. hus they would be willing to swap their rupee loan with fore" loan and book in forward cover or make the payments on spot
63
basis on the day of disbursements.
hese corporates may also hus many corporates
consider the option of raising new loans in foreign currency and swap a rupee loan if it turns out to be cheaper option. would fall under this category. Ba ks Banks act as the authori'ed dealers and are instrumental in arranging swaps. hey have to take the swaps on their books. A bank would enter into swap with a party and then try to find another with opposite re)uirement to hedge itself against any fluctuation in e"change rates. hey would normally keep a spread between the offer and bid rate thus make profit from transaction. counterparties. hey also take up the credit risk of
?. RIS6S ASSOCIATED WITH SWAPS Jiven the flow of supply and demand, it is unlikely that swaps held by the principals e"actly offset each other, so the principals are e"posed to various types of market riskC they would take steps to hedge such risk. All market prices move according to supply and demand and the swaps market is no e"ception. A principal taking on a swap could hedge against the underlying instrument, although such Za decision would depend on the structure of his or her swaps book. A principal can also ZwarehouseZ a swap until an opposite deal is found. As with other derivatives, swaps do not present new forms of riskC they involve risks with which traders are well familiar, such as those associated with credit, market, li)uidity and documentation. Interest4 rate swaps involve a credit risk which reflects the ability or otherwise of each counterparty to make payments owed under the swaps agreement. 0 his credit risk is less than would be the case with an outright loan because, should a default occur, the counterparty is not e"posed to loss of the principal amount.1 he payments involve the
6"
outlay or receipt of the net differences between the fi"ed and floating rate. Because swaps carry a credit risk, a swap obligation cannot be assigned to another party without the consent of the first coun4 terparty. #utrig$t ris% occurs when a swaps trader is not completely s)uare 0balanced1 but has some e"posure to a particular level of interest rates or change in the slope of the yield curve. asis ris% involves the risk of a movement between the swap and the product used to hedge it. #waps are now managed as warehouses of future cash flows and the price risk of each net future cash flow is hedged.
C. FACTORS TO BE 7OO6ED AT WHI7E DOING A SWAP hough swaps can be used in the above conditions effectively, corporates need to look at a few factors before deciding to swap. T+" "s$i#a$""$ "5,'s1%"
hey need to estimate the net e"posure that they are likely to have in the future. Iro-ecting the growth in e"ports/ imports, taking into account the changes in management and government policies can do this.
E5,"&$"- %a !" '0 "5&+a !" %a$"s his can be determined by a fundamental and technical analysis. .or fundamental analysis one needs to keep track of the balance of payment condition, JDI growth rate, etc. of the country. he technical
65
factors look at past trends and e"pected demand4supply position. @ther factors like political stability also need to be considered. E5,"&$"- i $"%"s$ %a$"s #ince currency swaps include e"change of interest payments, the interest rates also need to be traced. By keeping an eye on the yield curve of long term bonds and the macro economic variables of different countries, the interest rates can be estimated. A#'1 $ '0 &'("% $' ." $ak" <aving estimated the amount of e"posure, the e"pected e"change rates and the interest rates, the parties can determine the risks involved and can decide upon the amount of cover to be taken. his shall depend on the management policy whether they believe in minimi'ing the risk for a given level of return or ma"imi'ing the gain for a given level of risk. he risk taking capability of a corporate will depend upon the financial backup to absorb the losses, if any, the availability of time and resources to monitor the fore" market.
D. OTHER MAEOR DERIVATIVES Wa%%a $s( @ptions generally have lives of upto one year, the ma-ority of options traded on options e"changes having a ma"imum maturity of
66
nine months. Longer4dated options are called warrants and are generally traded over4the4counter. 7EAPS( he acronym L2AI# means Long4 erm 2)uity Anticipation
#ecurities. hese are options having a maturity of upto three years. Bask"$s( Basket options are options on portfolios of underlying assets. he underlying asset is usually a moving average or a basket of assets. 2)uity inde" options are a form of basket options. Derivatives do not have a fi"ed form. Apart from these derivatives, discussed by me, their can be and there are many other forms of derivatives e"isting in the market. hey are usually tailor made and keep on changing their form from time to time as per the need of the hour. Aontinuous engineering in this field of finance help to develop new kind of derivatives which can cater to the demand.
CHAPTER VIII - DERIVATIVES IN INDIAN CONTE4T
1. CURRENT SCENARIO IN INDIA
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he Indian capital market, which was lagging behind developed international markets like E#, #ingapore has seen plethora of changes in the last two years. he most notable being the introduction of derivatives trading, ban on the age old carry forward mechanism, Badla, and the transformation to &olling #ettlement from ,eekly settlement. Derivatives trading were introduced in a phased manner over a period of time with Inde" futures in Kune 9888, Inde" @ptions in April 9885, #tock @ptions in Kuly 9885 and finally Individual stock futures in 3ovember 9885. he Indian derivatives market is in the nascent stage rendering scope for many reforms. Introduction of rolling settlement has already shifted the focus of the speculators to the derivatives market. ,ith the introduction of these reforms, the derivatives market has become too big to be ignored by any serious market participant and it is more likely that the derivatives market volumes would be a multiple of the cash market in the near future. In an efficient market setting the derivatives offers lot of benefits as witnessed in various developed markets. he research is an attempt to evaluate the efficiency of the derivatives market in India. hough no market is 588L efficient, it is imperative to understand the e"tent of inefficiency in the market. .or instance many people use the derivatives market to hedge their risks and lack of knowledge about the e"tent of inefficiency will render the risk management tools ineffective or increase the cost of risk management. he Indian Derivatives is relatively younger and immature compared to other developed markets. he derivatives market was introduced in Kune 9888 with the introduction of Inde" .utures. It was e"pected that a market for derivatives would increase the efficiency of the markets. An efficient and active market is one that promotes speculation, which is a huge source of li)uidity for the markets. hedging would be ideal. direction. herefore, a market that provides opportunities for speculation along with provisions for he derivatives system is a step in this
68
#tarting from a controlled economy, India has moved towards a world where prices fluctuate every day. he introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and &eserve Bank of India+s 0&BI1 efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. 3#2 gauging the market re)uirements initiated the process of setting up derivative markets in India.
UNDERSTANDING THE INDIAN 7OCA7 MAR6ET Looking at Indian markets 4 on one hand, /'&a/ (a%ia $s of call/put options like te&i, mandi, fata% ' na(rana , being illegal are soon going to make way for e)uity derivatives. @n the other hand, we have the indigenous badla or carry forward financing system, often misunderstood to be a derivative. 2ssentially 9 mechanisms of badla work in the market( seedha badla, where the buyer can postpone payment of money 0by paying contango or financing charges to the v)a&badlawala1 and undha badla2 where the seller postpones delivery of shares 0by paying backwardation charges to the malbadlawala*. In the light of the %'/" '0 .a-/a2 it is essential to dispel a myth doing the rounds 4 that futures H options will eventually replace badla. ,hat people fail to understand is that badla H futures are fundamentall) different concepts in themselves and are not even remotely comparable. Badla is purely a means of cash & share financing By enabling the investor to trade in two settlement cycles, badla helps in building a seamless bridge acr ss settlements.
69
he high degree of leverage provided by badla encourages even retail investors to speculate on stocks, thus providing depth H width to the market. hus, to put it in a nutshell, for any e)uity market to function, it does need all of its vital constituents 4 the cas$, the futures, and the stoc% and mone) lending markets. ,hat the B#2+s badla or the 3#2+s ALBM 0Automated Lending H Borrowing Mechanism1 does, is that it integrates the cash, the stock H the money lending markets, which, the e)uity markets -ust cannot do without. Badla is thus here to stay, in the future, and with the futures]
NEED FOR DERIVATIVES IN INDIA TODAY In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. oday, derivatives have become part and parcel of the day4to4day life for ordinary people in ma-or part of the world. Entil the advent of 3#2, the Indian capital market had no access to the latest trading methods and was using traditional out4dated methods of trading. available means of trading. here was a huge gap between the investors+ aspirations of the markets and the he opening of Indian economy has precipitated the process of integration of India+s financial markets with the international financial markets. Introduction of risk management instruments in India has gained momentum in last few years thanks to &eserve Bank of India+s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market. Introduction of Derivatives trading was a ma-or milestone in the Indian capital markets. its introduction. he segment has been very active and growing since .or instance, as on date derivatives trading
constitutes greater than =8L of the total 3#2 volumes. In developed markets derivatives market serve various purposes such as hedging,
70
speculation and arbitrage. In India though the volumes are growing and high, the traders seem to be more of the speculators than hedgers. As figures show, the stock futures, considered the most speculative of the derivative instrument, constitute more than G8L of the total derivatives volumes. .or this scenario to change and for the market to serve all type of players, it has to be highly efficient. 2fficiency of the options H futures markets is key prere)uisite for players to use these as risk management tools. ,e test the efficiency of the market with special focus on pricing of the options. Implied volatility, being the most important and sensitive element of the option pricing, is used as the key indicator. he difference between the volatility of call and put options of similar type is established through statistical tests and smile curves. .inally the empirical findings are substantiated by other subtle measures measure like put4call parity, put4call ratio and e"isting market structure.
MYTHS AND REA7ITIES ABOUT DERIVATIVES IN INDIA In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. .inancial derivatives came into the spotlight along with the rise in uncertainty of post45678, when E# announced an end to the Bretton ,oods #ystem of fi"ed e"change rates leading to introduction of currency derivatives followed by other innovations including stock inde" futures. oday, derivatives have become part and parcel of the day4to4day life for ordinary people in ma-or parts of the world. ,hile this is true for many countries, there are still apprehensions about the introduction of derivatives. here are many myths about derivatives but the realities that are different especially for 2"change traded derivatives, which are well regulated with all the safety mechanisms in place.
71
,hat are these myths behind derivativesY
D"%i(a$i("s i &%"as" s,"&1/a$i' "&' '#i& ,1%,'s" ,hile the fact is...
a - -'
'$ s"%(" a )
3umerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low4cost, effective method for users to hedge and manage their e"posures to interest rates, commodity prices, or e"change rates. he need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. his period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on4line trading in the capital markets, etc. As the comple"ity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. market participants. Looking at the e)uity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock inde" futures and options. An e)uity fund, for e"ample, can reduce its e"posure to the stock market )uickly and at a relatively low cost without selling off part of its e)uity assets by using stock inde" futures or inde" options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, derivatives improve the allocation his situation led to development derivatives as effective risk management tools for the
72
of credit and the sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. 3ow that world markets for trade and finance have become more integrated, derivatives have strengthened these important linkages between global markets, increasing market li)uidity and efficiency and facilitating the flow of trade and finance.
D"%i(a$i("s a%" &'#,/"5 a - "5'$i& i s$%1#" $s $+a$ I -ia i ("s$'%s 3i// +a(" -i00i&1/$) i ,hile the fact is rading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. &eserve Bank of India allows forward trading in &upee4Dollar forward contracts, which has become a li)uid market. &eserve Bank of India also allows Aross Aurrency options trading. .orward Markets Aommission has allowed trading in Aommodity .orwards on Aommodities 2"changes, which are, called .utures in international markets. Aommodities futures in India are available in turmeric, black pepper, coffee, Jur 0-aggery1, hessian, castor seed oil etc. here are plans to set up commodities futures e"changes in #oya 0dollar denominated contracts1 in certain commodities. bean oil as also in Aotton. International markets have also been allowed &eserve Bank of India also allows the users to hedge their portfolios through derivatives e"changes abroad. Detailed guidelines have been prescribed by the &BI for the purpose of getting approvals to hedge the user+s e"posure in international markets. Derivatives in commodities markets have a long history. aegis of Bombay Aotton Ahairman, .orwards he first 1 -"%s$a -i !
commodity futures e"change was set up in 5F7> in Mumbai under the raders Association 0Dr.A.#.3aik, 56GF, Aommission, India, 56G;4GF1. A Markets
73
clearinghouse for clearing and settlement of these trades was set up in 565F. In oilseeds, a futures market was established in 5688. ,heat futures market began in <apur in 565;. .utures market in raw -ute was set up in Aalcutta in 5659. Bullion futures market was set up in Mumbai in 5698. <istory and e"istence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign e"change markets. Jovernment of India has also been facilitating the setting up and operations of these markets in India by providing approvals and defining appropriate regulatory frameworks for their operations. Approval for new e"changes in last si" months by the Jovernment of India also indicates that Jovernment of India does not consider this type of trading to be harmful albeit within proper regulatory framework. his amply proves that the concept of options and futures has been well ingrained in the Indian e)uities market for a long time and is not alien as it is made out to be. 2ven today, comple" strategies of options are being traded in many e"changes which are called te-i4mandi, -ota4 phatak, and bhav4bhav at different places in India 0:ohra and Bagari, 566F1.In that senseC the derivatives are not new to India and are also currently prevalent in various markets including e)uities markets.
T+" "5is$i ! &a,i$a/ #a%k"$ is sa0"% $+a ,hile the fact is
D"%i(a$i("s
,orld over, the spot markets in e)uities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular
7"
day 0 1, you have to settle these trades on the third working day from the date of trading 0 R;1. .utures market allow you to trade for a period of say 5 month or ; months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock e"changes allow the participants to trade during one4week period for settlement in the following week. he trades are netted for the settlement for the entire one4week period. In that sense, the Indian markets are already operating the futures style settlement rather than cash markets prevalent internationally. In this system, additionally, many e"changes also allow the forward trading called badla in Ju-arati and Aontango in 2nglish, which was prevalent in E\. his system is prevalent currently in .rance in their monthly settlement markets. It allowed one to even further increase the time to settle for almost ; months under the earlier regulations. his way, a curious mi" of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. he more efficient way from the regulatory perspective will be to separate out the derivatives from the cash market i.e. introduce rolling settlement in all e"changes and at the same time allow futures and options to trade. his way, the regulators will also be able to regulate both the markets easily and it will provide more fle"ibility to the market Iarticipants. In addition, the e"isting system although futures in addition, the e"isting system although futures style, does not ask for any margins from the clients. Jiven the volatility of the e)uities market in India, this system has become )uite prone to systemic collapse. his was evident in the M# #hoes scandal. At the time of default taking place on the B#2, the defaulting member of the B#2 Mr.^averi had a position close to &s.5F crores. <owever, due to the default, B#2 had to stop trading for a period of three days. At the same time, the Barings Bank failed on #ingapore Monetary 2"change
75
0#IM2D1 for the e"posure of more than E# [ 98 billion 0more than &s.F=,888 crore1 with a loss of appro"imately E# [ 688 million 0 around &s.;,F88 crore1. Although, the e"posure was so high and even the loss was also very big compared to the total e"posure on M# #hoes for B#2 of &s.5F crores, the #IM2D had taken so much margins that they did not stop trading for a single minute.
2. EAUITY DERIVATIVES IN INDIA - AN OVERVIEW
@ A 2MEI Q D2&I:A I:2#
raditionally e)uity derivatives have a long history in India in the
@ A market.
@ptions of various kinds 0called
e-i and Mandi and .atak1 in un4
organi'ed markets were traded as early as 5688 in Mumbai
he #A&A however banned all kind of options in 56>G.
OTC DERIVATIVE MAR6ETS TODAY
he prohibition on options in #A&A was removed in 566>. .oreign currency options in currency pairs other than &upee were the first options permitted by &BI.
76
he &eserve Bank of India has permitted options, interest rate swaps, currency swaps and other risk reductions @ A derivative products.
Besides the .orward market in currencies has been a vibrant market
in India for several decades.

In addition the .orward Markets Aommission has allowed the setting
up e.g.
of
commodities
futures
e"changes. of
oday
we trade
have
5F
commodities
e"changes
most
which
futures.
he Indian Iepper and #pice
raders Association 0II# A1 and
the Aoffee @wners .utures 2"change of India 0A@.2I1.

In 9888 an amendment to the #A&A e"panded the definition of
securities to included Derivatives thereby enabling stock e"changes to trade derivative products.
he year 9888 will herald the introduction of e"change traded e)uity derivatives in India for the first time.
EAUITY DERIVATIVES E4CHANGES IN INDIA

In the e)uity markets both the 3ational #tock 2"change of India Ltd.
03#21 and he #tock 2"change, Mumbai 0B#21 have applied to #2BI for setting up their derivatives segments.
77
he e"changes are e"pected to start trading in #tock Inde" futures by mid4May 9888.
3. BSE AND NSE Both the e"changes have set4up an in4house segment instead of setting up a separate e"change for derivatives.
B#2+s Derivatives #egment, will start with #ense" futures as it+s first
product.
3#2+s .utures H @ptions #egment will be launched with 3ifty futures
as the first product.
P%'-1&$ S,"&i0i&a$i' s BSE-3F S" s"5 F1$1%"s

Aontract #i'e 4 &s. >8 times the Inde"
ick #i'e 4 8.5 points or &s. > hursday of the month
2"piry day 4 last
#ettlement basis 4 cash settled Aontract cycle 4 ; months Active contracts 4 ; nearest months
P%'-1&$ S,"&i0i&a$i' s SGP CN4 Ni0$) F1$1%"s

Aontract #i'e 4 &s. 988 times the Inde"
ick #i'e 4 8.8> points or &s. 58
78
DERIVATIVES IN INDIA 2"piry day 4 last
hursday of the month
#ettlement basis 4 cash settled Aontract cycle 4 ; months Active contracts 4 ; nearest months
M"#."%s+i,
Membership for the new segment in both the e"changes is not
automatic and has to be separately applied for.

Membership is currently open on both the e"changes. All members will also have to be separately registered with #2BI
before they can be accepted.
79

Derivatives in India

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DERIVATIVES IN INDIA

CHAPTER I: - BASICS OF DERIVATIVES

3. FUNCTIONS OF DERIVATIVES IN THE ECONOMY

S,"&1/a$'%s : @pportunists Aapture market movements Increase profitability.

A%.i$%a!"1%s: 2arning profit without taking risk.

CHAPTER II: - TYPES OF DERIVATIVES

Over-thecounter Derivatives For ards

implications. @ A contracts are privately

located within individual institutions, leverage, or margining,

CHAPTER III: - FORWARDS

reasury bill is an e"ample of a riskless security. It pays

CHAPTER IV: - FUTURES

account at the time a futures contract is first entered into is known as

Mai $" a &" #a%!i : margin.

his is somewhat lower than the initial

his is set to ensure that the balance in the margin account

3. PAYOFF FOR FUTURES

*. STOC6 INDE4 FUTURES

,1%&+as" '0 ":1i$) s+a%"s i

01$1%" a - s,'$ #a%k"$s

T%a-i ! '% S,"&1/a$i ! 3i$+ ',$i' s

*. OPTION TRADING STRATEGIES

Vi"3 :ery bullish :ery bearish Mildly bullish H sure of no

term0weeks1 and bearish in longer

2"pects prices to be very volatile

Market will be volatile within a range

9. OPTION PAYOFFS AND POSITIONS

Buying a call option

,rite a call @ption

Buy a put option

,rite a put @ption

<ere @A 4 @ption Iremium 2 4 2"ercise Irice # 4 #hare Irice

>. HOW DO FUTURES DIFFER FROM OPTIONS@

.utures 2"change defines the

enter into, but can generate very large losses.

he two commonly used

hese entail swapping only the interest

C1%%" &) S3a,s i

he user in this case would be any corporate having a foreign he

ata 2"ports, <industan Levers Ltd., I A Ltd., and

basis on the day of disbursements.

hese corporates may also hus many corporates

CHAPTER VIII - DERIVATIVES IN INDIAN CONTE4T

1. CURRENT SCENARIO IN INDIA

,hat are these myths behind derivativesY

T+" "5is$i ! &a,i$a/ #a%k"$ is sa0"% $+a ,hile the fact is

2. EAUITY DERIVATIVES IN INDIA - AN OVERVIEW

@ A 2MEI Q D2&I:A I:2#

raditionally e)uity derivatives have a long history in India in the

e-i and Mandi and .atak1 in un4

organi'ed markets were traded as early as 5688 in Mumbai

he #A&A however banned all kind of options in 56>G.

OTC DERIVATIVE MAR6ETS TODAY

Besides the .orward market in currencies has been a vibrant market

in India for several decades.

he Indian Iepper and #pice

raders Association 0II# A1 and

the Aoffee @wners .utures 2"change of India 0A@.2I1.

EAUITY DERIVATIVES E4CHANGES IN INDIA

as the first product.

P%'-1&$ S,"&i0i&a$i' s BSE-3F S" s"5 F1$1%"s

ick #i'e 4 8.5 points or &s. > hursday of the month