Introduction of Derivatives

 Definition of Derivatives:

One of the most significant events in the securities markets has been the
development and expansion of financial derivatives. The term “derivatives” is
used to refer to financial instruments which derive their value from some
underlying assets. The underlying assets could be equities (shares), debt
(bonds, T-bills, and notes), currencies, and even indices of these various assets,
such as the Nifty 50 Index. Derivatives derive their names from their respective
underlying asset. Thus if a derivative’s underlying asset is equity, it is called
equity derivative and so on. Derivatives can be traded either on a regulated
exchange, such as the NSE or off the exchanges, i.e., directly between the
different parties, which is called “over-the-counter” (OTC) trading. (In India only
exchange traded equity derivatives are permitted under the law.) The basic
purpose of derivatives is to transfer the price risk (inherent in fluctuations of the
asset prices) from one party to another; they facilitate the allocation of risk to
those who are willing to take it. In so doing, derivatives help mitigate the risk
arising from the future uncertainty of prices. For example, on December 21, 2009
a rice farmer may wish to sell his harvest at a future date (say January 1, 2010)
for a pre-determined fixed price to eliminate the risk of change in prices by that
date. Such a transaction is an example of a derivatives contract. The price of this
derivative is driven by the spot price of rice which is the "underlying".

 Origin of derivatives:

While trading in derivatives products has grown tremendously in recent

times, the earliest evidence of these types of instruments can be traced back to
ancient Greece. Even though derivatives have been in existence in some form or
the other since ancient times, the advent of modern day derivatives contracts is
attributed to farmers’ need to protect themselves against a decline in crop prices
due to various economic and environmental factors. Thus, derivatives contracts
initially developed in commodities. The first “futures” contracts can be traced to
the Yodoya rice market in Osaka, Japan around 1650. The farmers were afraid of
rice prices falling in the future at the time of harvesting. To lock in a price (that is,
to sell the rice at a predetermined fixed price in the future), the farmers entered
into contracts with the buyers. These were evidently standardized contracts, much
like today’s futures contracts.

In 1848, the Chicago Board of Trade (CBOT) was established to facilitate

trading of forward contracts on various commodities. From then on, futures
contracts on commodities have remained more or less in the same form, as we
know them today. While the basics of derivatives are the same for all assets such
as equities, bonds, currencies, and commodities, we will focus on derivatives in
 the equity markets and all examples that we discuss will use stocks and index
(basket of stocks).
 Derivatives in India:

In India, derivatives markets have been functioning since the nineteenth

century, with organized trading in cotton through the establishment of the Cotton
Trade Association in 1875. Derivatives, as exchange traded financial instruments
were introduced in India in June 2000. The Star heroes for this project were L.C.
Gupta Committee & J. R. Verma Committee who gave the report in regards of
exchange dated derivatives & Risk management system for these instruments.
The efforts taken by them have shown a positive effect in The Securities Contracts
(Regulations) Act, 1956.

The Said Act defined “Derivatives” to include:

1. 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.
2. A contract which derives its value from the prices, or index of prices, of
underlying securities.

At Present, The equity derivatives market is the most active derivatives

market in India. Trading volumes in equity derivatives are, on an average, more
than three and half times the trading volumes in the cash equity markets.

 Milestones in the development of Indian derivative market:

November 18, 1996 L.C. Gupta Committee set up to draft a policy

framework for introducing derivatives

May 11, 1998 L.C. Gupta committee submits its report on the policy
framework

May 25, 2000 SEBI allows exchanges to trade in index futures

June 12, 2000 Trading on Nifty futures commences on the NSE

June 4, 2001 Trading for Nifty options commences on the NSE

July 2, 2001 Trading on Stock options commences on the NSE

November 9, 2001 Trading on Stock futures commences on the NSE

August 29, 2008 Currency derivatives trading commences on the NSE

August 31, 2009 Interest rate derivatives trading commences on the

NSE

73
Two important terms:

Before discussing derivatives, it would be useful to be familiar with two

terminologies relating to the underlying markets. These are as follows:

A. Spot Market:

In the context of securities, the spot market or cash market is a securities

market in which securities are sold for cash and delivered immediately. The
delivery happens after the settlement period. Let us describe this in the context of
India. The NSE’s cash market segment is known as the Capital Market (CM)
Segment. In this market, shares of SBI, Reliance, Infosys, ICICI Bank, and other
public listed companies are traded. The settlement period in this market is on a
T+2 bases i.e., the buyer of the shares receives the shares two working days after
trade date and the seller of the shares receives the money two working days after
the trade date.

B. Index:

Stock prices fluctuate continuously during any given period. Prices of some
stocks might move up while that of others may move down. In such a situation,
what can we say about the stock market as a whole? Has the market moved up or
has it moved down during a given period? Similarly, have stocks of a particular
sector moved up or down? To identify the general trend in the market (or any
given sector of the market such as banking), it is important to have a reference
barometer which can be monitored. Market participants use various indices for this
purpose. An index is a basket of identified stocks, and its value is computed by
taking the weighted average of the prices of the constituent stocks of the index. A
market index for example consists of a group of top stocks traded in the market
and its value changes as the prices of its constituent stocks change. In India, Nifty
Index is the most popular stock index and it is based on the top 50 stocks traded
in the market. Just as derivatives on stocks are called stock derivatives,
derivatives on indices such as Nifty are called index derivatives.

73
 TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The

Counter Derivatives

National Stock Exchange Bombay Stock Exchange National Commodity & Derivative
exchange

Index Future Index option Stock option Stock future

TYPES OF DERIVATIVES

Derivative
s

Future Option Forward Swaps

73
 Definition of Basic Derivatives

There are various types of derivatives traded on exchanges across the

world. They range from the very simple to the most complex products. The
following are the four basic forms of derivatives, which are the building blocks for
many complex derivatives instruments (the latter are beyond the scope of this
Material):

· Forwards
· Futures
· Options
· Swaps

Knowledge of these instruments is necessary in order to understand the

basics of derivatives. We shall now discuss each of them in detail.

• Forwards

A forward contract or simply a forward is a contract between two parties to

buy or sell an asset at a certain future date for a certain price that is pre-decided
on the date of the contract. The future date is referred to as expiry date and the
pre-decided price is referred to as Forward Price.

In short, a forward is an agreement between two parties in which one

party, the buyer, enters into an agreement with the other party, the seller that he
would buy from the seller an underlying asset on the expiry date at the forward
price. Remember that it is different from a spot market contract, which involves
immediate payment and immediate transfer of asset.

Forward contracts are traded only in Over the Counter (OTC) market and
not in stock exchanges. OTC market is a private market where
individuals/institutions can trade through negotiations on a one to one basis.

The party that agrees to buy the asset on a future date is referred to as a
long investor and is said to have a long position. Similarly the party that agrees to
sell the asset in a future date is referred to as a short investor and is said to have
a short position. The price agreed upon is called the delivery price or the Forward
Price.

Features of Forward Contracts :

 They are bilateral contracts and hence exposed to counter-party risk.

73
 Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.

 The contract price is generally not available in public domain.

 On the expiration 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
counter-party, w h i c h often results in high prices being charged.

A. Settlement of forward contracts

When a forward contract expires, there are two alternate arrangements

possible to settle the obligation of the parties: physical settlement and cash
settlement. Both types of settlements happen on the expiry date and are given
below.

I. Physical Settlement:

A forward contract can be settled by the physical delivery of the underlying

asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and
the payment of the agreed forward price by the buyer to the seller on the agreed
settlement date. The following example will help us understand the physical
settlement process.

II. Cash Settlement:

Cash settlement does not involve actual delivery or receipt of the security.
Each party either pays (receives) cash equal to the net loss (profit) arising out of
their respective position in the contract. So, in case of Scenario I mentioned
above, where the spot price at the expiry date (ST) was greater than the forward
price (FT), the party with the short position will have to pay an amount equivalent
to the net loss to the part y at the long position. In our example, Tom will simply
pay Rs. 5000 to Jerry on the expiry date. The opposite is the case in Scenario
(III), when ST < FT. The long party will be at a loss and have to pay an amount
equivalent to the net loss to the short party. In our example, Jerry will have to
pay Rs. 5000 to Tom on the expiry date. In case of Scenario (II) where ST = FT,
there is no need for any party to pay anything to the other party.

Please note that the profit and loss position in case of physical settlement
and cash settlement is the same except for the transaction costs which is involved
in the physical settlement.

B. Default risk in forward contracts

73
 A drawback of forward contracts is that they are subject to default risk.
Regardless of whether the contract is for physical or cash settlement, there exists
a potential for one party to default, i.e. not honor the contract. It could be either
the buyer or the seller. This results in the other party suffering a loss. This risk of
making losses due to any of the two parties defaulting is known as counter party
risk. The main reason behind such risk is the absence of any mediator between
the parties, who could have undertaken the task of ensuring that both the parties
fulfill their obligations arising out of the contract. Default risk is also referred to as
counter party risk or credit risk.

• Futures

Like a forward contract, a futures contract is an agreement between two

parties in which the buyer agrees to buy an underlying asset from the seller, at a
future date at a price that is agreed upon today. However, unlike a forward
contract, a futures contract is not a private transaction but gets traded on a
recognized stock exchange. In addition, a futures contract is standardized by the
exchange. All the terms, other than the price, are set by the stock exchange
(rather than by individual parties as in the case of a forward contract). Also, both
buyer and seller of the futures contracts are protected against the counter party
risk by an entity called the Clearing Corporation. The Clearing Corporation
provides this guarantee to ensure that the buyer or the seller of a futures contract
does not suffer as a result of the counter party defaulting on its obligation. In case
one of the parties defaults, the Clearing Corporation steps in to fulfill the
obligation of this party, so that the other party does not suffer due to non-
fulfillment of the contract. To be able to guarantee the fulfillment of the
obligations under the contract, the Clearing Corporation holds an amount as a
security from both the parties. This amount is called the Margin money and can be
in the form of cash or other financial assets. Also, since the futures contracts are
traded on the stock exchanges, the parties have the flexibility of closing out the
contract prior to the maturity by squaring off the transactions in the market.

Swaps: Swaps are private agreements between two parties to exchange cash flows in
the future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are:

• Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency.
• Currency swaps: These 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.

73
Warrants: Options generally have lives of upto one year, the majority of options traded
on options exchanges having a maximum maturity of nine months. Longer-dated options
are called warrants and are generally traded over-the-counter.

LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are
options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The underlying
asset is usually a moving average or a basket of assets. Equity index options are a form
of basket options.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus a swaption is an option on a forward swap. Rather than
have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A
receiver swaption is an option to receive fixed and pay floating. A payer swaption is an
option to pay fixed and receive floating.1

1.3 Participants and Functions

Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in

the derivatives market. Hedgers face risk associated with the price of an asset. They use
futures or options markets to reduce or eliminate this risk. Speculators wish to bet on
future movements in the price of an asset. Futures and options contracts can give them
an extra leverage; that is, they can increase both the potential gains and potential losses
in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy
between prices in two different markets. If, for example, 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.

The derivative market performs a number of economic functions. First,

prices in an organized derivatives market reflect the perception of market participants
about the future and lead the prices of underlying to the perceived future level. The
prices of derivatives converge with the prices of the underlying at the expiration of
derivative contract. Thus derivatives help in discovery of future as well as current prices.
Second, the derivatives market helps to transfer risks from those who have them but
may not like them to those who have appetite for them. Third, derivatives, due to their
inherent nature, are linked to the underlying cash markets. With the introduction of
1

73
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. Fourth, speculative trades shift to a more controlled
environment of derivatives market. In the absence of an organized derivatives market,
speculators trade in the underlying cash markets. Margining, monitoring and surveillance
of the activities of various participants become extremely difficult in these kind of mixed
markets. Fifth, an important incidental benefit that flows from derivatives trading is that
it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of
attracting many bright, creative, well-educated people with an entrepreneurial attitude.
They often energize others to create new businesses, new products and new employment
opportunities, the benefit of which are immense. Sixth, derivatives markets help increase
savings and investment in the long run. Transfer of risk enables market participants to
expand their volume of activity. Derivatives thus promote economic development to the
extent the later depends on the rate of savings and investment.

1.4 Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th 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 US addressed merchants’ concerns

about ensuring that there were buyers and sellers for commodities, “credit risk” remained
a serious problem. To deal with this problem, a group of Chicago businessmen formed
the

Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to
provide a centralized location known in advance for buyers and sellers to negotiate
forward contracts. In 1865, the CBOT went one step further and listed the first “exchange
traded” derivatives contract in the US; these contracts were called “futures contracts”. In
1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow
futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The

73
CBOT and the CME remain the two largest organized futures exchanges, indeed the two
largest “financial” exchanges of any kind in the world today.

The first stock index futures contract was traded at Kansas City
Board of Trade. Currently the most popular index futures contract in the world is based
on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties,
financial futures became the most active derivative instruments generating volumes
many times more than the commodity futures. Index futures, futures on T-bills and Euro-
Dollar futures are the three most popular futures contracts traded today. Other popular
international exchanges that trade derivatives are LIFFE in England, DTB in Germany,
SGX in Singapore, TIFFE in Japan, MATIF in France, etc.2

Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)

1995 1996 1997 1998 1999

Exchange traded instruments 9283 10018 12403 13932 13522

Interest rate futures and 8618 9257 11221 12643 11669

options

Currency futures and options 154 171 161 81 59

Stock Index future and options 511 591 1021 1208 1793

Some OTC instruments 17713 25453 29035 80317 88201

Interest rate swaps and options 16515 23894 27211 44259 53316

Currency swaps and options 1197 1560 1824 5948 4751

Other instruments - - - 30110 30134

Total 26996 35471 41438 94249 101723

Table 1.2 Chronology of instruments

1874 Commodity futures

1972 Foreign currency futures

1973 Equity options

2

73
1975 Treasury bond futures

1981 Currency swaps

1982 Interest rate swaps, T note futures, Eurodollar futures, Equity index futures,
Options on T bond futures, Exchange listed currency options

1983 Options on equity index, Options on T-note futures, Options on currency

futures, Options on equity index futures, interest rate caps and floors

1985 Eurodollar options, Swap options

1987 OTC compound options, OTC average options

1989 Futures on interest rate swaps, Quanto options

1990 Equity index swaps

1991 Differential swaps

1993 Captions, exchange listed FLEX options

1994 Credit default options

Exchange-traded vs. OTC derivatives markets

The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and
globalisation of financial activities. The recent developments in information technology
have contributed to a great extent to these developments. While both exchange-traded
and OTC 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 OTC derivative positions were the main cause of turbulence in financial markets
in 1998. These episodes of turbulence revealed the risks posed to market stability
originating in features of OTC derivative instruments and markets.

The OTC derivatives markets have the following features compared to exchange-traded
derivatives:

1. The management of counter-party (credit) risk is decentralized and located within

individual institutions,

73
 2. There are no formal centralized limits on individual positions, leverage, or
margining,
3. There are no formal rules for risk and burden-sharing,
4. There are no formal rules or mechanisms for ensuring market stability and
integrity, and for safeguarding the collective interests of market participants, and
5. The OTC contracts are generally not regulated by a regulatory authority and the
exchange’s self-regulatory organization, although they are affected indirectly by
national legal systems, banking supervision and market surveillance.

Some of the features of OTC derivatives markets embody risks to financial market
stability.

The following features of OTC derivatives markets can give rise to

instability in institutions, markets, and the international financial system: (i) the dynamic
nature of gross credit exposures; (ii) information asymmetries; (iii) the effects of OTC
derivative activities on available aggregate credit; (iv) the high concentration of OTC
derivative activities in major institutions; and (v) the central role of OTC derivatives
markets in the global financial system. Instability arises when shocks, such as counter-
party credit events and sharp movements in asset prices that underlie derivative
contracts, occur which significantly alter the perceptions of current and potential future
credit exposures. When asset prices change rapidly, the size and configuration of
counter-party exposures can become unsustainably large and provoke a rapid unwinding
of positions.

There has been some progress in addressing these risks and perceptions.
However, the progress has been limited in implementing reforms in risk management,
including counter-party, liquidity and operational risks, and OTC derivatives markets
continue to pose a threat to international financial stability. The problem is more acute as
heavy reliance on OTC derivatives creates the possibility of systemic financial events,
which fall outside the more formal clearing house structures. Moreover, those who
provide OTC derivative products, hedge their risks through the use of exchange traded
derivatives. In view of the inherent risks associated with OTC derivatives, and their
dependence on exchange traded derivatives, Indian law considers them illegal.

Indian Derivatives Market

Starting from a controlled economy, India has moved towards a world where prices
fluctuate every day. The introduction of risk management instruments in India gained

73
momentum in the last few years due to liberalisation process and Reserve Bank of India’s
(RBI) efforts in creating currency forward market. Derivatives are an integral part of
liberalisation process to manage risk. NSE gauging the market requirements initiated the
process of setting up derivative markets in India. In July 1999, derivatives trading
commenced in India

Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework

for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements (FRAs)
and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an Indian
index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures
trading.

9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

2.1 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. Today, derivatives have become part and
parcel of the day-to-day life for ordinary people in major part of the world.
Until the advent of NSE, the Indian capital market had no access to the latest trading
methods and was using traditional out-dated methods of trading. There was a huge gap
between the investors’ aspirations of the markets and the available means of trading. The
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 Reserve Bank of

73
India’s efforts in allowing forward contracts, cross currency options etc. which have
developed into a very large market.

2.2 Myths and realities about derivatives

In less than three decades of their coming into vogue, derivatives markets have become
the most important markets in the world. Financial derivatives came into the spotlight
along with the rise in uncertainty of post-1970, when US announced an end to the
Bretton Woods System of fixed exchange rates leading to introduction of currency
derivatives followed by other innovations including stock index futures. Today, derivatives
have become part and parcel of the day-to-day life for ordinary people in major parts of
the world. While this is true for many countries, there are still apprehensions about the
introduction of derivatives. There are many myths about derivatives but the realities that
are different especially for Exchange traded derivatives, which are well regulated with all
the safety mechanisms in place.

What are these myths behind derivatives?

• Derivatives increase speculation and do not serve any economic purpose

• Indian Market is not ready for derivative trading

• Disasters prove that derivatives are very risky and highly leveraged
instruments
• Derivatives are complex and exotic instruments that Indian investors will
find difficulty in understanding
• Is the existing capital market safer than Derivatives?

Derivatives increase speculation and do not serve any economic purpose

While the fact is...

Numerous 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 low-cost, effective method for users to hedge and manage
their exposures to interest rates, commodity prices, or exchange rates.
The 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. This period is marked by remarkable innovations in
the financial markets such as introduction of floating rates for the currencies, increased

73
trading in variety of derivatives instruments, on-line trading in the capital markets, etc.
As the complexity of instruments increased many folds, the accompanying risk factors
grew in gigantic proportions. This situation led to development derivatives as effective
risk management tools for the market participants.

Looking at the equity market, derivatives allow corporations and institutional

investors to effectively manage their portfolios of assets and liabilities through
instruments like stock index futures and options. An equity fund, for example, can reduce
its exposure to the stock market quickly and at a relatively low cost without selling off
part of its equity assets by using stock index futures or index options.

By providing investors and issuers with a wider array of tools for managing risks
and raising capital, derivatives improve the allocation of credit and the sharing of risk in
the global economy, lowering the cost of capital formation and stimulating economic
growth. Now that world markets for trade and finance have become more integrated,
derivatives have strengthened these important linkages between global markets,
increasing market liquidity and efficiency and facilitating the flow of trade and finance. 3

Indian Market is not ready for derivative trading

While the fact is...

Often the argument put forth against derivatives trading is that the Indian capital market
is not ready for derivatives trading. Here, we look into the pre-requisites, which are
needed for the introduction of derivatives and how Indian market fares:

PRE-REQUISITES INDIAN SCENARIO

Large market Capitalisation India is one of the largest market-capitalised countries in

Asia with a market capitalisation of more than Rs.765000
crores.

High Liquidity in the The daily average traded volume in Indian capital market
underlying today is around 7500 crores. Which means on an average
every month 14% of the country’s Market capitalisation
gets traded. These are clear indicators of high liquidity in

73
 the underlying.

Trade guarantee The first clearing corporation guaranteeing trades has

become fully functional from July 1996 in the form of
National Securities Clearing Corporation (NSCCL). NSCCL
is responsible for guaranteeing all open positions on the
National Stock Exchange (NSE) for which it does the
clearing.

A Strong Depository National Securities Depositories Limited (NSDL) which

started functioning in the year 1997 has revolutionalised
the security settlement in our country.

A Good legal guardian
In the Institution of SEBI (Securities and Exchange Board
of India) today the Indian capital market enjoys a strong,
independent, and innovative legal guardian who is helping
the market to evolve to a healthier place for trade
practices.

2.2.3 Disasters prove that derivatives are very risky and highly leveraged
instruments
While the fact is...

Disasters can take place in any system. The 1992 Security scam is a case in point.
Disasters are not necessarily due to dealing in derivatives, but derivatives make
headlines... Here I have tried to explain some of the important issues involved in
disasters related to derivatives. Careful observation will tell us that these disasters have
occurred due to lack of internal controls and/or outright fraud either by the employees or
promoters.

Barings Collapse

1. 233 year old British bank goes bankrupt on 26th February 1995
2. Downfall attributed to a single trader, 28 year old Nicholas Leeson
3. Loss arose due to large exposure to the Japanese futures market

73
 4. Leeson, chief trader for Barings futures in Singapore, takes huge position in index
futures of Nikkei 225
5. Market falls by more than 15% in the first two months of ’95 and Barings suffers
huge losses
6. Bank looses $1.3 billion from derivative trading
7. Loss wipes out the entire equity capital of Barings
The reasons for the collapse:

• Leeson was supposed to be arbitraging between Osaka Securities Exchange and

SIMEX -- a risk less strategy, while in truth it was an unhedged position.
• Leeson was heading both settlement and trading desk -- at most other banks the
functions are segregated, this helped Leeson to cover his losses -- Leeson was
unsupervised.
• Lack of independent risk management unit, again a deviation from prudential norms.
There were no proper internal control mechanisms leading to the discrepancies going
unnoticed – Internal audit report which warned of "excessive concentration of power
in Leeson’s hands" was ignored by the top management.
The conclusion as summarised by Wall Street Journal article

" Bank of England officials said they did not regard the problem in this case as one
peculiar to derivatives. In a case where a trader is taking unauthorised positions, they
said, the real question is the strength of an investment houses’ internal controls and the
external monitoring done by Exchanges and Regulators. "

Metallgesellschaft

1. Metallgesellshaft (MG) -- a hedge that went bad to the tune of $1.3 billion
Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered
through its American subsidiary - MGRM
2. MGRM offered long term contracts to supply 180 million barrels of oil products to
its clients -- commitments were quite large, equivalent to 85 days of Kuwait’s oil
output
3. MGRM created a hedge position for these long term contracts with short term
futures market through rolling hedge --, As there was no viable long term
contracts available
4. Company was exposed to basis risk -- risk of short term oil prices temporarily
deviating from long term prices.
5. In 1993, oil prices crashed, leading to billion dollars of margin call to be met in
cash. The Company was faced with temporary funds crunch.

73
 6. New management team decides to liquidate the remaining contracts, leading to a
loss of 1.3 billion.
7. Liquidation has been criticised, as the losses could have decreased over time.
Auditors’ report claims that the losses were caused by the size of the trading
exposure.
Reasons for the losses:

• The transactions carried out by the company were mainly OTC in nature and hence
lacked transparency and risk management system employed by a derivative exchange
• Large exposure
• Temporary funds crunch
• Lack of matching long-term contracts, which necessitated the company to use rolling
short term hedge -- problem arising from the hedging strategy
• Basis risk leading to short term loss

2.2.4 Derivatives are complex and exotic instruments that Indian investors will
have difficulty in understanding

While the fact is...

Trading in standard derivatives such as forwards, futures and options is already prevalent
in India and has a long history. Reserve Bank of India allows forward trading in Rupee-
Dollar forward contracts, which has become a liquid market. Reserve Bank of India also
allows Cross Currency options trading.

Forward Markets Commission has allowed trading in Commodity Forwards on

Commodities Exchanges, which are, called Futures in international markets. Commodities
futures in India are available in turmeric, black pepper, coffee, Gur (jaggery), hessian,
castor seed oil etc. There are plans to set up commodities futures exchanges in Soya
bean oil as also in Cotton. International markets have also been allowed (dollar
denominated contracts) in certain commodities. Reserve Bank of India also allows, the
users to hedge their portfolios through derivatives exchanges abroad. Detailed guidelines
have been prescribed by the RBI for the purpose of getting approvals to hedge the user’s
exposure in international markets.

73
Derivatives in commodities markets have a long history. The first commodity futures
exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders
Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 1963-
68). A clearinghouse for clearing and settlement of these trades was set up in 1918. In
oilseeds, a futures market was established in 1900. Wheat futures market began in
Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures
market was set up in Mumbai in 1920.

History and existence 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 exchange
markets. Government 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 exchanges in last six months by the Government of India also indicates
that Government of India does not consider this type of trading to be harmful albeit
within proper regulatory framework.

This amply proves that the concept of options and futures has been well ingrained in the
Indian equities market for a long time and is not alien as it is made out to be. Even
today, complex strategies of options are being traded in many exchanges which are
called teji-mandi, jota-phatak, bhav-bhav at different places in India (Vohra and
Bagari,1998)
In that sense, the derivatives are not new to India and are also currently prevalent in
various markets including equities markets.

2.2.5 Is the existing capital market more safer than Derivatives?

While the fact is...

73
World over, the spot markets in equities are operated on a principle of rolling settlement.
In this kind of trading, if you trade on a particular day (T), you have to settle these
trades on the third working day from the date of trading (T+3).

Futures market allow you to trade for a period of say 1 month or 3 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 exchanges allow the participants to trade during one-
week period for settlement in the following week. The trades are netted for the
settlement for the entire one-week 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 exchanges also allow the forward trading called badla
in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent
currently in France in their monthly settlement markets. It allowed one to even further
increase the time to settle for almost 3 months under the earlier regulations. This way, a
curious mix of futures style settlement with facility to carry the settlement obligations
forward creates discrepancies.

The 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 exchanges and at
the same time allow futures and options to trade. This way, the regulators will also be
able to regulate both the markets easily and it will provide more flexibility to the market
participants.

In addition, the existing system although futures style, does not ask for any margins
from the clients. Given the volatility of the equities market in India, this system has
become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At
the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri
had a position close to Rs.18 crores. However, due to the default, BSE had to stop
trading for a period of three days. At the same time, the Barings Bank failed on
Singapore Monetary Exchange (SIMEX) for the exposure of more than US $ 20 billion
(more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around

73
Rs.3,800 crore). Although, the exposure was so high and even the loss was also very big
compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had
taken so much margins that they did not stop trading for a single minute.

Comparision of New System with Existing System4

Many people and brokers in India think that the new system of Futures & Options and
banning of Badla is disadvantageous and introduced early, but I feel that this new system
is very useful especially to retail investors. It increases the no of options investors for
investment. In fact it should have been introduced much before and NSE had approved it
but was not active because of politicization in SEBI.

Description of the product

A Forward Rate Agreement (FRA) is a financial contract between two parties

exchanging 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 (fixed) and the settlement rate,
are made by the parties to one another. The settlement rate is the agreed
benchmark/reference rate prevailing on the settlement date.

An Interest Rate Swap (IRS) is a financial contract between two parties exchanging 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 period-Cash payments based on fixed/floating and floating rates are made by the
parties to one another.

Currency swaps can be defined as a legal agreement between two or more parties to
exchange interest obligation or interest receipts between two different currencies. It
involves three steps:

• Initial exchange of principal between the counter parties at an agreed upon rate of
exchange which is usually based on spot exchange rate. This exchange is optional and
its sole objective is to establish the quantum of the respective principal amounts for
the purpose for calculating the ongoing payments of interest and to establish the
principal amount to be re-exchanged at the maturity of the swap.

73
• Ongoing exchange of interest at the rates agreed upon at the outset of the
transaction.
• Re-exchange of principal amount on maturity at the initial rate of exchange.
This 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.

HISTORY OF DERIVATIVES :

The history of derivatives is quite colorful and surprisingly a lot longer than most
people think. Forward delivery contracts, stating what is to be delivered for a fixed price
at a specified place on a specified date, existed in ancient Greece and Rome. Roman
emperors entered forward contracts to provide the masses with their supply of Egyptian
grain. These contracts were also undertaken between farmers and merchants to
eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts
have existed for centuries for hedging price risk.

THE IMPORTANT ASPECTS IN THE HISTORY OF DERIVATIVE:

The first organized commodity exchange came into existence in the early 1700’s in
Japan.

The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed
in 1848 in the US to deal with the problem of ‘credit risk’ and to provide centralized
location to negotiate forward contracts.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for
the purpose of trading stock options. It was in 1973 again that black, Merton, and
Scholes invented the famous Black-Scholes Option Formula. This model helped in
assessing the fair price of an option which led to an increased interest in trading of
options.

The collapse of the Bretton Woods regime of fixed parties and the introduction of floating
rates for currencies in the international financial markets paved the way for
development of a number of financial derivatives which served as effective risk
management tools to cope with market uncertainties.

73
The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the
Nasdaq 100, and the Nikkei 225.

Options:

An option is a derivative contract between a buyer and a seller, where one

party (say First Party) gives to the other (say Second Party) the right, but not the
obligation, to buy from (or sell to) the First Party the underlying asset on or before
a specific day at an agreed-upon price. In return for granting the option, the party
granting the option collects a payment from the other party. This payment
collected is called the “premium” or price of the option.

The right to buy or sell is held by the “option buyer” (also called the option
holder); the party granting the right is t he “option seller” or “option writer”.
Unlike forwards and futures contracts, options require a cash payment (called the
premium) upfront from the option buyer to the option seller. This payment is
called option premium or option price. Options can be traded either on the stock
exchange or in over the counter (OTC) markets. Options traded on the exchanges
are backed by the Clearing Corporation thereby minimizing the risk arising due to
default by the counter parties involved. Options traded in the OTC market
however are not backed by the Clearing Corporation.

There are two types of options—call options and put options—which are
explained below.

A. Call option:

A call option is an option granting the right to the buyer of the option to
buy the underlying asset on a specific day at an agreed upon price, but not the
obligation to do so. It is the seller who grants this right to the buyer of the option.
It may be noted that the person who has the right to buy the underlying asset is
known as the “buyer of the call option”. The price at which the buyer has the right
to buy the asset is agreed upon at the time of entering the contract. This price is
known as the strike price of the contract (call option strike price in this case).
Since the buyer of the call option has the right (but no obligation) to buy the
underlying asset, he will exercise his right to buy the underlying asset if and only
if the price of the underlying asset in the market is more than the strike price on

73
 or before the expiry date of the contract. The buyer of the call option does not
have an obligation to buy if he does not want to.

Illustration :

An investor buys one European Call option on one share of Reliance Petroleum at a
premium of Rs. 2 per share on 31 July . The strike price is Rs.60 and the contract
matures on 30 September . The payoffs for the investor on the basis of fluctuating spot
prices at any time are shown by the payoff table (Table 1). It may be clear form the
graph that even in the worst case scenario, the investor would only lose a maximum of
Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited
profits opportunity.

On the other hand the seller of the call option has a payoff chart completely reverse of
the call options buyer. The maximum loss that he can have is unlimited though a profit of
Rs.2 per share would be made on the premium payment by the buyer.

Payoff from Call Buying/Long (Rs.)

S Xt c Payoff Net Profit
57 60 2 0 -2
58 60 2 0 -2
59 60 2 0 -2
60 60 2 0 -2

73
 61 60 2 1 -1
62 60 2 2 0
63 60 2 3 1
64 60 2 4 2
65 60 2 5 3
66 60 2 6 4

Exercising the Call Option and what are its

implication
For the Buyer and the Seller ?

The Call option gives the buyer a right to buy the requisite shares on a specific date at a
specific price. This puts the seller under the obligation to sell the shares on that specific
date and specific price. The Call Buyer exercises his option only when he/ she feels it is
profitable. This Process is called "Exercising the Option".

This leads us to the fact that if the spot price is lower than the strike price then it might
be profitable for the investor to buy the share in the open market and forgo the premium
paid.

The implications for a buyer are that it is his/her decision whether to

exercise the option or not. In case the investor expects prices to rise far above the strike
price in the future then he/she would surely be interested in
buying call options.

On the other hand, if the seller feels that his shares are not giving the desired returns
and they are not going to perform any better in the future, a premium can be charged

73
and returns from selling the call option can be used to make up for the desired returns.
At the end of the options contract there is an exchange of the underlying asset. In the
real world, most of the deals are closed with another counter or reverse deal. There is no
requirement to exchange the underlying assets then as the investor gets out of the
contract just before its expiry.

B. Put option

A put option is a contract granting the right to the buyer of the option to
sell the underlying asset on or before a specific day at an agreed upon price, but
not the obligation to do so. It is the seller who grants this right to the buyer of the
option. The person who has the right to sell the underlying asset is known as the
“buyer of the put option”. The price at which the buyer has the right to sell the
asset is agreed upon at the time of entering the contract. This price is known as
the strike price of the contract (put option strike price in this case). Since the
buyer of the put option has the right (but not the obligation) to sell the underlying
asset, he will exercise his right to sell the underlying asset if and only if the price
of the underlying asset in the market is less than the strike price on or before the
expiry date of the contract. The buyer of the put option does not have the
obligation to sell if he does not want to.

Types of options:
Options can be divided into two different categories depending upon the
primary exercise styles associated with options. These categories are:

European Options:
European options are options that can be exercised only on the expiration
date. All options based on indices such as Nifty, Mini Nifty, Bank Nifty, CNX IT
traded at the NSE are European options which can be exercised by the buyer (of
the option) only on the final settlement date or the expiry date.

American options:
American options are options that can be exercised on any day on or
before the expiry date. All options on individual stocks like Reliance, SBI, and
Infosys traded at the NSE are American options. They can be exercised by the
buyer on any day on or before the final settlement date or the expiry date.

Illustration:

Suppose Salman Khan has “bought a call option” of 2000 shares of

Hindustan Unilever Limited (HLL) at a strike price of Rs 260 per share at a
premium of Rs 10. This option gives Salman Khan, the buyer of the option, the
right to buy 2000 shares of HLL from the seller of the option, on or before August

73
 27, 2009 (expiry date of the option). The seller of the option has the obligation to
sell 2000 shares of HLL at Rs 260 per share on or before August 27, 2009 (i.e.
whenever asked by the buyer of the option).

Suppose instead of buying a call, Salman Khan has “sold a put option” on
100 Reliance Industries (RIL) shares at a strike price of Rs 2000 at a premium of
Rs 8. This option is an obligation to Salman Khan to buy 100 shares of Reliance
Industries (RIL) at a price of Rs 2000 per share on or before August 27 (expiry
date of the option) i.e., as and when asked by the buyer of the put option. It
depends on the option buyer as to when he exercises the option. As stated earlier,
the buyer does not have the obligation to exercise the option.

Illustration 2:
An investor buys one European Put Option on one share of Reliance Petroleum at a
premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures
on 30 September. The payoff table shows the fluctuations of net profit with a change in
the spot price.

The payoff for the put buyer is :max (Xt - S, 0)

The payoff for a put writer is : -max(Xt - S, 0) or min(S - Xt, 0)

Payoff from Put Buying/Long (Rs.)

S Xt p Payoff Net Profit
55 60 2 5 3
56 60 2 4 2
57 60 2 3 1
58 60 2 2 0
59 60 2 1 -1
60 60 2 0 -2
61 60 2 0 -2
62 60 2 0 -2
63 60 2 0 -2
64 60 2 0 -2

73
 These are the two basic options that form the whole gamut of transactions
in the options trading. These in combination with other derivatives creat a whole
world of instruments to choose form depending on the kind of requirement and
the kind of market expectations.

1. Application of Derivatives

In this Unit, we look at the participants in the derivatives markets and how
they use derivatives contracts.

 Participants in the Derivatives Market:

Based on the application that derivatives are put to, the investors can be broadly
classified into three groups:

• Hedgers
• Speculators
• Arbitrageurs

We shall now look at each of these categories in detail:

• Hedgers:

These investors have a position (i.e., have bought stocks) in the underlying
market but are worried about a potential loss arising out of a change in the asset
price in the future. Hedgers participate in the derivatives market to lock the prices
at which they will be able to transact in the future. Thus, they try to avoid price
risk through holding a position in the derivatives market. Different hedgers take
different positions in the derivatives market based on their exposure in the
underlying market. A hedger normally takes an opposite position in the derivatives
market to what he has in the underlying market.
Hedging in futures market can be done through two positions, viz. short
hedge and long hedge.

73
Short Hedge
A short hedge involves taking a short position in the futures market. Short
hedge position is taken by someone who already owns the underlying asset or is
expecting a future receipt of the underlying asset.

For example, an investor holding Reliance shares may be worried about

adverse future price movements and may want to hedge the price risk. He can do
so by holding a short position in the derivatives market. The investor can go short
in Reliance futures at the NSE. This protects him from price movements in
Reliance stock. In case the price of Reliance shares falls, the investor will lose
money in the shares but will make up for this loss by the gain made in Reliance
Futures. Note that a short position holder in a futures contract makes a profit if
the price of the underlying asset falls in the future. In this way, futures contract
allows an investor to manage his price risk.
Similarly, a sugar manufacturing company could hedge against any
probable loss in the future due to a fall in the prices of sugar by holding a short
position in the futures/ forwards market. If the prices of sugar fall, the company
may lose on the sugar sale but the loss will be offset by profit made in the futures
contract.

Long Hedge
A long hedge involves holding a long position in the futures market. A Long
position holder agrees to buy the underlying asset at the expiry date by paying
the agreed futures/ forward price. This strategy is used by those who will need to
acquire the underlying asset in the future.

For example, a chocolate manufacturer who needs to acquire sugar in the

future will be worried about any loss that may arise if the price of sugar increases
in the future. To hedge against this risk, the chocolate manufacturer can hold a
long position in the sugar futures. If the price of sugar rises, the chocolate
manufacture may have to pay more to acquire sugar in the normal market, but he
will be compensated against this loss through a profit that will arise in the futures
market. Note that a long position holder in a futures contract makes a profit if the
price of the underlying asset increases in the future.

Long hedge strategy can also be used by those investors who desire to
purchase the underlying asset at a future date (that is, when he acquires the cash

73
to purchase the asset) but wants to lock the prevailing price in the market. This
may be because he thinks that the prevailing price is very low.

For example, suppose the current spot price of Wipro Ltd. is Rs. 250 per
stock. An investor is expecting to have Rs. 250 at the end of the month. The
investor feels that Wipro Ltd. is at a very attractive level and he may miss the
opportunity to buy the stock if he waits till the end of the month. In such a case,
he can buy Wipro Ltd. in the futures market. By doing so, he can lock in the price
of the stock. Assuming that he buys Wipro Ltd. in the futures market at Rs. 250
(this becomes his locked-in price), there can be three probable scenarios:

• Speculators:

A Speculator is one who bets on the derivatives market based on his views
on the potential movement of the underlying stock price. Speculators take large,
calculated risks as they trade based on anticipated future price movements. They
hope to make quick, large gains; but may not always be successful. They normally
have shorter holding time for their positions as compared to hedgers. If the price
of the underlying moves as per their expectation they can make large profits.
However, if the price moves in the opposite direction of their assessment, the
losses can also be enormous
• Arbitrageurs:

Arbitrageurs attempt to profit from pricing inefficiencies in the market by

making simultaneous trades that offset each other and capture a risk-free profit.
An arbitrageur may also seek to make profit in case there is price discrepancy
between the stock price in the cash and the derivatives markets.

For example, if on 1st August, 2009 the SBI share is trading at Rs. 1780 in
the cash market and the futures contract of SBI is trading at Rs. 1790, the
arbitrageur would buy the SBI shares (i.e. make an investment of Rs. 1780) in the
spot market and sell the same number of SBI futures contracts. On expiry day
(say 24 August, 2009), the price of SBI futures contracts will close at the price at
which SBI closes in the spot market. In other words, the settlement of the futures
contract will happen at the closing price of the SBI shares and that is why the
futures and spot pr ices are said to converge on the expiry day. On expiry day,
the arbitrageur will sell the SBI stock in the spot market and buy the futures
contract, both of which will happen at the closing price of SBI in the spot market.
Since the arbitrageur has entered into off-setting positions, he will be able to earn
Rs. 10 irrespective of the prevailing market price on the expiry date.

There are three possible price scenarios at which SBI can close on expiry
day. Let us calculate the profit/ loss of the arbitrageur in each of the scenarios
where he had initially (1 August) purchased SBI shares in the spot market at Rs
1780 and sold the futures contract of SBI at Rs. 1790:

Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10,
which was the difference between the spot price of SBI and futures price of SBI,
when the transaction was entered into. This is called a “risk less profit” since once
the transaction is entered into on 1 August, 2009 (due to the price difference
between spot and futures), the profit is locked.

73
 Irrespective of where the underlying share price closes on the expiry y date
of the contract, a profit of Rs. 10 is assured. The investment made by the
arbitrageur is Rs. 1780 (when he buys SBI in the spot market). He makes this
investment on 1 August 2009 and gets a return of Rs. 10 on this investment in 23
days (24 August). This means a return of 0.56% in 23 days. If we annualize this,
it is a return of nearly 9% per annum. One should also note that this opportunity
to make a risk-less return of 9% per annum will not always remain. The difference
between the spot and futures price arose due to some inefficiency (in the market),
which was exploited by the arbitrageur by buying shares in spot and selling
futures. As more and more such arbitrage trades take place, the difference
between spot and futures prices would narrow thereby reducing the attractiveness
of further arbitrage.

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.

24

Example:
Calls
Reliance 350 Stock Series

Other uncommon options include ;

Naked Options: These are options which are not combined with an offsetting contract to
cover the existing positions.

Covered Options: These are option contracts in which the shares are already owned by
an investor (in case of covered call options) and in case the option is exercised then the
offsetting of the deal can be done by selling these shares held.

73
Options Pricing

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.
Changes in the underlying security price can increase or decrease the value of an
option. These price changes have opposite effects on calls and puts. For instance, as the
value of the underlying security rises, a call will generally increase and the value of a put
will generally decrease in price. A decrease in the underlying security's value will
generally have the opposite effect.

EUROPEAN OPTIONS AMERICAN OPTIONS

Buying Buying
PARAMETERS CALL PUT CALL PUT
Spot Price (S)
Strike Price (Xt)
Time to Expiration (T) ? ?
Volatility ()
Risk Free Interest Rates (r)
Dividends (D)

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.

73
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.

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.

TIME OF 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.

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.

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 becomes 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.

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.

 Uses of Derivatives:

o Risk management:

73
 The most important purpose of the derivatives market is risk management.
Risk management for an investor comprises of the following three processes:

· Identifying the desired level of risk that the investor is willing to take on
his
Investments;
· Identifying and measuring the actual level of risk that the investor is
carrying; and
· Making arrangements which may include trading (buying/selling) of
derivatives contracts that allow him to match the actual and desired levels of risk.

The example of hedging discussed above illustrates the process of risk

management through futures.

o Market efficiency:
Efficient markets are fair and competitive and do not allow an investor to
make risk free profits. Derivatives assist in improving the efficiency of the
markets, by providing a self-correcting mechanism. Arbitrageurs are one section
of market participants who trade whenever there is an opportunity to make risk
free profits till the opportunity ceases to exist. Risk free profits are not easy to
make in more efficient markets. When trading occurs, there is a possibility that
some amount of mispricing might occur in the markets. The arbitrageurs step in to
take advantage of this mispricing by buying from the cheaper market and selling
in the higher market. Their actions quickly narrow the prices and thereby reducing
the inefficiencies.

o Price discovery:
One of the primary functions of derivatives markets is price discovery.
They provide valuable information about the prices and expected price fluctuations
of the underlying assets in two ways:

· First, many of these assets are traded in markets in different geographical

locations. Because of this, assets may be traded at different prices in different
markets. In derivatives markets, the price of the contract often serves as a proxy
for the price of the underlying asset. For example, gold may trade at different
prices in Mumbai and Delhi but a derivatives contract on gold would have one
value and so traders in Mumbai and Delhi can validate the prices of spot markets
in their respective location to see if it is cheap or expensive and trade accordingly.

· Second, the prices of the futures contracts serve as prices that can be
used to get a sense of the market expectation of future prices. For example, say
there is a company that produces sugar and expects that the production of sugar
will take two months from today. As sugar prices fluctuate daily, the company
does not know if after two months the price of sugar will be higher or lower than it
is today. How does it predict where the price of sugar will be in future? It can do
this by monitoring prices of derivatives contract on sugar (say a Sugar Forward
contract). If the forward price of sugar is trading higher than the spot price that
means that the market is expecting the sugar spot price to go up in future.
2. Trading Futures

To understand futures trading and profit/loss that can occur while trading,
knowledge of pay-off diagrams is necessary. Pay-off refers to profit or loss in a trade.
A pay-off is positive if the investor makes a profit and negative if he makes a loss. A

73
pay-off diagram represents profit/loss in the form of a graph which has the stock
price on the X axis and the profit/ loss on the Y axis. Thus, from the graph an investor
can calculate the profit or loss that his position can make for different stock price
values. Forwards and futures have same pay-offs. In other words, their profit/loss
values behave in a similar fashion for different values of stock price. In this Unit, we
shall focus on pay-offs of futures contracts.

 Pay-off of Futures
The Pay-off of a futures contract on maturity depends on the spot price of the
underlying asset at the time of maturity and the price at which the contract was
initially traded. There are two positions that could be taken in a futures contract:

a. Long position: one who buys the asset at the futures price (F) takes the
long position and
b. Short position: one who sells the asset at the futures price (F) takes the
short position.

In general, the pay-off for a long position in a futures contract on one unit of
an asset is: Long Pay-off = S T – F

Where F is the traded futures price and ST is the spot price of the asset at
expiry of the contract (that is, closing price on the expiry date). This is because the
holder of the contract is obligated to buy the asset worth ST for F.

Similarly, the pay-off from a short position in a futures contract on one unit of
asset is: Short Pay-off = F – ST

 Pay-off diagram for a long futures position:

The Figure 4.1 depicts the payoff diagram for an investor who is long on a
futures contract. The investor has gone long in the futures contract at a price F.

The long investor makes profits if the spot price (ST) at expiry exceeds the
futures contract price F, and makes losses if the opposite happens. In the above
diagram, the slanted line is a 45 degree line, implying that for every one rupee
change in the price of the underlying, the profit/ loss will change by one rupee. As can
be seen from the diagram, if ST is less than F, the investor makes a loss and the

73
higher the ST , the lower the loss. Similarly, if S T is greater than F, the investor
makes a profit and higher the S T, the higher is the profit.

 Pay-off diagram for a short position:

Figure 4.2 is the pay-off diagram for someone who has taken a short position
on a futures contract on the stock at a price F.

Here, the investor makes profits if the spot price (ST) at expiry is below the
futures contract price F, and makes losses if the opposite happens. Here, if ST is less
than F, the investor makes a profit and the higher the ST , the lower the profit.
Similarly, if ST is greater than F, the investor makes a loss and the higher the S T,
the lower is the profit.
As can be seen from the pay-off diagrams for futures contracts, the pay-off is
depicted by a straight line (both buy and sell). Such pay-off diagrams are known as
linear pay-offs.

 A theoretical model for Future pricing:

While futures prices in reality are determined by demand and supply, one can
obtain a theoretical Futures price, using the following model:

F = SerT

Where:
F = Futures price
S = Spot price of the underlying asset
r = Cost of financing (using continuously compounded interest rate)
T = Time till expiration in years
e = 2.71828
3. Trading Options

In this Unit we will discuss pay-outs for various strategies using options and
strategies which can be used to improve returns by using options.

 Option Payout:

73
 There are two sides to every option contract. On the one side is the option
buyer who has taken a long position (i.e., has bought the option). On the other side is
the option seller who has taken a short position (i.e., has sold the option). The seller
of the option receives a premium from the buyer of the option. It may be noted that
while computing profit and loss, premium has to be taken into consideration. Also,
when a buyer makes profit, the seller makes a loss of equal magnitude and vice
versa. In this section, we will discuss payouts for various strategies using options.

 A long position in a call option:

In this strategy, the investor has the right to buy the asset in the future at a
predetermined strike price i.e., strike price (K) and the option seller has the obligation
to sell the asset at the strike price (K). If the settlement price (underlying stock
closing price) of the asset is above the strike price, then the call option buyer will
exercise his option and buy the stock at the strike price (K). If the settlement price
(underlying stock closing price) is lower than the strike price, the option buyer will not
exercise the option as he can buy the same stock from the market at a price lower
than the strike price.

 A long position in a put option:

In this strategy, the investor has bought the right to sell the underlying asset
in the future at a predetermined strike price (K). If the settlement price (underlying
stock closing price) at maturity is lower than the strike price, then the put option
holder will exercise his option and sell the stock at the strike price (K). If the
settlement price (underlying stock closing price) is higher than the strike price, the
option buyer will not exercise the option as he can sell the same stock in the market
at a price higher than the strike price.

73
 A short position in a call option:

In this strategy, the option seller has an obligation to sell the asset at a
predetermined strike price (K) if the buyer of the option chooses to exercise the
option. The buyer of the option will exercise the option if the spot price at maturity is
any value higher than (K). If the spot price is lower than (K), the buyer of the option
will not exercise his/her option.

 A short position in a put option:

In this strategy, the option seller has an obligation to buy the asset at a
predetermined strike price (K) if the buyer of the option chooses to exercise his/her
option. The buyer of the option will exercise his option to sell at (K) if the spot price
at maturity is lower than (K). If the spot price is higher than (K), then the option
buyer will not exercise his/her option.

73
• Option Strategies:

An option strategy is implemented to try and make gains from the movement
in the underlying price of an asset. As discussed above, options are derivatives that
give the buyer the right to exercise the option at a future date. Unlike futures and
forwards which have linear pay-offs and do not require an initial outlay (upfront
payment), options have non linear pay-offs and do require an initial outlay (or
premium). In this section we discuss main fundamental strategies which can be used
to maximize returns by using options.

 Long option strategy:

A long option strategy is a strategy of buying an option according to the view

on future price movement of the underlying. A person with a bullish opinion on the
underlying will buy a call option on that asset/security, while a person with a bearish
opinion on the underlying will buy a put option on that asset/security. An important
characteristic of long option strategies is limited risk and unlimited profit potential. An
option buyer can only lose the amount paid for the option premium. At the same
time, theoretically, the profit potential is unlimited.

Calls:
An investor having a bullish opinion on underlying can expect to have positive
returns by buying a call option on that asset/security. When a call option is
purchased, the call option holder is exposed to the stock performance in the spot
market without actually possessing the stock and does so for a fraction of the cost
involved in purchasing the stock in the spot market. The cost incurred by the call
option holder is the option premium. Thus, he can take advantage of a smaller
investment and maximize his profits.
Consider the purchase of a call option at the price (premium) c. We take

ST = Spot price at time T

K = Strike price

73
 The payout in two scenarios is as follows:

Profit/Loss = – c, if S T = K

Profit/Loss = (ST - K) – c if S T = K

Let us explain this with some examples. Mr. Rocketsingh buys a Call on an
index (such as Nifty 50) with a strike price of Rs. 2000 for premium of Rs. 81.
Consider the values of the index at expiration as 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 0 – 81 = – 81 (maximum loss = premium paid)

For ST = 1900, Profit/Loss = 0 – 81 = – 81 (maximum loss = premium paid)
For ST = 2100, Profit/Loss = 2100 – 2000 – 81 = 19
For ST = 2200, Profit/Loss = 2200 – 2000 – 81 = 119

As we can see from the example, the maximum loss suffered by Mr.
Rocketsingh i.e. the buyer of the Call option is Rs. 81, which is the premium that he
paid to buy the option. His maximum profits are unlimited and they depend on where
the underlying price moves.

Puts:

An investor having a bearish opinion on the underlying can expect to have

positive returns by buying a put option on that asset/security. When a put option is
purchased, the put option buyer has the right to sell the stock at the strike price on or
before the expiry date depending on where the underlying price is.

Consider the purchase of a put option at price (premium) p. We take

ST = Spot price at time T

K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = (K – ST ) – p if ST = K

Profit/Loss = – p if ST = K

Let us explain this with some examples. Mr. Yuvrajsingh buys a put at a strike
price of Rs. 2000 for a premium of Rs. 79. Consider the values of the index at
expiration at 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 2000 – 1800 – 79 = 121

For ST = 1900, Profit/Loss = 2000 – 1900 – 79 = 21
For ST = 2100, Profit/Loss = – 79 (maximum loss is the premium paid)
For ST = 2200, Profit/Loss = – 79 (maximum loss is the premium paid)

As we can see from the example, the maximum loss suffered by Mr.
Yuvrajsingh i.e. the buyer of the Put option is Rs. 79, which is the premium that he
paid to buy the option. His maximum profits are unlimited and depend on where the
underlying price moves.

73
 Short options strategy:

A short options strategy is a strategy where options are sold to make money
upfront with a view that the options will expire out of money at the expiry date (i.e.,
the buyer of the option will not exercise the same and the seller can keep the
premium). As opposed to a long options strategy, here a person with a bullish opinion
on the underlying will sell a put option in the hope that prices will rise and the buyer
will not exercise the option leading to profit for the seller. On the other hand, a
person with a bearish view on the underlying will sell a call option in the hope that
prices will fall and the buyer will not exercise the option leading to profit for the seller.
As opposed to a long options strategy where the downside was limited to the price
paid for the option, here the downside is unlimited and the profit is limited to the
price of selling the option (the premium).

Calls:
An investor with a bearish opinion on the underlying can take advantage of
falling stock prices by selling a call option on the asset/security. If the stock price
falls, the profit to the seller will be the premium earned by selling the option. He will
lose in case the stock price increases above the strike price.

Consider the selling of a call option at the price (premium) c. We take

ST = Spot price at time T

K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = c if ST = K

Profit/Loss = c – (ST – K) if S T = K
Now consider this example: Mr. Debojit sells a call at a strike price of Rs 2000
for a premium of Rs 81. Consider values of index at expiration at 1800, 1900, 2100,
and 2200.

For ST = 1800, Profit/Loss = 81 (maximum profit = premium received)

For ST = 1900, Profit/Loss = 81 (maximum profit = premium received)
For ST = 2100, Profit/Loss = 81 – (2100 – 2000) = – 19
For ST =2200, Profit/Loss = 81 – (2100 – 2200) = – 119

As we can see from the example above, the maximum loss suffered by Mr.
Debojit i.e. the seller of the Call option is unlimited (this is the reverse of the buyer’s
gains). His maximum profits are limited to the premium received.

Puts:
An investor with a bullish opinion on the underlying can take advantage of
rising prices by selling a put option on the asset/security. If the stock price rises, the
profit to the seller will be the premium earned by selling the option. He will lose in
case the stock price falls below the strike price.

Consider the sale of a put option at the price (premium) p. We take:

ST = Spot price at time T

73
 K = exercise price

The payout in two scenarios is as follows:

Profit/Loss = p – (K – ST) if S T = K

Profit/Loss = p if ST = K

We sell a put at a strike price of Rs. 2000 for Rs. 79. Consider values of index
at expiration as 1800, 1900, 2100, and 2200.

For ST = 1800, Profit/Loss = 79 – (2000 – 1800) = (–) 121

For ST = 1900, Profit/Loss = 79 – (2000 – 1900) = (–) 21
For ST = 2100, Profit/Loss = 79 (maximum profit = premium received)
For ST = 2200, Profit/Loss = 79 (maximum profit = premium received)

As we can see from the example above the maximum loss suffered by the
seller of the Put option is unlimited (this is the reverse of the buyer’s gains). His
maximum profits are limited to the premium received.

Determination of option prices:

Like in case of any traded good, the price of any option is determined by the
demand for and supply of that option. This price has two components: intrinsic value
and time value.

• Intrinsic value of an option:

Intrinsic value of an option at a given time is the amount the holder of the
option will get if he exercises the option at that time. In other words, the intrinsic
value of an option is the amount the option is in-the-money (ITM). If the option is
out-of the- money (OTM), its intrinsic value is zero. Putting it another way, the
intrinsic value of a call is Max [0, (St — K)] which means that the intrinsic value of a
call is the greater of 0 or (St — K).
Similarly, the intrinsic value of a put is Max [0, K — St] i.e., the greater of 0 or
(K — S t) where K is the strike price and S t is the spot price.

• Time value of an option:

In addition to the intrinsic value, the seller charges a ‘time value’ from the
buyers of the option. This is because the more time there is for the contract to expire,
the greater the chance that the exercise of the contract will become more profitable
for the buyer. This is a risk for the seller and he seeks compensation for it by
demanding a ‘time value’. The time value of an option can be obtained by taking the
difference between its premium and its intrinsic value. Both calls and puts have time
value. An option that is Out-of-the-money (OTM) or At-the-money (ATM) has only
time value and no intrinsic value. Usually, the maximum time value exists when the
option is ATM. The longer the time to expiration, the greater is an option’s time value,
all else being equal. At expiration, an option has no time value.

73
Illustration:
In the following two tables, five different examples are given for call option
and put option respectively. As stated earlier, premium is determined by demand and
supply. The examples show how intrinsic value and time value vary depending on
underlying price, strike price and premium.

Intrinsic and Time Value for Call Options: Example (Amt in

Rs)

Underlying Strike Premium Intrinsic Time Value

Price Price Value
100 90 12 10 2
101 90 13 11 2
103 90 14 13 1
88 90 1 0 1
95 90 5.50 5 0.50

Intrinsic and Time Value for Put Options: Example (Amt in

Rs)

Underlying Strike Premium Intrinsic Time Value

Price Price Value
100 110 12 10 2
99 110 13 11 2
97 110 14 13 1
112 110 1 0 1
105 110 5.50 5 0.50

Factors affecting Options Prices:

The supply and demand of options and hence their prices are influenced by the
following factors:

· The underlying price,

· The strike price,
· The time to expiration,
· The underlying asset’s volatility, and
· Risk free rate

Each of the five parameters has a different impact on the option pricing of a
Call and a Put.

The underlying price:

73
 Call and Put options react differently to the movement in the underlying price.
As the underlying price increases, intrinsic value of a call increases and intrinsic value
of a put decreases. Thus, in the case of a Call option, the higher the price of the
underlying asset from strike price, the higher is the value (premium) of the call
option. On the other hand, in case of a put option, the higher the price of the
underlying asset, the lower is the value of the put option.

The strike price:

The strike price is specified in the option contract and does not change over
time. The higher the strike price, the smaller is the intrinsic value of a call option and
the greater is the intrinsic value of a put option. Everything else remaining constant,
as the strike price increases, the value of a call option decreases and the value of a
put option increases.
Similarly, as the strike price decreases, the price of the call option increases
while that of a put option decreases.

Time to expiration:

Time to expiration is the time remaining for the option to expire.

Obviously, the time remaining in an option’s life moves constantly towards
zero. Even if the underlying price is constant, the option price will still change since
time reduces constantly and the time for which the risk is remaining is reducing. The
time value of both call as well as put option decreases to zero (and hence, the price of
the option falls to its intrinsic value) as the time to expiration approaches zero. As
time passes and a call option approaches maturity, its value declines, all other
parameters remaining constant. Similarly, the value of a put option also decreases as
we approach maturity. This is called “time-decay”.

Volatility:

Volatility is an important factor in the price of an option. Volatility is defined as

the uncertainty of returns. The more volatile the underlying higher is the price of the
option on the underlying. Whether we are discussing a call or a put, this relationship
remains the same.

Risk free rate:

Risk free rate of return is the theoretical rate of return of an investment which
has no risk (zero risk). Government securities are considered to be risk free since
their return is assured by the Government. Risk free rate is the amount of return
which an investor is guaranteed to get over the life time of an option without taking
any risk. As we increase the risk free rate the price of the call option increases
marginally whereas the price of the put option decreases marginally. It may however
be noted that option prices do not change much with changes in the risk free rate.

The impact of all the parameters which affect the price of an option is given in
the table below:

With an Increase in Price of Call Option Price of Put Option

Parameter:
Asset Price(Underlying Price) ⇑ ⇓

73
 Exercise Price(Strike Price) ⇓ ⇑
Time of Expiration ⇑ ⇑
Volatility ⇑ ⇑
Risk Free Rate ⇑ ⇓

Even though option prices are determined by market demand and supply,
there are various models of getting a fair value of the options, the most popular of
which is the Black Scholes - Merton Model. In this model, the theoretical value of the
options is obtained by inputting into formula values of the above-mentioned five
factors. It may be noted that the prices arrived at by using this model are only
indicative.

4. Derivatives Trading On Exchange

NSE trades in futures and options (F&O) contracts on its F&O Segment. Its
derivatives markets clock daily volumes of Rs 60,000 crores on an average.

Derivatives Trading on NSE:

The F&O segment on NSE provides trading facilities for the following derivative
instruments:

· Index futures,
· Index options,
· Individual stock futures, and
· Individual stock options.

As an investor one can invest in any of these products. All these products have different
Contract specifications.

 Contract specifications for index based futures:

Index futures are futures contracts on an index, like the Nifty. The underlying
asset in case of index futures is the index itself. For example, Nifty futures traded in NSE
track spot Nifty returns. If the Nifty index rises, so does the pay off of the long position in
Nifty futures. Part from Nifty, CNX IT, Bank Nifty, CNX Nifty Junior, CNX 100, Nifty
Midcap 50 and Mini Nifty 50 futures contracts are also traded on the NSE. They have one-
month, two-month, and three month expiry cycle: a one-month Nifty futures contract
would expire in the current month, a two-month contract the next month, and a three-
month contract the month after. All contracts expire on the last Thursday of every
month, or the previous trading day if the last Thursday is a trading holiday. Thus, a
September 2009 contract would expire on the last Thursday of September 2009, which
would be the final settlement date of the contract. Table 6.1 summarizes contract
specifications for S&P Nifty Index Futures.

73
Table 6.1: Contract Specification for S&P Nifty Index Futures

Underlying Index S&P CNX Nifty

Exchange of trading National Stock Exchange of India Limited

Security Descriptor FUTIDX NIFTY

Contract Size Permitted lot size is 50

(minimum value Rs 2 lakh)

Trading Cycle The future contracts have a maximum of
Three month trading cycle - the near
month (one), the next month (two), and
the far month (three). New contracts are
introduced on the next trading day
following the expiry of the near month
Contract.

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Mark-to-market and final settlement are

cash settled on T+1 basis

Settlement Price Daily Settlement price is the closing price

of the futures contracts for the trading
day
and the final settlement price is the value
of the underlying index on the last trading
day

 Contract specifications for index based options:

73
 Index based options are similar to index based futures as far as the underlying is
concerned i.e., in both the cases the underlying security is an Index. As the value of the
index increases, the value of the call option on index increases, while put option value
reduces. All index based options traded on NSE are European type options and expire on
the last Thursday of the expiry month. They have expiries of one month or two months,
or three months. Longer dated expiry contracts with expiries up to 3.5 years have also
been introduced for trading. Table 6.2 summarizes contract specifications for S&P Nifty
Index Options.

Table 6.2: Contract Specification for S&P CNX Nifty Options

Underlying Index S&P CNX Nifty

Security Descriptor OPTIDX NIFTY

Contract Size Permitted lot size is 50

(minimum value Rs 2 lakh)

Trading Cycle The Option contracts have a maximum of
three month trading cycle---the near
month (one), the next month (two), and
The far month (three). New contracts are
introduced on the next trading day
following the expiry of the near month
Contract.

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Cash Settlement on T+1 basis

Style of Option European

Daily Settlement Not Applicable
Settlement Price Daily Settlement price is the closing price
of the futures contracts for the trading
day
and the final settlement price is the value
of the underlying index on the last trading
day

 Contract specifications for stock based futures

Stock based futures are futures based on individual stocks. The underlying on
these futures are the individual company stocks traded on the Exchange. The expiration

73
cycle of the stock futures is same as that of index futures. Table 6.3 summarizes the
contract Specification for Stock Futures.

Table 6.3: Contract Specification for Stock Futures

Underlying Index Individual Securities

Security Descriptor NSE

Contract Size As Specified by the exchange (Minimum

Value of Rs. 2 lakh)
Trading Cycle The futures contracts have a maximum of
three month trading cycle---the near
month (one), the next month (two), and
The far month (three). New contracts are
introduced on the next trading day
following the expiry of the near month
contract

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last
Thursday is a trading holiday

Settlement Basis Mark to market and final settlement is

cash
settled on T+1 basis

Settlement Price Daily settlement price is the closing price

of the futures contracts for the trading
day
and the final settlement price is the
closing
price of the underlying security on the
last

73
 Trading day.

 Contract specifications for stock based options:

Stock based options are options for which the underlying is individual stocks. As
opposed to index based options, all the stock based options at the NSE have American
style settlement. Table 6.4 summarizes the contract specification for Stock Options.

Table 6.4: Contract Specification for Stock Options

Underlying Index Individual Securities available for trading

in
cash market

Security Descriptor OPTSTK

Contract Size As Specified by the exchange (Minimum

Value of Rs. 2 lakh)
Trading Cycle The options contracts have a maximum of
three month trading cycle—the near
month
(one), the next month (two), and the far
Month (three). New contracts are
introduced on the next trading day
following the expiry of near month
contract

Expiry Day The last Thursday of the expiry month or

the previous trading day if the last

73
 Thursday is a trading holiday

Settlement Basis Daily Settlement on T+1 basis and final

option exercise settlement on T+1 basis

Style of Option American

Daily Settlement Premium Value (Net)
Settlement Price Closing price of underlying on exercise
day
or on expiry day

5. Accounting & Taxation effects of Derivatives

Accounting Area

73
 The Institute of Chartered Accountants of India (ICAI) has issued guidance notes
on accounting of index future contracts from the view point of parties who enter into such
future contracts as buyers or sellers. For other parties involved in the trading process,
like brokers, trading members, clearing members and clearing corporations a trade in
equity index futures is similar to a trade in; say shares, and accounting remains similar
as in the case of buying or selling of shares. As such after getting the real importance of
the Derivatives in the market, The Institute of Chartered Accountants of India (ICAI) has
also issued Accounting Standard 30 – “Financial Instruments – Recognition and
Measurement” which emphasis on the materiality of the derivative concept including its
Accounting and Taxation effects;

Accounting for Futures:

1. Accounting at the inception:

• Initial Margin paid to be debited:

“Initial Margin-Future A/c”
• Additional Margins to be accounted as above.
• When contract is made, no entry to be passed.
• On the Balance Sheet date the above account is shown under the heads
Current Assets.
• Initial Margin in the form of Bank guarantees or by lodging securities should be
disclosed in notes to A/cs.

2. Accounting at the time of daily settlement:

• Payments made or received on account of daily settlement is credited/debited

to:
“Mark-to-Market Margin – Future A/c”

3. Accounting for open positions:

• Anticipated loss to be provided for and anticipated profits to be ignored.

• Net payment made to the broker – “current assets, loans and advances (net of
provision for loss)”

4. Accounting at the time of final settlement:

• Profit/Loss = Final settlement price – Contract price

• Debited/Credited to “Mark to Market Margin – Futures A/c”
• Loss to be adjusted first against the provision made for the anticipated losses
and balance from the P&L.
• FIFO Method is followed.

73
 Accounting for Options:

1. Accounting at the Inception:

• Initial Margin paid to be paid by Seller to be debited:

• “Equity Index/ Stock Option Margin A/c”
• Buyer/holder not required to pay margin.
• Premium is to be paid to the seller by the holder of the option.
Which is debited:
• “Equity Index/ Stock Option Premium A/c”

2. Accounting at the time of payment/receipt of margin:

• Payments made or received on account of daily settlement is credited/debited

by the seller to:
• “Equity Index/ Stock Option Margin A/c”
• In case of deposit made by him instead of Bank A/c “Deposit for Margin A/c”
will be debited or credited.
• On Balance sheet date balance in the above A/c is shown under the head
“Current Assets”.

3. Accounting at the time of final settlement:

• On exercise of the option:

A. For Buyer premium to be debited to P&L and credited to “Equity Index /
Stock Option Premium A/c”
B. For Seller premium to be credited to P&L and debited to “Equity Index /
Stock Option Premium A/c”
• Final settlement price - Strike price = if -ve then paid by the writer.

INTERNATIONAL DERIVATIVES

Many exchanges in the world now offer futures contracts. Eurex, the German-Swiss
derivatives exchange, was the world’s biggest financial futures exchange at the end of
1999, overtaking the Chicago Board of Trade for the first time after a huge increase in
contracts traded in 1999. Eurex traded more than 379 million contracts during 1999,
53% more than in 1998.

Major Equity Derivative Exchanges in the World

Chicago Mercantile Exchange (CME)

Futures and Options on currencies, interest rates, stock indexes and agricultural
commodities are traded on CME.

The International Monetary Market (IMM) was formed in 1972 and became a division of
IMM in 1976. It began trading 7 foreign currencies in 1972, which were the first financial
futures contracts ever to be traded.

73
Eurex
Eurex is owned jointly by Deutsche Borse AG and The Swiss Exchange, each of which
hold 50% stake in the company. It was formed by merger of German Deutsche
Terminborse (DTB) and Switzerland’s SOFFEX. It has a fully electronic trading platform.

Hongkong Futures Exchange

The Exchange operates futures and options markets on a broad range of products
including equity index, stock, interest rate and foreign exchange products. These
products are traded either on the Exchange's trading floor via open outcry or
electronically on its Hong Kong Futures

The London International Financial Futures and Options Exchange (LIFFE)

LIFFE offers the most extensive range of derivative products of any exchange in the
world – providing futures and options contracts across six different currencies and across
four product lines – bonds, short term interest rates, equity indices & individual stocks
and commodities. The London Clearing House (LCH) acts as central counterparty to all
transactions on LIFFE, and offers the world’s most diverse range of margin offsets.

Singapore Exchange
Singapore exchange is the first demutualised integrated securities and derivatives
exchange in Asia Pacific. Inaugurated on 1st December 1999, It operates through several
subsidiaries

Other Financial Derivative Exchanges in the World

73
American Stock Exchange AEX-Options Exchange
(Netherlands)
MATIF (France)
MONEP (France)
Warsaw Stock Exchange (Poland)
Belgian Futures & Options
Chicago Board Options Exchange Exchange

Commodities and Futures Exchange

Budapest Stock Exchange
(Brazil)
Chicago Board of Trade
Commodity and Monetary Exchange of
Malaysia
Helsinki Exchange
Hong Kong Futures Exchange
Copenhagen Stock Exchange
Italian Derivatives Market (IDEM)
MICEX (Russia)
MICEX (Russia)
Montreal Exchange
Kansas City Board of Trade (USA)
New York Board of Trade
Korea Stock Exchange
New York Mercantile Exchange
New Zealand Futures & Options
Exchange Ltd.
OM London Exchange
Oporto Derivatives Exchange (Portugal)
Osaka Securities Exchange (Japan)
Oslo Stock Exchange (Norway)
South African Futures Exchange
Pacific Exchange (USA)
Spanish Financial Futures Market
Philadelphia Stock Exchange
Spanish Options Exchange
Rio de Janeiro Stock Exchange
Swedish Futures & Options Market
Taiwan International Mercantile
Exchange Santiago Stock Exchange
Sao Paulo Stock Exchange
Tokyo Stock Exchange
Toronto Futures Exchange

73
Popular Stock Index Futures in the World

NYSE Composite :

The NYSE composite was amongst the first stock index futures contract to be listed on
May 6, 1982 at the New York Futures Exchange (NYFE) a subsidiary of NYSE. It is
broadest of the broad stock indexes available representing every common stock traded
on the NYSE. It also has three choices in terms of its contract size depending on the
multiplier that best suits an investor. The regular contract launched on May 6, 1982 has a
multiplier of $500 times the index. The NYSE Large Composite Index Contract has
multiplier at $ 1000 while the NYSE small Composite Index uses a $ 250 multiplier.NYSE
large contract was aimed at institutional users who could reduce their commission costs.

73
S&P 500

It is a market-cap index representing 500 leading companies in leading industries in U.S.

in large cap blue chip stocks. It is most often used as the benchmark by fund managers
for judging their performance in US markets.S&P 500 futures contract dominates stock
index trading in the US. Fifteen years later share rise in index value and consequently
contract size led to reduction in contract multiplies to $ 250.

Dow Jones Industrial Average

It is the oldest and most well known stock measure in the world. Dow Jones & Company
started it in May 26, 1896. The next index in US came only 60 years later. The longevity
accounts for its continued popularity today as a preferred measure of the market.

It is a price-weighted index of 30 of the largest most liquid blue chip US stocks, a number
that has held steady since 1928.

RUSSEL 1000

This is sub set of the broader Russel 3000 index which tracks only U. S. companies.
NYBOT ( New York Board of Trade ) started futures and options based on Russel 1000 is
march 99, offering two contract size – one with $500 multiplier and another with a $1000
multiplier.Russel 1000 is a market capitalization index, but each ones weighting in the
index is based on available market capitalization. It is the stocks with the most tradable
outstanding shares at the highest price that will hold the most influence on the index
movement.

S & P Midcap 400

It is a capitalization weighted index of 400 U.S. stocks representing companies whose

capitalization is in the middle range of all firms. None of the stocks in S&P 500 can be in
S&P Midcap 400 and vice versa. Futures & Options on this index are traded at CME with a
Contract multiplier of $500.

NASDAQ 100

It comprises of top 100 non-financial stocks, domestic as well as foreign, listed on

NASDAQ. It trades on CME with two different contract multipliers - $100 and $20. It is a
market cap index with modified capitalization to reduce the overwhelming influence of its
top stocks like microsoft.

73
Hang Seng Index

This index is market capitalization weighted index of 33 stocks, representing about 70%
of the stock market’s total capitalization. Futures on Hang Seng Index are traded on
Hong Kong futures Exchange with a contract multiplier of H. K. $50.

Nikkei 225 Average

It is Japan’s longest running stock index. It is a price weighted stock index. Future
contracts on NIKKEI 225 trade or three exchange CME, OSE (Osaka) and Simex with
contract multiples of $5, Yen 1000 & Yen 500 respectively.

DAX

It is Germany’s blue chip index of 30 leading stocks. It is calculated on total returns basis
and not just on price basis.Income from dividends and rights issues are reinvested in the
index portfolio and are reflected in the index value. It is traded on Eurex with a contract
multiplier of Euro 25.

MIB-30

The MIB-30 is a capitalization weighted index of 30 blue chip stocks listed on the Italian
exchange. Futures & Options are traded in Italian derivatives market with a contract
multiples of Euro 5. The index typically accounts for more than 70% of the markets’ total
capitalization.

OMX

The Swedish Equity Index(OMX) is a capital weighted index of the 30 stocks with the
market trading volumes at the Stockholm Stock exchange. They account for about 66%
of the total market capitalization. Futures on the index are traded on OM Stockholm and
OM London.

FTSE 100

The FTSE 100 represents the value of the 100 largest companies listed on the LSE. These
blue chip stocks typically equal 2/3rd of the market’s total capitalization. FISE 100 is
maintained by FTSE International Ltd, a company formed in 1995 and jointly owned by
LSE and the Financial times. It is a market capitalization index. Futures & options on the
index are traded on LIFFE with a contract multiplier of Pound 10.

73
[5.0] BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

RISK MANAGEMENT
Futures and options contract can be used for altering the risk of investing in
spot market. For instance, consider an investor who owns an asset. He will
always be worried that the price may fall before he can sell the asset. He
can protect himself by selling a futures contract, or by buying a Put option.
This will help offset their losses in the spot market. Similarly, if the spot
price falls below the exercise price, the put option can always be exercised.

40
PRICE DISCOVERY
Price discovery refers to the markets ability to determine true equilibrium
prices. Futures prices are believed to contain information about future spot
prices and help in disseminating such information. As we have seen, futures
markets provide a low cost trading mechanism. Thus information pertaining
to supply and demand easily percolates into such markets. Options markets
provide information about the volatility or risk of the underlying asset.

OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction

costs. Secondly, they offer greater liquidity. Large spot transactions can
often lead to significant price changes. However, futures markets tend to be
more liquid than spot markets, because herein you can take large positions
by depositing relatively small margins

73
MARKET EFFICIENCY
The availability of derivatives makes markets more efficient; spot, futures and
options markets are inextricably linked. Since it is easier and cheaper to
trade in derivatives, it is possible to exploit arbitrage opportunities quickly
and to keep prices in alignment. Hence these markets help to ensure that
prices reflect true values.

INTRODUCTION OF FUTURES IN INDIA

The first derivative product to be introduced in the Indian securities market is going to be
"INDEX FUTURES".
In the world, first index futures were traded in U.S. on Kansas City Board of Trade
(KCBT) on Value Line Arithmetic Index (VLAI) in 1982.

What are 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".

Frequently used terms in Index Futures market

Contract Size - The value of the contract at a specific level of Index. It is Index level
Multiplier.

73
Multiplier - It is a pre-determined value, used to arrive at the contract size. It is the
price per index point.

Tick Size - It is the minimum price difference between two quotes of similar nature.

Contract Month - The month in which the contract will expire.

Expiry Day - The last day on which the contract is available for trading.

Open interest - Total outstanding long or short positions in the market at any specific
point in time. As total long positions for market would be equal to total short positions,
for calculation of open Interest, only one side of the contracts is counted.

Volume - No. of contracts traded during a specific period of time. During a day, during a
week or during a month.

Long position- Outstanding/unsettled purchase position at any point of time.

Short position - Outstanding/ unsettled sales position at any point of time.

Open position - Outstanding/unsettled long or short position at any point of time.

Physical delivery - Open position at the expiry of the contract is settled through
delivery of the underlying. In futures market, delivery is low.

Cash settlement - Open position at the expiry of the contract is settled in cash. These
contracts are designated as cash settled contracts. Index Futures fall in this category.

Concept of basis in futures market

 Basis is defined as the difference between cash and futures prices:

 Basis can be either positive or negative (in Index futures, basis generally is
negative).
 Basis may change its sign several times during the life of the contract.
 Basis turns to zero at maturity of the futures contract i.e. both cash and future
prices converge at maturity

73
Pricing Futures

Cost and carry model of Futures pricing

Fair price = Spot price + Cost of carry – Inflows

FPtT = CPt + CPt (RtT - DtT) (T-t)/365

FPtT - Fair price of the asset at time t for time T.

CPt - Cash price of the asset.
RtT - Interest rate at time t for the period up to T.
DtT - Inflows in terms of dividend or interest between t and T.

Cost of carry = Financing cost, Storage cost and insurance cost.

If Futures price > Fair price; Buy in the cash market and simultaneously sell in
the futures market.
If Futures price < Fair price; Sell in the cash market and simultaneously buy in
the futures market.

This arbitrage between Cash and Future markets will remain till prices in the Cash and
Future markets get aligned.

Set of assumptions

- No seasonal demand and supply in the underlying asset.

- Storability of the underlying asset is not a problem.
- The underlying asset can be sold short.
- No transaction cost; No taxes.
- No margin requirements, and so the analysis relates to a forward contract, rather
than a futures contract.

Index Futures and cost and carry model

73
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 - Spot prices.
F - Future prices.
E(S) - Expected Spot prices.

51

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 market’s expectations)

pecific 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.

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.

73
Speculators bring liquidity to the system, provide insurance to the hedgers and facilitate
the price discovery in the market.

Margining in Futures market

Whole system dwells on margins:

Daily Margins
Initial Margins
Maintenance margin

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.

Initial Margins
Margins to cover the potential losses for one day.
To be collected on the basis of value at risk at 99% of the days.

Maintenance margin
This is somewhat lower than the initial margin. This is set to ensure that the 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
expected to top up the margin account to the initial margin level before trading
commences on the next day.

73
Derivative Markets today

The Reserve Bank of India has permitted options, interest rate swaps, currency swaps
and other risk reductions OTC derivative products.

Forward Markets Commission has allowed the setting up of commodities futures

exchanges. Today we have 18 commodities exchanges most of which trade futures.
e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee Owners
Futures Exchange of India (COFEI). In 2000 an amendment to the SCRA expanded the
definition of securities to included Derivatives thereby enabling stock exchanges to trade
derivative products.

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.

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.

BSE's and NSE’s plans

Both the exchanges have set-up an in-house segment instead of setting up a separate
exchange for derivatives.

73
BSE’s Derivatives Segment, will start with Sensex futures as it’s first product.
NSE’s Futures & Options Segment will be launched with Nifty futures as the first product.

Product Specifications BSE-30 Sensex Future

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

ProductSpecifications S&P CNX Nifty Futures

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

Membership
Membership for the new segment in both the exchanges is not automatic and has to be
separately applied for.
Membership is currently open on both the exchanges.
All members will also have to be separately registered with SEBI before they can be
accepted.

Trading Systems
NSE’s Trading system for it’s futures and options segment is called NEAT F&O. It is based
on the NEAT system for the cash segment.
BSE’s trading system for its derivatives segment is called DTSS. It is built on a platform
different from the BOLT system though most of the features are common.

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.

Certification programs
The NSE certification programme is called NCFM (NSE’s Certification in Financial
Markets). NSE has outsourced training for this to various institutes around the country.
The BSE certification programme is called BCDE (BSE’s Certification for the Derivatives
Exchange). BSE conducts it’s own training run by it’s training institute. Both these
programmes are approved by SEBI.

Rules and Laws

Both the BSE and the NSE have been give in-principle approval on their rule and laws by
SEBI. According to the SEBI chairman, the Gazette notification of the Bye-Laws after the
final approval is expected to be completed by May 2000

73
Expected advantages of derivatives to the cash market

 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.
 Higher liquidity.


INTRODUCTION TO INDEXES

What’s an 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.

What’s a 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.

Why do we need an 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.

[8.4] What does the number mean?

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 weightages to the stocks in the portfolio.

73
But why a portfolio? Why not the entire market?

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.

How are the stocks in the portfolio weighted?

There are basically three types of weighing :Market Capitalisation weighted

Price weighted
Equal weighted
As may be discerned, the stocks in the index could be weighted based on their individual
prices, their market capitalisation or equally.

What is the better weighing option?

The market capitalisation weighted model is the most popular and widely considered to
be the best way of determining the index values.
In India both the BSE-30 Sensex and the S&P CNX Nifty are market capitalisation
weighted indexes.

Who owns the index? Who computes it ?

Typically exchanges around the world compute their own index and own it too. The
Sensex and the Nifty are case in point.
There are notable exceptions like the S&P 500 Index in the U.S. (owned by S&P which is
a credit rating company) and the Strait Times Index in Singapore (owned by the
newspaper of the same name).

Who decides what stocks to include? How?

Most index providers have a index committee of some sort that decides on the
composition of the index based on standardised selection and elimination criteria.
The criteria for selection of course depends on the philosophy of the index and its
objective.

Selection Criteria

Most indexes attempt to strike a balance between the following criteria.

Better Industry representation

Maximum coverage of market capitalization

Higher Liquidity or Lower Impact cost.

73
Industry Representation

Since the objective of any index is to be a proxy for the market it becomes imperative
that the broad industry sectors are faithfully represented in the Index too.Though this
seems like an easy enough task, in practice it is very difficult to achieve due to a number
of issues, not least of them being the basic method of industry classification.

Market Capitalisation

Another objective that most index providers strive to achieve is to ensure coverage of
some minimum level of the capitalisation of the entire market. As a result within every
industry the largest market capitalisation stocks tend to select themselves. However it is
quite a balancing act to achieve the same minimum level for every industry.

Liquidity or Impact Cost

It is important from the point of usability for all the stocks that are part of the index to be
highly liquid. The reasons are two-fold. An illiquid stock has stale prices and this tends to
give a flawed value to the index. Further for passive fund managers, the entry and exit
cost at a particular index level is high if the stocks are illiquid. This cost is also called the
impact cost of the index.

What is a Benchmark Index?

An index which acts as the benchmark in the market has an important role to play.While
it has to be responsive to the changes in the market place and allow for new industries or
give up on dead industries, at the same time it should also maintain a degree of
continuity in order to survive as an benchmark index.

What are 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.

73
What are 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 know 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 it’s better to replicate the index. Example in India are
UTI’s fund on the Sensex , IDBI MF’s fund on the Nifty

Exchange traded funds (ETFs)

These are similar to index funds that are traded on an exchange. These are pretty
popular world wide with non-resident investors who like to take an exposure to the entire
market.

S&P’s SPDRs and MSCI’s WEBS products are amongst the most popular products.

Index futures
Index futures are possibly the single most popular exchange traded derivatives products
today.The S&P 500 futures products is 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.

What is the trend abroad?

Although we have a whole host of popular exchange owned indexes abroad including the
DAX 30, the CAC 40 and the Hang Seng we see an increasing trend where global index
providers are seen to have more influence among the foreign funds and investing
community.

What do Global Index providers bring ?

In the age of cross border capital flows and global funds, global index provider provide
the uniformity and standardization in their index philosophy and methodologies that
allows a global fund to compare performance across regions or sectors.
By following a common industry classification standard in all the countries that they
operate in, index providers hope to wean away liquidity from the more popular and home

73
grown indexes.Also global providers are currently, the only ones in a position to provide
pan-continental or pan-global indexes.

What does the future look like?

The future in India looks pretty exciting with Index futures being launched and Index
options expected to follow. Hopefully with the growing popularity of ETF’s we might see
SEBI allowing them in India too.Globally while the debate between active and passive
fund management still rages, we see standardised indexes growing in popularity.

Financial Risk Management

Four Steps in Risk Management

Understand the nature of various risks.
Define a risk management policy for the organization and quantifying maximum risk that
organization is willing to take if quantifiable.
Measure the risks if quantifiable and enumerate otherwise.
Build internal control mechanism to control and monitor all the risks.

Step 1 – Understand the nature of various risks

Risks can be classified into four categories.

 Price or Market Risk

 Counterparty or Credit Risk
 Dealing Risk
 Settlement Risk
 Operating Risks

Price or market 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.

Counterparty or credit Risk 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.

73
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.

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.

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.

Step 2 - Define Risk Policy

Decide the basic risk policy that the organisation wants to have. This may vary from
taking no risk (cover all) to taking high risks (open all). Most organisations would fall
somewhere in between the two extremes. Risk and reward go hand in hand.

Cost Center Vs. Profit Center

A cost centre approach looks at exposure management as insurance against adverse

movements. One is not looking for optimisation of cost or realisation but meeting certain
budgeted or targeted rates. In a profit centre approach, the business is taking deliberate
risks to make money out of price movements.

Step 3- 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,
Modelling, Simulation, Stress Testing, Back Testing, etc.

Step 4- 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.

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.

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.).

Taxation Area

73
 Prior to the year 2005, the Income Tax Act did not have any specific provision
regarding taxability of derivatives. The only tax provisions which had indirect bearing on
derivatives transactions were sections 73(1) and 43(5). Under these sections, trade in
derivatives was considered “speculative transactions” for the purpose of determining tax
liability. All profits and losses were taxed under the speculative income category.
Therefore, loss on derivatives transactions could be set off only against other speculative
income and the same could not be set off against any other income. This resulted in high
tax liability.

Finance Act, 2005 has amended section 43(5) so as to exclude transactions in

derivatives carried out in a “recognized stock exchange” from ‘speculative transaction’.
This implies that derivatives transactions that take place in a “recognized stock
exchange” are not taxed as speculative income or loss. They are treated under the
business income head of the Income tax Act. Any losses on these activities can be set off
against any business income in the year and the losses can be carried forward and set off
against any other business income for the next eight years.

In simple words it can be said Income from derivative contracts:

-Not a speculative income

-Treated as Business income

-Losses can be set off against any other income during the year & Carried forward to
eight subsequent years

-Securities transaction tax paid on such transactions is eligible as deduction.

Arbitrage beyond option price bounds

The value of an option before expiration depends on six factors:

The level of the underlying index

The exercise price of the option

The time to expiration

The volatility of the index

The risk-free rate of interest

Dividends expected during the life of the option

These factors set general boundaries for possible option prices. If the option price is
above the upper bound or below the lower bound, there are profitable arbitrage
opportunities. We shall try to get an intuitive understanding about these bounds.

Upper bounds for calls and puts

73
A call option gives the holder the right to buy the index for a certain price. No matter
what happens, the option can never be worth more than the index. Hence the index level
is an upper bound to the option price.

C (less than equal to) I

If this relationship is not true, an arbitrageur can easily make a riskless profit by buying
the index and selling the call option. As we know a put option gives the holder the right
to sell the index for X. No matter how low the index becomes, the option can never be
worth more than X. Hence,

P (less than equal to) X

If this is not true, an arbitrageur would make profit by writing puts.

Lower bounds for calls and puts

The lower bound for the price of a call option is given by S-X (1+r) –T The price of a call

must be worth at least this much else, it will be possible to make risk less profit

S-X (1+r) –T < C

Consider an example. Suppose the exercise price for a three-month

Nifty call option is 1260. The spot index stands at 1386 and the risk-free rate of interest
is 12% per annum. In this case, he lower bound for the option price is 1386-1260
–0.25
(1+1.2) i.e. 161.20 Suppose the call is available at a premium of Rs.150 which is less
than the theoretical minimum of Rs. 163.20. An arbitrageur can buy a call and short the
index. This provides a cashflow of 1386-150 = 1236. If invested for three months at 12%
per annum, the Rs.1236 grows to Rs.1273. At the end of three months, the option
expires. At this point, the following could happen:

1. The index is above 1260, in which case the arbitrageur exercises his option and buys
back the index at 1260 making a profit of Rs.1273 - 1260 = Rs.13.

2. The index is below 1260 at say 1235, in which case the arbitrageur buys back the
index at the market price. He makes an even greater profit of 1273 - 1235 = Rs.38.

-T
The lower bound for the price of a put option is given by X (1+r) –
S. The price of a put must be worth at least this much else, it will be possible to make
riskless profits.

73
 -T
X (1+r) –S. < P

Consider an Example. Suppose exercise price for three- month Nifty put option is 1260.
The spot index stands at 1165 and the risk-free rate of interest is 12% per annum. In
this case the lower bound for the option price is Rs.59.80. Suppose the put is available at
a premium of Rs.45 which is less than the theoretical minimum of Rs.59.80. An
arbitrageur can borrow Rs.1210 for three months to buy both the put and the index. At
the end of the three months, the arbitrageur will be required to pay Rs.1246.3. Three
months later the option expires. At this point, the following could happen:

1. The index is below 1260, in which case the arbitrageur exercises his option, sells the
index at Rs.1260, repays the loan amount of Rs.1246.3 and makes a profit of Rs.13.7.

2. The index is above 1260 at say 1275, in which case the arbitrageur discards the
option, sells the index at 1275, repays the loan amount of Rs.1246.3 and makes an even
greater profit of 1275 - 1246.3 = Rs.28.7.

73
 Bibliography

Books

1. Options Futures, and other Derivatives by John C Hull

2. Derivatives FAQ by Ajay Shah
3. NSE’s Certification in Financial Markets: - Derivatives Core module
4. Investment Monitor Magazine July 2001

Reports

1. Regulatory framework for financial derivatives in India by Dr. L.C.Gupta

2. Risk containment in the derivatives markets by Prof.J.R.Verma

Websites

1. www.derivativesindia.com
2. www.nse-india.com
3. www.sebi.gov.in
4. www.scribd.com
5. www.appliederivatives.com
6. www.rediff/money/derivatives.htm

73
Derivatives Are New Packages of Old Things – Peter Fortune

---------*********---------

The End

73