Introduction to derivatives

Introduction to derivatives
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices.

Derivatives defined
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

Arbitrage
Arbitrage is an important concept in valuing (pricing ) derivative securities. If a return greater than risk free return can be earned by holding a portfolio of assets that produce a certain (risk less) return, then arbitrage opportunity exists. Arbitrage opportunity arises when securities are mis priced

Principals of Derivatives
There are 2 types of arbitrage arguments that are useful in study and use of derivative -law of one price, 2 securities that have identical cash flow in the future, regardless of the future events, should have the same price. If A & B have the identical future payoffs and A is priced is lower than B, buy A and sell B

Principals of Derivatives
The second type of arbitrage is used when 2 securities with uncertain returns can be combined in a portfolio that have a certain payoff. If a portfolio consisting of A and B has a certain pay off, the portfolio should yield the risk free rate. If this no arbitrage condition is violated in that the certain return of A and B together is higher than the risk free rate, an arbitrage opportunity exists.

Products, participants and functions

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants - hedgers, speculators, and arbitrageurs trade in the derivatives market.

Need for Derivatives Market.

The derivative market helps to transfer the risks from those who have them but may not like them to those who appetite for them. Market Risk Credit Risk Price Discovery. Increased integration of national financial markets with the international markets. Derivative market helps to increase savings and investment in the long run.

Types of derivatives
Forwards Futures Swaps Warrants

DERIVATIVES WORLD

Types of markets
Cash: Payment is made as soon as the deal is struck Tom:Price is decided today whereas the transaction will be settled on the next business day Spot: Price is decided today whereas the transaction is settled two (or More) business days later

Forward/future: Price is decided today whereas the transaction takes place on a future date (few months)

Exchange-traded vs. OTC derivatives markets

The management of counter-party (credit) risk is decentralized and located within individual institutions, There are no formal centralized limits on individual positions, leverage, or margining, There are no formal rules for risk and burden-sharing, There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and The OTC contracts are generally not regulated by a regulatory authority and the exchanges self regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance

Derivatives market in India

The derivatives trading on the exchange commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Nifty Index. Currently, the futures contracts have a maximum of 3-month expiration cycles. Three contracts are available for trading, with 1 month, 2 months and 3 months expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.

CLEARING AND SETTLEMENT

Understanding volume
They benchmark the degree of activity Volume is the velocity of trading or number of contracts traded in a day (and not the sum of buyers & sellers) . To determine volume, simply add either all buyers or all sellers. Number of contract traded includes creation of new contract, transfer or liquidation of a contract.

Understanding Open Interest

Open Interest (OI) measures the number of contracts held at the conclusion of a trading session It is a description of participation -traders show their conviction to the market participation by taking their positions home with them, at least overnight. Important as many transactions may take place during the day without initiating new contracts

An example
Day 1 Trader A buys one contract Trader B sells one contract Trader C buys one contract Trader D sells one contract Day 2 Trader E buys one contract Trader A sells to offset Day 3 Trader F buys one contract Trader G sells one contract Trader B buys to offset Trader C sells to offset Trader E sells to offset Trader D buys to offset OI - 4 contracts Vol. - 2 contract

OI - 4 contracts Vol. - 1 contract OI - 2 contracts Vol. - 3 contracts

SETTLEMENT MECHANISM
Final Settlement: On expiry of the Futures market , all positions of a CM , as existing at the close of trading hours on the expiry day, are marked to market at the final settlement price of the contract , and the resulting profit/loss shall be settled in cash. The loss/profit amount shall be debited /credited to the relevant CMs on T+1 Day. Final settlement price shall be the closing price of the underlying security in the capital market segment of the NSE/BSE, on the expiration day of the futures contract.

SETTLEMENT MECHANISM
Premium Settlement: Buyers of option contracts are liable to pay the premium amount to the sellers. The pay-in and pay-out of the premium settlement is on T+1 days. Exercise Settlement: Interim Exercise Settlement: An investor can exercise his in-the-money options at any time during trading hours. It shall be effected at the close of the trading hours ,on the day of exercise.

SETTLEMENT MECHANISM
The investor who has exercised the option will receive the exercised settlement value per unit of the option from the investor who has been assigned the option contract. Exercise settlement value is the difference between the strike price and the exercise price. Exercise settlement price is the closing price of the security on which the option was purchased The settlement is on T+1 days.

SETTLEMENT MECHANISM
Exercise Settlement : Final Exercise settlement shall be effected for all open long in-the-money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long positions shall be exercised and automatically assigned to short positions in option contracts with the same series, on a random basis. Final Settlement on T+1 days.

Trading mechanism
The futures and options trading system of NSE, called NEAT-F&O trading system, provides a fully automated screenbased trading for Nifty futures & options and stock futures & options on a nationwide basis and an online monitoring and surveillance mechanism. It supports an anonymous order driven market which provides complete transparency of trading operations and operates on strict price time priority. It is similar to that of trading of equities in the Cash Market (CM) segment.

Clearing and settlement

NSCCL undertakes clearing and settlement of all deals executed on the NSEs F&O segment. It acts as legal counterparty to all deals on the F&O segment and guarantees settlement.

Clearing
The first step in clearing process is working out open positions or obligations of members. Positions are calculated on net basis (buysell) for each contract. Clients positions are arrived at by summing together net (buy-sell) positions of each individual

Settlement
All futures and options contracts are cash settled, i.e. through exchange of cash. The underlying for index futures/options of the Nifty index cannot be delivered. Futures and options on individual securities can be delivered as in the spot market. However, it has been currently mandated that stock options and futures would also be cash settled.

Risk management system The salient features of risk containment measures on the F&O segment are: NSCCL charges an upfront initial margin for all the open positions of a CM up to client level. It follows the VaR based margining system NSCCL computes the initial margin percentage for each Nifty index futures contract on a daily basis

Market Index
What are some major uses of securitymarket indicator series (indexes)? Factors in Constructing Market Indexes? What are the major stock-market indexes series Bond-market indexes

Uses of Security Market

For calculating benchmark returns to judge portfolio performance For development of an index portfolio For technical analysis, to predict future price movements To compute a securitys systematic risk by examining how its return responds to changes in the market index

Factors in Constructing Market Indexes

The sample of firms to include
What is the intended population that the sample is to represent? How large a sample is needed for the index to be representative?

Weighting system for sample members

Should the weighting system be based on price, total firm value, or equally weighted?

Stock-Market Indicator Series

Price-Weighted Series
Dow Jones Industrial Average (DJIA)

Value-Weighted Series
NYSE Composite S&P 500 Index BSE Sensex

Price weighted Index (DJIA)

Best-known, oldest, most popular index Price-weighted average of thirty large well-known industrial stocks, leaders in their industry and listed. Total the current price of the 30 stocks and divide by a divisor

Criticism of the Price weighted Index

Sample used is limited
30 non-randomly selected blue-chip stocks are not representative of the all listed stocks

Price-weighted series(emphasis on price rather than value)

Places more weight on higher-priced stocks rather than those with higher market values Introduces a downward bias in DJIA by reducing weight of growing companies whose stock splits

Value-Weighted Series
Although the price weighted index is a popular index, the most popular type is value-weighted. Derive the initial total market value of all stocks used in the series Market Value = Number of Shares Outstanding x Current Market Price Beginning index value is usually 100, new market values change the value of the index Automatic adjustment for splits Weighting depends on market value

Value-Weighted Series
Index t PQ P Q
t b t b

Beginning Index Value

where: Indext = index value on day t Pt = ending prices for stocks on day t Qt = number of outstanding shares on day t Pb = ending price for stocks on base day Qb = number of outstanding shares on base day

Date Price O/s Shares Product January 1, 2000 300 10000 3000000 January 1, 2004 360 150000 54000000 Value of Index 1800

Bond-Market Indicator Series

Relatively new and not widely published Growth in fixed-income mutual funds increase need for reliable benchmarks for evaluating performance Increasing interest in bond index funds, which requires an index to emulate
Many managers have not matched aggregate bond market return

Difficulties in Creating a BondMarket Index

Range of bond quality varies from Treasury securities to bonds in default Bond market changes constantly with new issues, maturities, calls, and sinking funds Bond prices are affected differently by changing interest rates dependent on maturity, coupon, and market yield Correctly pricing individual bond issues can be a challenge without current and continuous transaction prices available

Total Index Returns Index ALL 234.82 1 yr -3 yr 3-8 yr 8+ TB GS 191.8

Principal Avg. Portfolio Avg. Portfolio Portfolio Returns Residual Modified Coupon YTM Duration index Maturity Duration 127.37 8.93 9.092 7.293 5.751 5.548 98.46 10.514 9.652 0 8.93 1.913 5.54 0.401 9.778 7.578 7.064 7.324 6.043 7.299 1.736 4.367 8.427 0.397 6.123 1.673 4.218 8.129 0.385 5.908

229.39 115.92 286.5 145.87 195.39 195.39 239.28 119.95

8.235 14.427

Introduction to futures and options

Forward contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

 Bilateral Contracts Custom Designed Contract price is not availble in public domain Can be off set with the same counterparty

The salient features of forward contracts are:

Limitations of forward markets

Forward markets world-wide are afflicted by several problems: Lack of centralisation of trading Counterparty risk Illiquidity

Introduction to futures
Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy v or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered,(or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way.

Introduction to options
Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an upfront payment.