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www.ranasingh.org
DER!vAT!vES
Dr. Rana Singh
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Futures S Options

erivatives
Part!
An !ntroduction

at is a erivative Security?
erivative securities, more appropriately
termed as derivative contracts, are assets
wic confer te investors wo take
positions in tem wit certain rigts or
obligations.

y o e Call Tem
erivatives?
Tey owe teir existence to te presence of a
market for an underlying asset or portfolio of
assets, wic may be considered as primary
securities.
Consequently suc contracts are derived from
tese underlying assets, and ence te name.
Tus if tere were to be no market for te
underlying assets, tere would be no derivatives.

road Categories of erivatives


Forward Contracts
Futures Contracts
Options Contracts
Swaps

ore Complex erivatives


Futures Options - Options contracts wic
are written on futures contracts
Compound options - Options contracts
wic are written on options contracts
Swaptions - Options on Swaps

efinition of a Forward Contract


A forward contract is an agreement
between two parties tat calls for te
delivery of an asset on a specified future
date at a price tat is negotiated at te
time of entering into te contract.

Forward Contracts (Cont.)


Every forward contract as a buyer and a
seller.
Te buyer as an obligation to pay cas
and take delivery on te future date.
Te seller as an obligation to take te
cas and make delivery on te future date.
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efinition of a Futures Contract
A futures contract too is a contract tat
calls for te delivery of an asset on a
specified future date at a price tat is fixed
at te outset.
!t too imposes an obligation on te buyer
to take delivery and on te seller to make
delivery.
Tus it is essentially similar to a forward
contract.
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Forward versus Futures
Yet tere are key differences between te
two types of contracts.
A forward contract is an OverteCounter
or OTC contract.
Tis means tat te terms of te
agreement are negotiated individually
between te buyer and te seller.
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Forward vs. Futures (Cont.)
Futures contracts are owever traded on
organized futures excanges, just te way
common stocks are traded on stock
excanges.
Te features of suc contracts, like te
date and place of delivery, and te quantity
to be delivered per contract, are fixed by
te excange.
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Forward vs. Futures (Cont.)
Te only job of te potential buyer and
seller wile negotiating a contract, is to
ensure tat tey agree on te price at
wic tey wis to transact.
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Options
An options contract gives te buyer te
rigt to transact on or before a future date
at a price tat is fixed at te outset.
!t imposes an obligation on te seller of te
contract to transact as per te agreed upon
terms, if te buyer of te contract were to
exercise is rigt.
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%igts
at is te difference between a %igt and
an Obligation.
An Obligation is a binding commitment to
perform.
A %igt owever, gives te freedom to
perform if desired.
!t need be exercised only if te older
wises to do so.
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%igts (Cont.)
!n a transaction to trade an asset at a
future date, bot parties cannot be given
rigts.
For, if it is in te interest of one party to go
troug wit te transaction wen te time
comes, it obviously will not be in te
interest of te oter.
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%igts (Cont.)
Consequently wile obligations can be
imposed on bot te parties to te
contract, like in te case of a forward or a
futures contract, a rigt can be given to
only one of te two parties.
Hence, wile a buyer of an option acquires
a rigt, te seller as an obligation to
perform imposed on im.
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Options (Cont.)
e ave said tat an option older
acquires a rigt to transact.
Tere are two possible transactions from
an investor's standpoint - purcases and
sales.
Consequently tere are two types of
options - Calls and Puts.
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Options (Cont.)
A Call Option gives te older te rigt to
acquire te asset.
A Put Option gives te older te rigt to
sell te asset.
!f a call older were to exercise is rigt,
te seller of te call would ave to make
delivery of te asset.
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Options (Cont.)
!f te older of a put were to exercise is
rigt, te seller of te put would ave to
accept delivery.
e ave said tat an option older as te
rigt to transact on or before a certain
specified date.
Certain options permit te older to
exercise is rigt only on a future date.
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Options (Cont.)
Tese are known as European Options.
Oter types of options permit te older to
exercise is rigt at any point in time on or
before a specified future date.
Tese are known as American Options.
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Longs S Sorts
Te buyer of a forward, futures, or options
contract is known as te Long.
He is said to ave taken a Long Position.
Te seller of a forward, futures, or options
contract, is known as te Sort.
He is said to ave taken a Sort Position.
!n te case of options, a Sort is also
known as te option riter.
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Comparison of Futures/Forwards
versus Options
!nstrument Nature of
Long's
Commitment
Nature of
Short's
Commitment
Forward/Futures
Contract
Obligation to
buy
Obligation to
sell
Call Options %igt to buy Obligation to
sell
Put Options %igt to sell Obligation to
buy
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Swaps
A swap is a contractual agreement between
two parties to excange specified cas
flows at predefined points in time.
Tere are two broad categories of swaps -
!nterest %ate Swaps and Currency Swaps.
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!nterest %ate Swaps
!n te case of tese contracts, te cas
flows being excanged, represent interest
payments on a specified principal, wic
are computed using two different
parameters.
For instance one interest payment may be
computed using a fixed rate of interest,
wile te oter may be based on a variable
rate suc as L!O%.
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!nterest %ate Swaps (Cont.)
Tere are also swaps were bot te
interest payments are computed using two
different variable rates - For instance one
may be based on te L!O% and te oter
on te Prime %ate of a country.
Obviously a fixedfixed swap will not make
sense.
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!nterest %ate Swaps (Cont.)
Since bot te interest payments are
denominated in te same currency, te
actual principal is not excanged.
Consequently te principal is known as a
notional principal.
Also, once te interest due from one party
to te oter is calculated, only te
difference or te net amount is excanged.
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Currency Swaps
Tese are also known as crosscurrency
swaps.
!n tis case te two parties first excange
principal amounts denominated in two
different currencies.
Eac party will ten compute interest on
te amount received by it as per a pre
defined yardstick, and excange it
periodically.
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Currency Swaps (Cont.)
At te termination of te swap te principal
amounts will be swapped back.
!n tis case, since te payments being
excanged are denominated in two
different currencies, we can ave fixed
floating, floatingfloating, as well as fixed
fixed swaps.
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Actors in te arket
Tere are tree broad categories of market
participants:
Hedgers
Speculators
Arbitrageurs
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Hedgers
Tese are people wo ave already
acquired a position in te spot market prior
to entering te derivatives market.
Tey may ave bougt te asset
underlying te derivatives contract, in
wic case tey are said to be Long in te
spot.
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Hedgers (Cont.)
Or else tey may ave sold te underlying
asset in te spot market witout owning it,
in wic case tey are said to ave a Sort
position in te spot market.
!n eiter case tey are exposed to Price
%isk.

Hedgers (Cont.)
Price risk is te risk tat te price of te
asset may move in an unfavourable
direction from teir standpoint.
at is adverse depends on weter tey
are long or sort in te spot market.
For a long, falling prices represent a
negative movement.

Hedgers (Cont.)
For a sort, rising prices represent an
undesirable movement.
ot longs and sorts can use derivatives
to minimize, and under certain conditions,
even eliminate Price %isk.
Tis is te purpose of edging.

Speculators
Unlike edgers wo seek to mitigate teir
exposure to risk, speculators consciously
take on risk.
Tey are not owever gamblers, in te
sense tat tey do not play te market for
te seer trill of it.

Speculators (Cont.)
Tey are calculated risk takers, wo will
take a risky position, only if tey perceive
tat te expected return is commensurate
wit te risk.
A speculator may eiter be betting tat te
market will rise, or e could be betting tat
te market will fall.

Hedgers S Speculators
Te two categories of investors
complement eac oter.
Te market needs bot types of players to
function efficiently.
Often if a edger takes a long position, te
corresponding sort position will be taken
by a speculator and vice versa.

Arbitrageurs
Tese are traders looking to make costless
and riskless profits.
Since derivatives by definition are based on
markets for an underlying asset, it is but
obvious tat te price of a derivatives
contract must be related to te price of te
asset in te spot market.

Arbitrageurs (Cont.)
Arbitrageurs scan te market constantly for
discrepancies from te required pricing
relationsips.
!f tey see an opportunity for exploiting a
misaligned price witout taking a risk, and
after accounting for te opportunity cost of
funds tat are required to be deployed,
tey will seize it and exploit it to te ilt.
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Arbitrageurs (Cont.)
Arbitrage activities terefore keep te
market efficient.
Tat is, suc activities ensure tat prices
closely conform to teir values as predicted
by economic teory.
arket participants, like brokerage ouses
and investment banks ave an advantage
wen it comes to arbitrage vis a vis
individuals.
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Arbitrageurs (Cont.)
Firstly, tey do not typically pay
commissions for tey can arrange teir own
trades.
Secondly, tey ave ready access to large
amounts of capital at a competitive cost.
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Assets Underlying Futures
Contracts
Till about two decades ago most of te
action was in futures contracts on
commodities.
ut nowadays most of te action is in
financial futures.
Among commodities, we ave contracts on
agricultural commodities, livestock and
meat, food and fibre, metals, lumber, and
petroleum products.

Food grains S Oil seeds


Corn
Oats
Soybeans
eat

Livestock S eat
Hogs
Feeder Cattle
Live Cattle
Pork ellies

Food S Fibre
Cocoa
Coffee
Cotton
Sugar
%ice
Frozen Orange ]uice Concentrate

etals
Copper
Silver
Cold
Platinum
Palladium

Petroleum S Energy Products


Crude Oil
Heating Oil
Casoline
Propane
Electricity

Financial Futures
Traditionally we ave ad tree categories
of financial futures:
Foreign currency futures
Stock index futures
!nterest rate futures
Te latest entrant is futures contracts on
individual stocks - called single stock
futures or individual stock futures

Foreign Currency Futures


Australian ollars
Canadian ollars
ritis Pounds
]apanese Yen
Euro
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ajor Stock !ndex Futures
Te ]!A
SSP 00
Nikkei
NASAQ100
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!nterest %ate Futures
Tbill Futures
Tnote Futures
Tbond Futures
Eurodollar Futures
Federal Funds Futures
exican Tbill (CETES) Futures
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Assets Underlying Options
Contracts
Historically most of te action as been in
stock options.
Commodity options do exist but do not
trade in te same volumes as commodity
futures.
Options on foreign currencies, stock
indices, and interest rates are also
available.

ajor Clobal Futures Excanges


S Trading volumes in 2001
EXCHANCE vOLUNE in Nillions
CE 1.0
COT 210.0
NYEX .0
EU%EX .1
L!FFE 11.
Tokyo Commodity Ex. .
orea Stock Ex. 1.
Singapore Excange 0.
SF .2

Cicago versus Frankfurt


EU%EX is a relatively new excange.
However it is a state of te art electronic
trading platform.
Te Cicago excanges ave traditionally
been floor based, or wat are called open
outcry excanges.
Competition is now forcing tem to
embrace tecnological innovations.

Equity Options arkets S


Trading volumes in 2000
EXCHANCE Stock Options
volume in
1,000s
!ndex Options
volume in
1,000s
AEX 20,1 1,
COE 21,12 ,
COT NT 200
CE NT 0
!SE ,1 NT
EU%EX ,2 ,200
O 0,2 ,1
orea SE NT 1,2

y Te rouaa?
erivatives as a concept ave been around
for a long time.
!n fact tere is a ypotesis tat suc
contracts originated in !ndia, a few
centuries ago.
ut tey ave gained tremendous visibility
only over te past two to tree decades.

y? (Cont.)
Te question is, wat are te possible
explanations for tis surge in interest.
Till te 10s, most of te trading activities
were confined primarily to commodity
futures markets.
However, financial futures ave gained a
lot of importance, and te bulk of te
observed trading, is in suc contracts.

y ? (Cont.)
Te simple fact is tat over te past few
decades, te exposure to economic risks,
especially tose impacting financial
securities, as increased manifold for most
economic agents.
Let us take te case of commodities first.
Tere was a war in te iddle East in
1.

Commodities
Subsequently, Arab nations began to use
crude oil prices as a policy instrument.
Tis lead to enormous volatility and
unpredictability in oil prices.
Te result was an enanced volatility in te
prices of virtually all commodities.
0
Commodities (Cont.)
Te is because te transportation costs of
all commodities is directly correlated wit
te price of crude oil.
Since commodity prices became volatile,
instruments for risk management became
increasingly popular.
Consequently commodity derivatives got a
furter impetus.
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Excange %ates
Te retton oods system of fixed
excange rates based on a Cold Excange
standard was abandoned in te 10s and
currencies began to float freely against
eac oter.
volatility of excange rates, and its
management, lead to te growt of te
market for FO%EX derivatives.
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!nterest %ates
Traditionally, central banks of countries
ave desisted from making frequent
canges in te structure of interest rates.
However, beginning wit te early 10's,
te U.S. Federal %eserve under te
cairmansip of Paul volcker began to use
money supply as a tool for controlling te
economy.

!nterest %ates (Cont.)


!nterest rates consequently became market
dependent and volatile.
Tis ad an impact on all facets of te
economy since te cost of borrowed funds,
namely interest, as direct consequences
for te bottom lines of businesses.
Hence interest rate derivatives got a fillip.

LPC
!n te 10s and 10s, many economies
wic ad remained regulated until ten,
began to embrace an LPC policy -
Liberalization, Privatization, and
Clobalization.
it te removal of controls, capital began
to flow freely across borders.

LPC (Cont.)
As economies became interconnected,
risks generated in one market were easily
transmitted to oter parts of te world.
%isk management terefore became an
issue of universal concern, leading to an
explosion in derivatives trading.

eregulation of te rokerage
!ndustry
On 1 ay 1, fixed brokerage commissions
were abolised in te U.S.
Tis is called ay ay
Subsequently, brokers and clients were given te
freedom to negotiate commissions wile dealing
wit eac oter.
!n October 1, fixed commissions were
eliminated in London, and in 1 ]apan
deregulated its brokerage industry.

eregulation (Cont.)
Also, from February 1, te LSE began
admitting foreign brokerage firms as full
members.
Te objective of te entire exercise was to
make London an attractive international
financial market, wic could effectively
compete wit markets in te U.S.

eregulation (Cont.)
London as a tremendous locational
advantage in te sense tat it is located in
between markets in te U.S. and tose in
te Far East.
Hence it is a vital middle link for traders
wo wis to transact round te clock.

eregulation (Cont.)
!n a deregulated brokerage environment,
commissions vary substantially from broker
to broker, and depend on te extent and
quality of services provided by te firm.
A full service broker will carge te igest
commissions, but will offer valueadded
services and advice.
0
eregulation (Cont.)
A deepdiscount broker will carge te
least but will provide only te bare
minimum by way of service.
Here is a comparison of fees carged on an
average by different categories of brokers
in te U.S.
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rokerage %ates
rokerage
Type
Commission
on Stock
Options
Commissions
on Futures
eepdiscount $1 per contract,
minimum $1
per trade
$ per contract
iscount $2 + 1. of
principal
$20 per contract
Full Service $0$100 per
trade
$0$12 per
contract
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!T
Finally, te key driver beind te
derivatives revolution as been te rapid
growt in te field of !T.
From streamlining backend operations to
facilitating arbitrage using stock index
futures, computers ave played a pivotal
role.

%evival of Trading in !ndia


Financial sector reforms ave been an
integral part of te liberalization process.
!nitially te focus was on streamlining and
modernizing te cas market for securities.
various steps were terefore taken in tis
regard.
A modern electronic excange, te NSE
was set up in 1.

!ndia (Cont.)
Te National Securities Clearing
Corporation (NSCCL) was set up to clear
and settle trades.
ematerialized trading was introduced wit
te setting up of te NSL.
Te attention ten sifted to derivatives,
for it was felt tat tat investors in !ndia
needed access to risk management tools.

!ndia (Cont.)
Tere was owever a legal barrier.
Te Securities Contracts %egulation Act,
SC%A, proibited trading in derivatives.
Under tis Act forward trading in securities
was banned in 1.
Forward trading on certain agricultural
commodities owever was permitted,
altoug tese markets ave been very
tin.

!ndia (Cont.)
Te first step was to repeal tis Act.
Te Securities Laws (Amendments)
Ordinance was promulgated in 1.
Tis ordinance witdrew te proibition on
options on securities.
Te next task was to develop a regulatory
framework to facilitate derivatives trading.

!ndia (Cont.)
SE! set up te L.C. Cupta committee in
1 to develop suc a framework.
Te committee submitted its report in
1.
!t recommended tat derivatives be
declared as securities so tat te regulatory
framework applicable for te trading of
securities could also be extended to include
derivatives trading.

!ndia (Cont.)
Trading in derivatives as its inerent risks
from te standpoint of nonperformance of
a party wit an obligation to perform.
For tis purpose SE! appointed te
].%. varma Committee to recommend a
suitable risk management framework.
Tis committee submitted its report in
1.

!ndia (Cont.)
Te SC%A was amended in ecember 1
to include derivatives witin te ambit of
securities.
Te Act made it clear tat trading in
derivatives would be legal and valid only if
suc contracts were to be traded on a
recognized stock excange.
Tus OTC derivatives were ruled out.
0
!ndia (Cont.)
!n arc 2000, te notification proibiting
forward trading was rescinded.
!n ay 2000 SE! permitted te NSE and
te SE to commence trading in
derivatives.
To begin wit trading in index futures was
allowed.
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!ndia (Cont.)
Tus futures on te SSP CNX Nifty and te
SE0 (Sensex) were introduced in ]une
2000.
Approval for index options and options on
stocks was subsequently granted.
!ndex options were launced in ]une 2001
and stock options in ]uly 2001.
Finally futures on stocks were launced in
November 2001.
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Turnover in Crores
Nonth !ndex
Futures
Stock
Futures
!ndex
Options
Stock
Options
Total
]un00
ec00 2 2
]un01 0 1
]ul01 10 2 201
Nov01 2 211 010 0
ar02 21 1 0 200
200102 212 11 21 1012

!nterest %ate erivatives


!n ]uly 1 te %! permitted banks to
enter into interest rate swap contracts.
On 2 ]une 200 te Finance inister
launced futures trading on te NSE on T
bills and 10 year bonds.

y Use erivatives
erivatives ave many vital economic roles
in te free market system.
Firstly, not every one as te same
propensity to take risks.
Hedgers consciously seek to avoid risk,
wile speculators consciously take on risk.
Tus risk reallocation is made feasible by
active derivatives markets.

y erivatives? (Cont.)
!n a free market economy, prices are
everyting.
!t is essential tat prices accurately convey
all pertinent information, if decision making
in suc economies is to be optimal.
How does te system ensure tat prices
fully reflect all relevant information?

y erivatives? (Cont.)
!t does so by allowing people to trade.
An investor wose perception of te value
of an asset differs from tat of oters, will
seek to initiate a trade in te market for
te asset.
!f te perception is tat te asset is
undervalued, tere will be pressure to buy.

y erivatives? (Cont.)
On te oter and if tere is a perception
tat te asset is overvalued, tere will be
pressure to sell.
Te imbalance on one or te oter side of
te market will ensure tat te price
eventually attains a level were demand is
equal to te supply.

y erivatives? (Cont.)
en new information is obtained by
investors, trades will obviously be induced,
for suc information will invariably ave
implications for asset prices.
!n practice it is easier and ceaper for
investors to enter derivatives markets as
opposed to cas or spot markets.

y erivatives? (Cont.)
Tis is because, te investor can trade in a
derivatives market by depositing a
relatively small performance guarantee or
collateral known as te margin.
On te contrary taking a long position in
te spot market would entail paying te full
price of te asset.
0
y erivatives? (Cont.)
Similarly it is easier to take a sort position
in derivatives tan to sort sell in te spot
markets.
!n fact, many assets cannot be sold sort in
te spot market.
Consequently new information filters into
derivatives markets very fast.
1
y erivatives? (Cont.)
Tus derivatives facilitate Price iscovery.
ecause of te ig volumes of
transactions in suc markets, transactions
costs tend to be lower tan in spot
markets.
Tis in turn fuels even more trading
activity.
Also derivative markets tend to be very
liquid.
2
y erivatives? (Cont.)
Tat is, investors wo enter tese markets,
usually find tat traders wo are willing to
take te opposite side are readily available.
Tis enables traders to trade witout
aving to induce a transaction by making
major price concessions.

y erivatives? (Cont.)
erivatives improve te overall efficiency of
te free market system.
ue to te ease of trading, and te lower
associated costs, information quickly filters
into tese markets.
At te same time spot and derivatives
prices are inextricably linked.

y erivatives? (Cont.)
Consequently, if tere is a perceived
misalignment of prices, arbitrageurs will
move in for te kill.
Teir activities will eventually lead to te
efficiency of spot markets as well.
Finally derivatives facilitate speculation.
And speculation is vital for te free market
system.

Tank You
Questions / doubts /queries are most
welcome.

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