Chapter 27 Derivatives and Option Pricing Theory 987

Same as Index Same as Index Same as Index

Last Thursday

month
futures futures futures
epiry
the As stipulated by As stipulated by
of Same as Index
Permilted lot size
20 futures NSE (not less than NSE (not less than
200 &
multiples
Rs. 2 lakhs) Rs. 2 lakhs)
Is
t h e r e o f

Re. 0.05
Re. 0.05
Theoretical value Previous day closing Same as Index
Prerious day value of underlying options
of the options
closing
contract arrived security.
Nifty value. Black-
at based on
Scholes model.
16 Daily close price Daily settlement price Same as Index
Daily settlement options

price Operating ranges Operating ranges

Operating ranges are kept at 99% of
43 awYueni Operating r a n g e s
996 ot arekept at + 20%
+ 10%
are kept at the base price.
693 N rA a n d s

are kept at the base price as individual

20,000 units or
Lower of 1% of market Same
wide position limit futures
units (
20,000

freeze greater stipulated for open

antity greater
00 or Rs. 5 c r o r e s
positions

Derivatives
Iraded
0TC and txchange Exchange Traded
stinction Between
9

Over-The-Counter
Futures and options.
etc
Rlures

Floors, Collars,
Swaps
Forwards, Caps, like NSE, BSE
who Organized exchanges
amp
of market
makers in capital markets
Networks consisting and other exchanges
and negotiate like Chicago,
Narket
information
around the world
exchange price Kansas City and
others.
transactions. New York,
Standardized contracts
needs to
Custom-tailored to meet specific
AgTeements within accepted guidelines.
counter-parties Guaranteed contract performance.
counter-parties.
Default/credit risk to the in
SEBI guidelines
Risk Regulated by
regulated by
Not formally regulated. India. US exchanges
Regulation Commodity Futures Trading
Commission (CFTC).
settlement and intra-day
have electronic Daily electronically posted
prices
market-some
Ability to value Varies by individual inquiry
posting, others require
and valuation.

Commodities Exchangesink a for

fluctuations. The reasons
considerable degree of
market, the prices undergo These imbalances.
na commodity be crop failure, bad weather and demand-supply
the farmers and industries
ce fluctuations may
in turn lead to price risk.
This price risk is largely borne by
ctuations hedge
materials. If the participants agamst
commodities are used as raw with agrieul
Where agricultural fluctuations associated
able to insulate against the inherent to use tne
price risk, they will be of the simplest methods to hedge is
ural commodities, keeping this in mind,
o n e

Commodity exchanges as a trading platform.

 988 Part Two: Advanced Financial Management
A buy or sell anything, it only
commodity exchange is like a stock exchange. It does not on provi
a
platform members to buy and sell. It deals with
to contracts agricultural commoditieshede
metals and minerals. Manufacturers, producers, mining companies, traders, brokers and m
companies/processors use the commodity exchange. On the other hand, a stock exchange
trading platform for financial products. Manufacturers are those in the metal businessand
processing. Producers are represented by farmers. Mining companies/processors deal
essential minerals such as coal, aluminium. A trader is a person who buys and sells a comml
and a broker is a member of the market place who represents thetrader and in exchangerecei
a commission for the service. The commodities provides an efficient and low-cost marketi
platform for commodities. Besides, members can get worldwide price information and a me
to the risk of losing money due to price fluctuation. The
limit isprice determined demand
by
Supply, and it is not the decision of the commodity exchange. In a commodity exchange actend
physical products that are non-financial in nature agro products such as wheat, castc
groundnutorsesame, industrial products such as aluminium, zinc, nickel and also precious meta
like gold and silver are traded. etals

Commodity Futures
A commodity futures is a contractual agreement between two parties to buy or sell a
specified
quantity and quality of commodity at a certain time in the future at a certain price agreed upon
at the time of entering into the contract on the
commodity futures exchange. The primary
objective for any futures exchange are effective price discovery and effticient price risk manage
ment. An investment commodity is
generally held for investment purposes whereas
commodities are held mainly for consumption purposes. Gold and silver can be consumption
investment commodities whereas oil and steel can be classified as classified as
There are basically two markets consumption commodities.
present within the commodities markets, the cash market and
futures market. The cash market is the market for
buying and selling physical commodity at a
negotiated price. Delivery of the commodity takes place immediately. While the futures market
is the market for buying and
selling standardized contracts of the commodity at a predetermined
price. Delivery of the commodity takes place during a future
option of delivery is exercised. delivery period of the contract if the
The Foreign Currency Regulation Act (FCRA) defines commodities as
property other than actionable claims, money and securities. every kind of movable
commodity spot and derivatives (futures). If any one takes a Commodity trading is the trading in
future performance of buy or sell
position based on the
agricultural commodities or commodities like gold, silver
then it is done by metals or crude,
trading in commodities derivatives. Commodities
National Commodity and Derivative derivatives are traded on
(MCX). Trading in commodity futuresExchange (NCDEX), and the Multi-Commodity Exchange
is quite similar to
markets, long position and short position can be taken by the equity futures trading. Like in equit
equivalent the case of the commodity
in hedgers and speculators. The SEBI
In 1952, Forward Contracts trading markets is the 'Forward Markets Commisston.
established in 1953 under theRegulation Act was passed and the
Forward Market Commission
1990s, futures trading in all Ministry Consumer Affairs and Public Administration. Till the was
of
the
economy took place in 1991, major commodities
late
following which
was
futures prohibited/suspended. Liberalizationo
ties. The National
Agricultural Policy was announcedtrading was permitted in several
in July 2000. It commou
allowing futures trading in agricultural emphasized the neea
Futures trading was permitted in all the commodities for risk
management
commodities from April 2003. and price discoy
level commodity exchanges were Accordingly, three nau
established viz,
(a) National Commodity and Derivative
(b) National Multi Commodity ExchangeExchange Ltd. (NCDEX)
(NMCE)
(c) Multi Commodity Exchange (MCX)
 Chapter 27 Derivatives and Option Pricing Theory 989

dhe above rthree national exchanges, there are about 20regional commodity exchanges
above
the
Artfrom

stablished
in India namely-

a (Commodity
) Haryana Exchange, Hissar
Commodity Exchange Bikaner
Bikaner

Association, Jaipur
a Bullion
rendranagar Cotton Oil & Oilseeds Association, Surendranagar
Rajikc Seeds, Oilseeds and
Seeds, Ooil: Bullion Merchants Association, Rajkot
a Rajkot Commodity Exchange, Ahmedabad
Ahmedabad
Mumbai
BombayCommodity Exchange,
East India Cotton.Association Ltd, Mumbai
) Mumbai
Ltd.,
E-Sugar India
Ltd., Bhatinda
0
(0
Bhatinda O1 Exchange
) Vijay
Beopar Chamber, Muzaffarnagar
Commodities Exchange, Meerut
2) Meerut Agro
of Commerce, Hapur
(13) Chamber
Oil and Oilseeds Exchange, Delhi
Rajdhani
14
(15) E-Commodities, Delhi
Jute and Hessian Exchange, Kolkata
(16) The East India
Commercial Exchange, Gwalior
(17) Central India
(18) The Spices and Oilseeds Exchange, Sangli
Kochi
(09) India Pepper and Spice Trade Association,
Kochi
20) First Commodity Exchange of India Ltd.,
are 100 commodities available
Inallthese national and regional commodity stock exchanges there
tor trading. Some of them are named as below
Mustard seed, Cotton seed, Sunflower, Rice bran,
a) Edible oilseed complexes Groundnut,
Soya oil etc.
6) Food grains : Cereals, Pulses, Maize etc.
) Metals: Gold, Silver, Copper, Zinc, Aluminium etc.

(0) Spices: Turmeric, Pepper, Cardamom etc.

) Fibres: Cotton, Jute etc.

0) Energy:Crude oil, Natural gas etc.

8) Others: Cotton seed, Sugar, Jaggery, Rubber etc.

risk borne by farmers and those engaged in the

Ctuations in the commodity prices are a major
processing industry in India. These prices
witness tluctuationsand volatilities on a large scale.
be attributed to the following factors:
t y in agricultural commodities can

Seasonality of the crops

Weather-related impacts on the crops
Availability of stocks
Supply and demand situation
Need*Or
fo Regulation of Commodity Derivatives Market
The gulation of commodity derivatives market is required for the following reasons:
l o ensure that markets efficiently perform the twin economic fluctuations of price discov

ery and price risk management.

 991
Chapter 27 Derivatives and Option Pricing Theory

Swaps

ean be defined as the exchange of one stream of futurc cashflow with another strcam o
sap vith different characteristics. A swap is an agrecment between two or more pecople/
h exchange sets of cashflows over a period in future. Swaps are agreements on the hnes
ayfor you, if youll pay for me. The principle involved here is referred to as maiching
s assets and liabilities that will move up or down together. Swaps can be anyo
hecause. creates
the following categories:

Only-Swaps These are typically used for hedging loan transactions. If a corporate
persinYen and wants to swap the loan into US$ or Rupee, it could opt for a product like
eng-only-swaps (POS). This helps you movethe principalfrom one currency to another. Most
have
mnanies, who have gone for external commercial borrowings (ECBs) denominated in Yen,
oforaPOS.This locks in their liability by moving the loan from Yen to Dollar, which protects
the against the Dollar-Yen exchange rate movements.
interest rate swap is an agreement whereby one party exchange one set of
Mterest Rate Swaps An
for another. In interest rate swaps, only interest rate part of the loan is
interest rate payments
considered. If a company takes a view that the interest rates are going to be higher and if it has
horrowed in floating rate, say linked to the LIBOR, then it could do an interest rate swap-it pays
converts a floating rate
a fixed rate ánd receives a floating rate from the bank. This effectively
when they expect
liability into a fixed rate liability. Companies enter into interest rate swaps
interest rates to move up or down. When they expect interest rates to move up, they would do a
rate from the bank, and pay a fixed rate. Similarly, when
Swap by which they willreceive a floating
a fixed rate from
they expect interest rates to fall, they would do a swap by which they will receive
the bank, and have to pay a floating rate. Most common arrangement is an exchange of fixed
interest rate payment for another rate over a time period. The interest rates are calculated on
notional values of principals

Currency Swaps The currency swaps are arrangements whereby

currencies exchanged
are ata
The is a derivative instrument
specitied exchange rates and specified intervals. currency swap
which takes care of both, principal-only-swap and interest rate swap, together. If a company haas
borowed in US $ and wants to convert it into a Rupee loan, it can do a currency swap, wherein
t will receive from the bank the principal and interest in US $, and pay the bank a fixed Rupee
interest rate and also freeze its principal payment for the entire tenure of the loan. Effectively, the
Dollar loan becomes a Rupee loan in Indian rupees.
CarryTrade Swap In a carry trade swap, a company can move from a higher interest rate currency
0a lower interest rate currency and rather than hedging the full currency risk through forward
contract which wouldeliminatethe carry, it can reduce the cost of hedging by buying options with
aknock-out (an option which ceases to exist if a knock-outevent happens anda particular level
shit-ike Yenhittinga particular level againstthe Dollar). As long as the knock-out doesn't happen,
nen the company has to buy the Swiss franc/Yen at the market rate prevailing on the date of
1aturity and settle the deal on maturity and hence will get expoSed to the currency fluctuation
Ween the US dollar and Swiss franc or between the US dollar and Japanese yen. Banks use
rous permutations and combinations to structure products and create a payoff (risk-reward

quation) that a client is comfortable.

Credit Derivatives
In
recent years credit derivatives have evolved as major risk management tools. The new
ternational rules of the Basle Accord, 1988 that brought credit derivatives into existence. Basle
torms requiredbanksto set aside some part of their capital against their loans. Banks seeking to
Feducetheirexposureand related risk-based capital requirements to corporate credits have found