Derivative Management

TWO MARKS

1 Meaning: A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. Its a contract which derives the value from the underlying asset. The underlying asset may be stock/bond/currency or commodity. 2. Definition: A derivative is a financial instrument whose value changes in relation to changes in a variable, such as an interest rate, commodity price, credit rating, or foreign exchange rate. It also requires either a small or no initial investment, and it is settled at a future date. It allows an entity to speculate on or hedge against future changes in market factors at minimal initial cost. 3. Forward contracts:

A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India). Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place. Forward contracts suffer from poor liquidity and default risk.

4. Future contracts

Future contracts are organized/ standardized contracts, which are traded on the exchanges. These contracts, being standardized and traded on the exchanges are very liquid in nature. In futures market, clearing corporation/ house provides the settlement guarantee

5. Options Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.

6. Index Futures

Index futures are the future contracts for which underlying is the cash market index. For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE may launch a future contract on "S&P CNX NIFTY".

7. Operators in the derivatives market

Hedgers - Operators, who want to transfer a risk component of their portfolio. Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-pricing.

8. Derivatives Markets Derivatives markets broadly can be classified into two categories, those that are traded on the exchange and those traded one to one or over the counter. They are hence known as

Exchange Traded Derivatives OTC Derivatives (Over The Counter)

9. OTC Equity Derivatives

Traditionally equity derivatives have a long history in India in the OTC market. Options of various kinds (called Teji and Mandi and Fatak) in un-organized markets were traded as early as 1900 in Mumbai The SCRA however banned all kind of options in 1956.

10. Equity Derivatives Exchanges in India

In the equity markets both the National Stock Exchange of India Ltd. (NSE) and The Stock Exchange, Mumbai (BSE) have applied to SEBI for setting up their derivatives segments. The exchanges are expected to start trading in Stock Index futures by mid-May 2000.

11. BSEs and NSEs plans

Both the exchanges have set-up an in-house segment instead of setting up a separate exchange for derivatives. BSEs Derivatives Segment, will start with Sensex futures as its first product. NSEs Futures & Options Segment will be launched with Nifty futures as the first product.

12. Product Specifications BSE-30 Sensex Futures

Contract Size - Rs. 50 times the Index Tick Size - 0.1 points or Rs. 5 Expiry day - last Thursday of the month Settlement basis - cash settled Contract cycle - 3 months Active contracts - 3 nearest months

13. Product Specifications S&P CNX Nifty Futures

Contract Size - Rs. 200 times the Index Tick Size - 0.05 points or Rs. 10 Expiry day - last Thursday of the month Settlement basis - cash settled Contract cycle - 3 months Active contracts - 3 nearest months

14. Settlement and Risk Management systems

Systems for settlement and risk management are required to satisfy the conditions specified by the L.C. Gupta Committee and the J.R. Verma committee. These include upfront margins, daily settlement, online surveillance and position monitoring and risk management using the Value-at-Risk concept.

15. Index Futures and cost and carry model In the normal market, relationship between cash and future indices is described by the cost and carry model of futures pricing. Expectancy Model of Futures pricing

S F E(S) - Expected Spot prices.

Spot Future

prices. prices.

Expectancy model says that many a times it is not the relationship between the fair price and future price but the expected spot and future price which leads the market. This happens mainly when underlying is not storable or may not be sold short. For instance in commodities market. E(S) can be above or below the current spot prices. (This reflects markets expectations) Contango market- Market when Future prices are above cash prices. Backwardation market - Market when future prices are below cash prices.

16. Relationship between forward & future markets

Analyze the different dimensions of Forward and Future Contracts: (Risk; Liquidity; Leverage; Margining etc....) Assign value to each factor to arrive at the contract price. (Perception plays a crucial role in price determination) Any substantial difference in the Forward and Future prices will trigger arbitrage.

17. Risk management through Futures

Basic objective of introduction of futures is to manage the price risk. Index futures are used to manage the systemic risk, vested in the investment in securities.

18. Hedge terminology

Long hedge- When you hedge by going long in futures market. Short hedge - When you hedge by going short in futures market. Cross hedge - When a futures contract is not available on an asset, you hedge your position in cash market on this asset by going long or short on the futures for another asset whose prices are closely associated with that of your underlying. Hedge Contract Month- Maturity month of the contract through which hedge is accomplished. Hedge Ratio - Number of future contracts required to hedge the position.

19. Some specific uses of Index Futures

Portfolio Restructuring - An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of Index Futures. Index Funds - These are the funds which imitate/replicate index with an objective to generate the return equivalent to the Index. This is called Passive Investment Strategy.

20. Speculation in the Futures market

Speculation is all about taking position in the futures market without having the underlying. Speculators operate in the market with motive to make money. They take: Naked positions - Position in any future contract. Spread positions - Opposite positions in two future contracts. This is a conservative speculative strategy

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21. Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate the price discovery in the market. 22. Arbitrageurs in Futures market Arbitrageurs facilitate the alignment of prices among different markets through operating in them simultaneously. 23. Margining in Futures market
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Whole system dwells on margins: Daily Margins Initial Margins Special Margins

24. Daily Margins

Daily margins are collected to cover the losses which have already taken place on open positions. Price for daily settlement - Closing price of futures index. Price for final settlement - Closing price of cash index. For daily margins, two legs of spread positions would be treated independently. Daily margins should be received by CC/CH and/or exchange from its members before the market opens for the trading on the very next day. Daily margins would be paid only in cash.

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25. Initial Margins

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Margins to cover the potential losses for one day. To be collected on the basis of value at risk at 99% of the days. Different initial margins on: Naked long and short positions.

Spread positions.

26. Expected advantages of derivatives to the cash market

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Higher liquidity Availability of risk management products attracts more investors to the cash market. Arbitrage between cash and futures markets fetches additional business to cash market. Improvement in delivery based business. Lesser volatility Improved price discovery.

27. L C Gupta Committee

Appointed on 18th November 1996 To develop appropriate regulatory framework for derivatives trading Focus on financial derivatives and in particular, equity derivatives Submitted its report in March 1998 Approved by SEBI in May and circulated in June 1998

28. Derivatives Exchanges

Existing exchanges may start Derivative segments or separate exchanges may be set up On-line screen trading with disaster recovery site Per half hour capacity should be 4-5 times the anticipated peak load Independent clearing Corporation/House Online surveillance capability Real-time information dissemination over at least 2 networks Minimum 50 members Separate membership for derivative segment - no automatic membership Separate governing council for derivatives segment Common Governing Council and Governing Board members not allowed Percentage of broker-members in the council to be prescribed by SEBI Chairman cannot carry on broking/dealing business during his term Arbitration and investor grievances cells in 4 regions Adequate inspection capability

30. Regulatory Recommendations

Emphasis on exchange-level regulation SEBI to act as regulator of last resort Modern systems for fool-proof and fail-proof regulation

All members to be inspected SEBI will approve rules, bye-laws and regulations New derivative contracts to be approved by SEBI Exchange to provide full details of proposed contract Economic purposes of the contract Likely contribution to the markets development Safeguards incorporated for investor protection and fair trading

31. Mark to Market and Settlement

Daily settlement of futures contracts Daily settlement price - closing price of futures Final settlement price - closing price of underlying security

32. Daily Mark to Market Stock index futures transactions are settled on a daily basis. Each evening, the closing price would be compared with the closing price of the previous evening and profit or loss computed by the exchange. The exchange would collect or pay the difference to the member-brokers on a daily basis. The broker could further pay the difference to his clients on a daily basis. Alternatively, the broker could settle with the client on a weekly basis (as daily fund movements could be difficult especially at the retail level). 33. Cash V/s Futures Market

CC - full novation i.e. Counterparty to each trade Value at risk - 99% confidence Daily settlement through EFT Trading and Clearing members Certification requirement Higher capital adequacy and deposit Compulsory collection of margins from clients Segregation of clients funds Shifting of positions to other members Client registration, risk disclosure document and ethical sales practices Inspection of all members SEBI approval for new contracts

34. J R Varma Committee Report

Constituted in June 1998 Submitted its report in Nov 1998 Objectives - recommend measures for risk containment in the Indian derivative market Opertionalise the recommendations of the L C Gupta Committee

35.

Options: Is it just Another Derivative Options on stocks were first traded on an organized stock exchange in 1973. Since then there has been extensive work on these instruments and manifold growth in the field has taken the world markets by storm. This financial innovation is present in cases of stocks, stock indices, foreign currencies, debt instruments, commodities, and futures contracts. 36. Options are of two basic types: The Call and the Terminology Put Option

37.A call option give the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this which is called "the call option premium or call option price". 38. A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price". 39. The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called the "Exercise date", "Expiration Date" or the "Date of Maturity". 40. There are two kind of options based on the date. The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date. 41.In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSE 42. Cash settled options are those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery 43. Settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts). 44. Options undertakings Stocks Foreign Currencies Stock Indices Commodities others - Futures Options, are options on the futures contracts or underlying assets are futures contracts. The futures contract generally matures shortly after the options expiration

45. Options Classifications Options are often classified as In the money - These result in a positive cash flow towards the investor At the money - These result in a zero-cash flow to the investor Out of money - These result in a negative cash flow for the investor 46. OPTIONS PRICING

Prices of options are commonly depend upon six factors. Unlike futures which derives there prices primarily from prices of the undertaking. Option's prices are far more complex. The table below helps understand the affect of each of these factors and gives a broad picture of option pricing keeping all other factors constant. The table presents the case of European as well as American Options. 47. SPOT PRICES: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favorable for the buyer. It is the other way round for the seller, more the Spot Price higher are the chances of his going into a loss. In case of a put Option, the payoff for the buyer is max (Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing. 48. STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option. 49. TIME TO EXPIRATION: More the time to Expiration more favorable is the option. This can only exist in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity. 50. VOLATILITY: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table shows all effects on the buyer side of the contract. 51. RISK FREE RATE OF INTEREST: In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices Discounting factor increases making the price fall In case of the put option both these factors increase and lead to a decline in the put value. A higher expected growth leads to a higher price taking the buyer to the position of loss in the payoff chart. The discounting factor increases and the future value become lesser.

In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favorable on the call option. 52. DIVIDENDS: When dividends are announced then the stock prices on ex-dividend are reduced. This is favorable for the put option and unfavorable for the call option. 53. Index An Index is a number used to represent the changes in a set of values between a base time period and another time period. 54. Stock Index A Stock Index is a number that helps you measure the levels of the market. Most stock indexes attempt to be proxies for the market they exist in. Returns on the index thus are supposed to represent returns on the market i.e. the returns that you could get if you had the entire market in your portfolio. 55. Index Students of Modern Portfolio Theory will appreciate that the aim of every portfolio manager is to beat the market. In order to benchmark the portfolio against the market we need some efficient proxy for the market. Indexes arose out of this need for a proxy. The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular portfolio. This portfolio is called the index portfolio and attempts a high degree of correlation with the market. Indexes differ based on the method of assigning the weight ages to the stocks in the portfolio. This is because for someone who wishes to replicate the return on the market it is infinitely more expensive to buy the whole market and for small portfolio sizes it is almost impossible. The alternative is to choose a portfolio that has a high degree of correlation with the market.

56. Market Capitalization Another objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalization of the entire market. As a result within every industry the largest market capitalization stocks tend to select themselves. However it is quite a balancing act to achieve the same minimum level for every industry. 57. Sectoral Indexes These indexes provide the benchmark for sector specific funds. Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing or Infrastructure use these indexes to keep track of the sector performance. 58. The uses of an Index Index based funds These funds tend to replicate the index as it is in order to match the returns on the market. This is also known as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence its better to replicate the index. Examples in India are

UTIs fund on the Sensex IDBI MFs fund on the Nifty

59. Exchange traded funds (ETFs) These are similar to index funds that are traded on an exchange. These are pretty popular worldwide with non-resident investors who like to take an exposure to the entire market. S&Ps SPDRs and MSCIs WEBS products are amongst the most popular products. 60. Index futures Index futures are possibly the single most popular exchange traded derivatives products today. The S&P 500 futures products are the largest traded index futures product in the world.

In India both the BSE and NSE are due to launch their own index futures product on their benchmark indexes the Sensex and the Nifty. 61. Four Steps in Risk Management 1. Understand the nature of various risks. 2. Define a risk management policy for the organization and quantifying maximum risk that organization is willing to take if quantifiable. 3. Measure the risks if quantifiable and enumerate otherwise. 4. Build internal control mechanism to control and monitor all the risks. 62. Understand Risks Risks can be classified into three categories.

Price or Market Risk Counterparty or Credit Risk Operating Risks

63. Price Risks This is the risk of loss due to change in market prices. Price risk can increase further due to Market Liquidity Risk, which arises when large positions in individual instruments or exposures reach more than a certain percentage of the market, instrument or issue. Such a large position could be potentially illiquid and not be capable of being replaced or hedged out at the current market value and as a result may be assumed to carry extra risk. 64. Counterparty Risks This is the risk of loss due to a default of the Counterparty in honoring its commitment in a transaction (Credit Risk). If the Counterparty is situated in another country, this also involves Country Risk, which is the risk of the Counterparty not honoring its commitment because of the restrictions imposed by the government though counterparty itself is capable to do so. 65. Dealing Risk Dealing Risk is the sum total of all unsettled transactions due for all dates in future. If the Counterparty goes bankrupt on any day, all unsettled transactions would have to be redone in the market at the current rates. The loss would be the difference between the original contract rate and the current rates. Dealing risk is therefore limited to only the movement in the prices and is measured as a percentage of the total exposure.

66. Settlement Risk Settlement risk is the risk of Counterparty defaulting on the day of the settlement. The risk in this case would be 100% of the exposure if the corporate gives value before receiving value from the Counterparty. In addition the transaction would have to be redone at the current market rates. 67. Operating Risks Operational risk is the risk that the organization may be exposed to financial loss either through human error, misjudgment, negligence and malfeasance, or through uncertainty, misunderstanding and confusion as to responsibility and authority. Following are the different kinds of operating risks:

Legal Regulatory Errors & Omissions Frauds Custodial Systems

68. Legal Legal risk is the risk that the organization will suffer financial loss either because contracts or individual provisions thereof are unenforceable or inadequately documented, or because the precise relationship with the counterparty is unclear. 69. Regulatory Regulatory risk is the risk of doing a transaction which is not as per the prevailing rules and laws of the country. 70. Errors & Omissions Errors and omissions are not uncommon in financial operations. These may relate to price, amount, value date, currency, buy/sell side or settlement instructions. Frauds Some examples of frauds are:

Front running Circular trading Undisclosed Personal trading Insider trading Routing deals to select brokers

71. Custodial Custodial risk is the loss of prime documents due to theft, fire, water, termites etc. This risk is enhanced when the documents are in transit. 72. Systems Risk Systems risk is due to significant deficiencies in the design or operation of supporting systems; or inability of systems to develop quickly enough to meet rapidly evolving user requirements; or establishment of a great many diverse, incompatible system configurations, which cannot be effectively linked by the automated transmission of data and which require considerable manual intervention. 73. Risk Measurement There are a number of different measures of price or market risk which are mainly based on historical and current market values Examples are Value at Risk (VAR), Revaluation, Modeling, Simulation, Stress Testing, Back Testing, etc. 74. Risk Control Control of Price Risk Position limits are established to control the level of price or market risk taken by the organization. Diversification is used to reduce systematic risk in a given portfolio. 77. Control of Credit Risk Credit limits are established for each counterparty for both Dealing Risk and Settlement Risk separately depending upon the risk perception of the counterparty. 78. Control of Operating Risk Establishment of an effective and efficient internal control structure over the trading and settlement activities, as well as implementing a timely and accurate management information system (M.I.S.). 79. Tools to control operating risks

Comprehensive Systems and Operations Manuals Proper Organizations structure and adequate personnel Separation of trading function from settlement, accounting and risk control functions.

Strict enforcement of authority and limits Written confirmation of all verbal dealings Voice recording Legally binding agreements with counterparties ensuring proposed transactions are not ultra virus. Contingency Planning Internal Audits Daily reconciliations Ethical standards and codes of conduct Dealing discipline

80 .In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap. The swap agreement defines the dates when the cash flows are to be paid and the way they are calculated.[1] Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.[1] 81. SWAP MARKET: Most swaps are traded over-the-counter (OTC), "tailor-made" for the counterparties. Some types of swaps are also exchanged on futures markets such as the Chicago Mercantile Exchange Holdings Inc., the largest U.S. futures market, the Chicago Board Options Exchange 82. Types of SWAP The five generic types of swaps, in order of their quantitative importance, are: interest rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are also many other types. 83. Interest Rate SWAP: The most common type of swap is a plain Vanilla interest rate swap. It is the exchange of a fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15 years. The reason for this exchange is to take benefit from comparative advantage 84. Currency swaps A currency swap involves exchanging principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal loan in another currency. Just like interest rate swaps; the currency swaps also are motivated by comparative advantage. Currency swaps (These entail swapping both principal and interest b/w the parties, with the cashflows in one direction being in a different currency than those in the opposite direction.

85. Commodity swaps A commodity swap is an agreement whereby a floating (or market or spot) price is exchanged for a fixed price over a specified period. The vast majority of commodity swaps involve crude oil. 86. Equity Swap An equity swap is a special type of total return swap, where the underlying asset is a stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this case you do not have to pay anything up front, but you do not have any voting or other rights that stock holders do. 87. Valuation The value of a swap is the net present value (NPV) of all estimated future cash flows. A swap is worth zero when it is first initiated, however after this time its value may become positive or negative.[1] There are two ways to value swaps: in terms of bond prices, or as a portfolio of forward contracts 89. NPA The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. 90. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices.