Professional Documents
Culture Documents
Dr Roshna Varghese
Session 2
Futures Stock , Commodity, currency futures
Session 3
Swaps Stock exchange regulations
Investment
Investment is a commitment of funds made in the expectation of some positive rate of return. Investment
Savings, , if Income > expenditure Expectation of return Tangible Asset Physical ass- E.g. Land, machinery, work of art Dealt in product market Intangible Asset Financial Assets - shares, bonds, derivatives, mutual funds, Dealt in Financial market
Characteristics of investment
Return Risk Marketability Safety
Investment Avenues
Corporate Securities
Equity shares Preference shares Debentures/Bonds GDRs/ADRs
Derivatives Govt and semi govt Securities Money market instruments Mutual fund schemes Deposits in banks and non banking companies Post office Savings/Life insurance policies Provident fund schemes Real assets Real estate, precious objects
Securities
Definition of Security Securities include shares, bonds, debentures or other marketable securities like securities of incorporated companies or other body corporates or government.
Securities Market
Money Market
Debt instruments having a maturity of less than one year are dealt in money market. T- bill market, Ready forward contracts (Repo) market, Call money market, Commercial Paper market
Capital Market
Securities with maturities of more than one year are bought and sold in the capital market. Equity Market; Debt Market ; Derivatives market Primary or Secondary market
Derivatives
Derivatives
Instruments that derive value from underlying assets. Changes in price of the underlying asset affect the price of the derivative security.
Securities
stock, Bonds and other debt instruments
Types of Derivatives
Options Futures Complex Derivatives
Swaps Credit Derivatives
Equity
Debt
Forex
Commoditi es
Forwards Futures
Derivatives - History
Not a modern invention
First option transaction by Greek Philosopher Thales from Miletus (624 BC 546 BC) Evolved from commodity markets
Establishment of Chicago Board of Trade (CBoT) in 1848 Publication of Black Scholes Option pricing model in 1973 In India
First organised futures market in 1875 in Bombay After independence, prohibited derivatives trading Reintroduction in 2000
Options
Option is the right to either buy or sell something, at a specified price within a specified period of time.
Is a contract in which the writer of the option grants the buyer of the option the right to purchase from or sell to the writer a designated instrument at a specific price within a specified period of time.
Options
The writer grants the right to the buyer for a certain sum of money option premium. The price at which the buyer can exercise the option Exercise price/ strike price/ striking price. Call option & Put option American option and European Option
Put option :
An option that grants the buyer the right to sell the designated instrument.
European option :
can be exercised only on the expiration date.
Seller
Unlimited risk Limited return potential
Commodity options
Agricultural commodities Industrial commodities
In India, option trading in all commodities is prohibited by Forwards Contracts (Regulation) Act, 1952
A std option contract : allows the buyer to buy or sell . shares of stock at a specific price. Call option & Put option Expiration date : date on which the option contract expires. Exercise price / Striking price Premium : Synonymous with price
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Buyer (holder). original seller is called writer. Seller is not the same as writer for an existing option. Option Buyer is in Long position Option Writers is in short position Writing calls covered : Writing call options against the shares owned by the writer Uncovered call options : Writing call options without owning the underlying shares.
At any time
, option maybe: Call ExP = MP ExP < MP ExP > MP Put ExP = MP ExP > MP ExP < MP
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Strike Price
Strike Price
Trading in derivatives
Trading in options on index and stocks commenced on NSE and BSE in 2001 Currency options in NSE and USE in October 2010
Financial Options
Single stock options
Trading in options on individual securities commenced from July , 2001. Option contracts are European style and cash settled and are available on 223 securities stipulated by the Securities & Exchange Board of India (SEBI). The value of the option contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction for the first time at any exchange Options contracts expire on the last Thursday of the expiry month.
If the last Thursday is a trading holiday, the contracts expire on the previous trading day.
Financial Options
Index Options
NSE introduced trading in index options on June 4, 2001. The options contracts are European style and cash settled The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction Nifty Index contract multiplier is 100 BSE Senses contract multiplier is 50
Trading cycle
S&P CNX Nifty options contracts have
3 consecutive monthly contracts On expiry of the near month contract, new contracts (monthly/quarterly/ half yearly contracts as applicable) are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract.
ET Reading - Options
ET reading of options
Open interest
Number of outstanding contracts at a particular point of time, typically at the end of the trading day. Total no of long positions will always be equal to the total number of short positions, only one side of the contract will be counted
Contracts
Option value
Rate of change in option price due to change in price of the underlying asset is known as Delta. Rate of change in option price due to time left to expiration is known as Theta. Rate of change in option price due to change in volatility of the underlying asset is known as Vega. Rate of change in option price due to change in interest rate is known as Rho.
Buyer of a strap believes that the security s price is more likely to rise than to fall.
Futures
Futures
A futures is a firm legal commitment between a buyer and a seller in which they agree to exchange something at a specified price at the end of a designated period of time. Exchange traded futures are standardized as to quantity, quality, time and place of delivery.
Features - Futures
All futures contracts are traded on the futures (derivatives) section of the stock exchange and commodity exchanges.
The futures contract will be settled at the prevailing spot price of the asset
Although these contracts cannot be liquidated before their expiry date, you can sell them on the exchange.
In other words, a futures contract is bought and sold regularly on the market till its expiry.
Types of Futures
Financial futures
A futures contract in a financial instrument like equity shares, stock market indices, debt securities or foreign currencies.
Commodity Futures
Agro based commodities Industry based commodities
Futures Terminology
The basis
The difference between the price of the underlying asset in the spot market and futures market is known as the basis.
Although both these prices generally move in line with each other, the basis is not constant. Generally, the basis will decrease with time and on expiry, the basis will become zero and the price of the underlying asset in both the markets will become the same.
Futures Terminology
Contango and Backwardation
Under normal market conditions, the price of the underlying asset in the futures market exceeds its price in the spot market. This is known as the 'Contango Market'. The reverse situation is called 'Backwardation'.
Types of Futures
Financial futures
A futures contract in a financial instrument like equity shares, stock market indices, debt securities or foreign currencies.
Commodity Futures
Agro based commodities Industry based commodities
Futures vs Options
Futures Options
1. In case of options the buyer enjoys 1. In case of futures, both the the right and not the obligation, to buyer and seller are buy or sell the underlying asset. obligated to buy/sell the 2. In case of options, the buyer faces underlying asset. a limited amount of risk (extent of 2. In case of futures contracts, premium paid) while the seller i.e. both the parties - the buyer the option writer, faces unlimited and the seller -face the same risk. level of risk. 3. The prices of options are 3. Futures contract prices are affected by the prices of the affected mainly by the prices underlying asset, time remaining of the underlying asset in the for expiry of the contract and cash market. volatility of the underlying asset.
Trading in derivatives
Trading in index futures began on NSE and BSE in 2000 Trading on single stock futures began on NSE and BSE in 2002 Introduction of interest rate futures on NSE and commodity futures in 2003 Currency futures was launched in NSE, BSE and MCX in August 2008
Commodity Futures
Currency futures
Agreement between two parties to exchange one currency for another at a specified date in future in an exchange rate being fixed at the time the agreement is entered into. Currency Futures are standard contracts of a specified quantity to exchange one currency for another at a specified date in the future called settlement date at a price that is fixed on the purchase date called futures price.
Currency futures was launched in NSE, BSE and MCX in August 2008
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Only US Dollar ($) futures is being traded against the Indian Rupee (INR) when introduced in Aug 2008. The contract for say the month of September will be called USDSEP2010.
RBI allowed futures trading in three more currencies the euro, the pound sterling and the yen - in Jan 2010. There are 12 near calendar months contract available for trading.
USD/INR - Quote/trade
On BSE-CDX, the underlying value is the rate of exchange between one unit of foreign currency and Indian Rupee. USD is the base currency and the variable currency is INR. One unit of USD (One Dollar) is priced in terms of INR. E.g. 1USD = INR 48.8525/8550 The minimum Lot Size/Contract Size is USD 1,000 (and in multiples of USD 1,000 thereafter).
Example
On 1/1/2011, 10-year bond was priced at Rs.95.43. Lot size 2,000 You believe the interest rate will go up, so you sell three futures contracts (6,000 bonds) @ Rs.98. On 31/1/2011, the 10-year bond is at Rs.88. You have a profit of Rs.10/bond or Rs.60,000 overall.
Example 2
On January 2011, 10-year bond was at Rs.92. March futures were trading at Rs.93. You thought interest rates would go down, so you purchased two futures contracts (4000 bonds) @ Rs.93. Interest rates went up! On expiration, the bond was at Rs. 83. A loss of Rs.40,000.
Commodity Futures
Commodity futures contract is a contractual agreement between two parties to buy or sell a specified quantity and quality of commodity at a certain time in future at a certain price agreed at the time of entering into the contract on the commodity exchange. The kinds of commodities being traded are:
Agriculture based commodities such as rice, wheat, sugar, Soybean, soya Oil, Chana, Palm Oil, Jeerra, Pepper, Turmeric, Chilli, Cardamon, Guar Gum, Guar Seed, Mentha Oil, RM seed. Mineral-based commodities such as gold, platinum, aluminum, copper, zinc, etc Energy Crude oil etc
Commodity Exchanges
Globally
New York Mercantile Exchange (NYMEX) Chicago Board of Trade (CBOT) Chicago Mercantile Exchange (CME) London Metal Exchange (LME)
In India
Multi Commodity Exchange of India (MCX) (2003), Mumbai National Commodity and Derivative Exchange (NCDEX) (2003), Mumbai National Multi Commodity Exchange of India (NMCE), (2003) Indian Commodity Exchange (ICEX)
Rubber
FUT-RBRRS4KTM-20-Jan-2006
Further, in respect of physical delivery, the exchange offers three types of delivery options viz. Seller's option for delivery, Compulsory delivery and Intention Matching option for delivery.
Forwards
FCRA defines forward contract as a contract for the delivery of goods and which is not a ready delivery contract Ready delivery contract is one which provides for delivery of goods and payment of price either immediately or within such period not exceeding 11 days after the date of the contract. Requires physical delivery of goods.
Forwards vs Futures
Feature Deals are done on Price risk Futures Organised exchanges Eliminated Forwards OTC market Eliminated Present Low Customised (negotiable)
ET Reading - Futures
Session 3
MARGIN REQUIREMENTS; TYPES OF ORDERS; WEATHER & ELECTRICITY DERIVATIVES; SWAPS
Margin Requirements
Initial Margin:
The margin that is required to be deposited to the clearing house of the exchange at the time of entering into the contract. A certain percentage of the contract value. Based on SPAN (Standard Portfolio Analysis of Risk)
Maintenance margin :
If margin money is reduced below the maintenance level, the member is expected to bring in additional amount and restore the margin at least to the initial level.
Margin Requirements
Marking to market :
The process of revaluing the contract based on the ruling price of the contracts is known as marking to market. With reference to the closing price of the underlying stock.
Margins - E.g.
For an options contract the initial margin and maintenance margin prescribed be Rs 4,000 and 3,000 respectively. Future price 75 Share price: Day 1 Rs 74 Day 2 Rs 73 Day 3 Rs 72 Day 4 Rs 76
Margins - Eg
Future price Rs 75 Contact value 7500
Particulars Share price Contract value Margin money a/c of Buyer 1 opening balance 2 Amt to be adjusted 3. Adjusted Balance 5 Closing balance Margin money a/c of seller 1 opening balance 2 Amt to be adjusted 3. Adjusted Balance 5 Closing balance
Day 1 74 7400 4,000 - 1000 3,000 3,000 4,000 1000 5,000 4,000
Day 2 72 7,200 3,000 -2,000 1,000 3,000 4,000 4,000 2,000 6,000 -2,000 4,000
Day 3 73 7,200 4,000 1,000 5,000 -1,000 4,000 4,000 -1,000 3,000 --3,000
Day 4 76 7,600 4,000 3,000 7,000 -3,000 4,000 3,000 -3,000 --4,000 4,000
4 Amt deposited/withdrawn -
An order in a market is an instruction from customers to brokers to buy or sell on the exchange.
Types of orders
Market order Limit order Stop loss order Time order
Good till day Good till date Good till cancelled
Types of Orders
Market order
is a buy or sell order to be executed immediately at current market prices. The order is filled at the best price available at the relevant time.
Limit order
is an order to buy a security at not more, or sell at not less, than a specific price. A buy limit order can only be executed at the limit price or lower; A sell limit order can only be executed at the limit price or higher.
Types of Orders
Time order
Good till day
order that is in force from the time the order is submitted to the end of the day's trading session
Weather derivatives
Weather derivatives are financial instruments
to reduce risk associated with adverse or unexpected weather conditions. the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative.
Players
Farmers can use - to hedge against poor harvests caused by drought or frost; theme parks -to insure against rainy weekends during peak summer seasons; and power companies A sports event managing company - to hedge the loss because if it rains the day of the sporting event, fewer tickets will be sold.
Weather derivatives
Chicago Mercantile Exchange introduced the first exchange-traded weather futures ( & options), in 1999 Heating Degree Days (HDD) or Cooling Degree Days (CDD) contracts Weather contracts on U.S. cities for the winter months are tied to an index of heating degree day (HDD) values. These values represent temperatures for days on which energy is used for heating. The contracts for U.S. cities in the summer months are geared to an index of cooling degree day (CDD) values, which represent temperatures for days on which energy is used for air conditioning. Both HDD and CDD values are calculated according to how many degrees a day's average temperature varies from a baseline of 65 Fahrenheit.
Weather derivatives
The baseline temperature is fixed; it is 65o Fahrenheit in the U.S and 18o Celsius in Europe. The Earth Satellite Corporation, an independent entity, calculates HDD and CDD index ensuring transparency and independence in the benchmark.
Weather derivatives
Measuring Daily Index Values An HDD value equals the number of degrees the day's average temperature is lower than 65 F. For example, a day's average temperature of 40 F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65 F, the value of the HDD would be zero. This is because in theory there typically would be no need for heating on a day warmer than 65. Measuring Daily Index Values An HDD value equals the number of degrees the day's average temperature is lower than 65 F. For example, a day's average temperature of 40 F would give you an HDD value of 25 (65 - 40). If the temperature exceeded 65 F, the value of the HDD would be zero. This is because in theory there typically would be no need for heating on a day warmer than 65. Measuring Monthly Index Values A monthly HDD or CDD index value is simply the sum of all daily HDD or CDD value recorded that month The value of a CME weather futures contract is determined by multiplying the monthly HDD or CDD value by $20.
Electricity Futures
Electricity future contracts represent the obligation to buy or sell a fixed amount of electricity at a prespecified contract price, known as the forward price, at certain time in the future (called maturity or expiration time). In other words, electricity futures are contracts between a buyer and a seller, where the buyer is obligated to take power and the seller is obligated to supply. Introduced in MCX on Jan 2009 and banned on Dec 2010
Swap
Recent origin since 1981. An agreement by two parties to exchange a series of cash flows in the future Types :
Foreign currency Swap Interest rate Swap
If both companies raise the needed funds in the market, then A has to pay 9% and firm B 8%. So it would be to their mutual advantage that if firm A raises the loan in dollars at 6% and firm B in Pound sterling and they exchange their liabilities. The arrangement would be
C
floating LIBOR +0.5%
Bank Fixed 9%
London Metal Exchange (LME) London Futures and Options Commodities Exchange (FOX)
Uses of Derivatives
Risk Management
Risk Transfer Hedging
Trading in derivatives
Forward rate agreement and Swaps permitted by RBI in 1999 Trading in index futures began on NSE and BSE in 2000 Trading in options on index and stocks commenced on NSE and BSE in 2001 Trading on single stock futures began on NSE and BSE in 2002 Introduction of interest rate futures on NSE and commodity futures in 2003 Currency futures was launched in NSE, BSE and MCX in August 2008 Currency options in NSE and USE in October 2010
References
S.S.S. Kumar(2007). Financial Derivatives. New Delhi : Prentice Hall India. John C. Hull. (2005). Options, Futures and Other Derivatives (6th Ed.). New Delhi : Prentice Hall Robert A. Strong. (2006). Derivatives : An Introduction. Singapore : Thomson Learning Bansal & Bansal. (2007). Derivatives and Financial Innovations. New Delhi : McGraw Hill. Websites
NSE, BSE, MCX, NCDEX