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CA Swatantra Singh, B.Com , FCA, MBA

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1 CA Swatantra Singh, B.Com , FCA, MBA
Presented By CA Swatantra Singh, B.Com , FCA, MBA ID: New Delhi , ,


3 What is a Derivative Security?
Derivative securities, more appropriately termed as derivative contracts, are assets which confer the investors who take positions in them with certain rights or obligations.

4 Why Do We Call Them Derivatives?
They owe their existence to the presence of a market for an underlying asset or portfolio of assets, which may be considered as primary securities. Consequently such contracts are derived from these underlying assets, and hence the name. Thus if there were to be no market for the underlying assets, there would be no derivatives.

5 Broad Categories of Derivatives
Forward Contracts Futures Contracts Options Contracts Swaps

6 More Complex Derivatives
Futures Options – Options contracts which are written on futures contracts Compound options – Options contracts which are written on options contracts Swaptions – Options on Swaps

7 Definition of a Forward Contract
A forward contract is an agreement between two parties that calls for the delivery of an asset on a specified future date at a price that is negotiated at the time of entering into the contract.

8 Forward Contracts (Cont…)
Every forward contract has a buyer and a seller. The buyer has an obligation to pay cash and take delivery on the future date. The seller has an obligation to take the cash and make delivery on the future date.

9 Definition of a Futures Contract
A futures contract too is a contract that calls for the delivery of an asset on a specified future date at a price that is fixed at the outset. It too imposes an obligation on the buyer to take delivery and on the seller to make delivery. Thus it is essentially similar to a forward contract.

10 Forward versus Futures
Yet there are key differences between the two types of contracts. A forward contract is an Over-the-Counter or OTC contract. This means that the terms of the agreement are negotiated individually between the buyer and the seller.

11 Forward vs. Futures (Cont…)
Futures contracts are however traded on organized futures exchanges, just the way common stocks are traded on stock exchanges. The features of such contracts, like the date and place of delivery, and the quantity to be delivered per contract, are fixed by the exchange.

12 Forward vs. Futures (Cont…)
The only job of the potential buyer and seller while negotiating a contract, is to ensure that they agree on the price at which they wish to transact.

13 Options An options contract gives the buyer the right to transact on or before a future date at a price that is fixed at the outset. It imposes an obligation on the seller of the contract to transact as per the agreed upon terms, if the buyer of the contract were to exercise his right.

14 Rights What is the difference between a Right and an Obligation.
An Obligation is a binding commitment to perform. A Right however, gives the freedom to perform if desired. It need be exercised only if the holder wishes to do so.

15 Rights (Cont…) In a transaction to trade an asset at a future date, both parties cannot be given rights. For, if it is in the interest of one party to go through with the transaction when the time comes, it obviously will not be in the interest of the other.

16 Rights (Cont…) Consequently while obligations can be imposed on both the parties to the contract, like in the case of a forward or a futures contract, a right can be given to only one of the two parties. Hence, while a buyer of an option acquires a right, the seller has an obligation to perform imposed on him.

17 Options (Cont…) We have said that an option holder acquires a right to transact. There are two possible transactions from an investor’s standpoint – purchases and sales. Consequently there are two types of options – Calls and Puts.

18 Options (Cont…) A Call Option gives the holder the right to acquire the asset. A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call would have to make delivery of the asset.

19 Options (Cont…) If the holder of a put were to exercise his right, the seller of the put would have to accept delivery. We have said that an option holder has the right to transact on or before a certain specified date. Certain options permit the holder to exercise his right only on a future date.

20 Options (Cont…) These are known as European Options.
Other types of options permit the holder to exercise his right at any point in time on or before a specified future date. These are known as American Options.

21 Longs & Shorts The buyer of a forward, futures, or options contract is known as the Long. He is said to have taken a Long Position. The seller of a forward, futures, or options contract, is known as the Short. He is said to have taken a Short Position. In the case of options, a Short is also known as the option Writer.

22 Comparison of Futures/Forwards versus Options
Instrument Nature of Long’s Commitment Nature of Short’s Commitment Forward/Futures Contract Obligation to buy Obligation to sell Call Options Right to buy Obligation to sell Put Options Right to sell

23 Swaps A swap is a contractual agreement between two parties to exchange specified cash flows at pre- defined points in time. There are two broad categories of swaps – Interest Rate Swaps and Currency Swaps.

24 Interest Rate Swaps In the case of these contracts, the cash flows being exchanged, represent interest payments on a specified principal, which are computed using two different parameters. For instance one interest payment may be computed using a fixed rate of interest, while the other may be based on a variable rate such as LIBOR.

25 Interest Rate Swaps (Cont…)
There are also swaps where both the interest payments are computed using two different variable rates – For instance one may be based on the LIBOR and the other on the Prime Rate of a country. Obviously a fixed-fixed swap will not make sense.

26 Interest Rate Swaps (Cont…)
Since both the interest payments are denominated in the same currency, the actual principal is not exchanged. Consequently the principal is known as a notional principal. Also, once the interest due from one party to the other is calculated, only the difference or the net amount is exchanged.

27 Currency Swaps These are also known as cross-currency swaps.
In this case the two parties first exchange principal amounts denominated in two different currencies. Each party will then compute interest on the amount received by it as per a pre-defined yardstick, and exchange it periodically.

28 Currency Swaps (Cont…)
At the termination of the swap the principal amounts will be swapped back. In this case, since the payments being exchanged are denominated in two different currencies, we can have fixed-floating, floating-floating, as well as fixed-fixed swaps.

29 Actors in the Market There are three broad categories of market participants: Hedgers Speculators Arbitrageurs

30 Hedgers These are people who have already acquired a position in the spot market prior to entering the derivatives market. They may have bought the asset underlying the derivatives contract, in which case they are said to be Long in the spot.

31 Hedgers (Cont…) Or else they may have sold the underlying asset in the spot market without owning it, in which case they are said to have a Short position in the spot market. In either case they are exposed to Price Risk.

32 Hedgers (Cont…) Price risk is the risk that the price of the asset may move in an unfavourable direction from their standpoint. What is adverse depends on whether they are long or short in the spot market. For a long, falling prices represent a negative movement.

33 Hedgers (Cont…) For a short, rising prices represent an undesirable movement. Both longs and shorts can use derivatives to minimize, and under certain conditions, even eliminate Price Risk. This is the purpose of hedging.

34 Speculators Unlike hedgers who seek to mitigate their exposure to risk, speculators consciously take on risk. They are not however gamblers, in the sense that they do not play the market for the sheer thrill of it.

35 Speculators (Cont…) They are calculated risk takers, who will take a risky position, only if they perceive that the expected return is commensurate with the risk. A speculator may either be betting that the market will rise, or he could be betting that the market will fall.

36 Hedgers & Speculators The two categories of investors complement each other. The market needs both types of players to function efficiently. Often if a hedger takes a long position, the corresponding short position will be taken by a speculator and vice versa.

37 Arbitrageurs These are traders looking to make costless and risk-less profits. Since derivatives by definition are based on markets for an underlying asset, it is but obvious that the price of a derivatives contract must be related to the price of the asset in the spot market.

38 Arbitrageurs (Cont…) Arbitrageurs scan the market constantly for discrepancies from the required pricing relationships. If they see an opportunity for exploiting a misaligned price without taking a risk, and after accounting for the opportunity cost of funds that are required to be deployed, they will seize it and exploit it to the hilt.

39 Arbitrageurs (Cont…) Arbitrage activities therefore keep the market efficient. That is, such activities ensure that prices closely conform to their values as predicted by economic theory. Market participants, like brokerage houses and investment banks have an advantage when it comes to arbitrage vis a vis individuals.

40 Arbitrageurs (Cont…) Firstly, they do not typically pay commissions for they can arrange their own trades. Secondly, they have ready access to large amounts of capital at a competitive cost.

41 Assets Underlying Futures Contracts
Till about two decades ago most of the action was in futures contracts on commodities. But nowadays most of the action is in financial futures. Among commodities, we have contracts on agricultural commodities, livestock and meat, food and fibre, metals, lumber, and petroleum products.

42 Food grains & Oil seeds Corn Oats Soybeans Wheat

43 Livestock & Meat Hogs Feeder Cattle Live Cattle Pork Bellies

44 Food & Fibre Cocoa Coffee Cotton Sugar Rice
Frozen Orange Juice Concentrate

45 Metals Copper Silver Gold Platinum Palladium

46 Petroleum & Energy Products
Crude Oil Heating Oil Gasoline Propane Electricity

47 Financial Futures Traditionally we have had three categories of financial futures: Foreign currency futures Stock index futures Interest rate futures The latest entrant is futures contracts on individual stocks – called single stock futures or individual stock futures

48 Foreign Currency Futures
Australian Dollars Canadian Dollars British Pounds Japanese Yen Euro

49 Major Stock Index Futures
The DJIA S&P 500 Nikkei NASDAQ-100

50 Interest Rate Futures T-bill Futures T-note Futures T-bond Futures
Eurodollar Futures Federal Funds Futures Mexican T-bill (CETES) Futures

51 The Role of Forward Market
A Forward is an obligation to buy or sell a financial instrument or physical commodity at some date in the future at an agreed price. For our purposes, forwards include over-the-counter(OTC) forward contracts and exchange-traded (ET) futures contracts. Forward contracts represent a starting point for all derivative valuation.

52 Instruments The following instruments are included in these two groups that make up Forwards: Foreign Exchange Forward contracts Forward Rate Agreements Forward Bonds Short-term interest rate futures Bond Futures Stock index futures Commodity futures contracts

53 Forward Vs Cash Transactions
We might expects any transaction that settles today to be a cash transaction and anything settling from tomorrow onward to be a Forward. Unfortunately, this is not always the case and depending on the underlying financial asset, a cash transaction can range from today for a money market transaction to several weeks, or longer in some securities markets. A forward transaction does not commence until the settlement day passes the cash settlement date. Eg.In foreign exchange market, a Forward is a transaction that settles after two business days. In the Indian Equity market minimum Forward we can have is 8 days.

54 Future A future contract is an agreement between two parties to buy or sell an underlying asset at a certain time in future at a certain price. Future Index is a type of derivative contracts which derive their value from an underlying index.

55 Deriving the Forward Price
Calculating the forward price is the same as asking the question –How much should I pay to buy something in the Future? A forward transaction can be replicated by purchasing the asset today and borrowing the money to finance it. The fair forward price indicates the price at which buyers and sellers are indifferent to buying and selling the underlying asset today or in the future,based on the current market cash price,cost of financing the asset and the expected return on the asset.

56 Deriving the Forward Price
The “Fair” forward price is given by the cash price plus the net cost of financing the asset over the term of the Forward contract. The interest cost tends to increase the forward price versus the cash price. Any cash return on the asset over the term of the forward contract tends to decrease the forward price versus the cash price.

57 Deriving the Forward Price
These general rules should apply to all forward prices on financial assets, regardless of whether it is an interest rate, foreign exchange or equity product, provided they operate in freely operating markets. It is worth noting that these relationships start to break down when we move away from financial assets,particularly to consumable commodities. This is so because the decision to have the physical commodity today or in the future also has to take into consideration when the commodity is required for consumption.

58 Price for Forward and Futures
The cost of CARRY model: Forward(or Futures)=(Spot Price+Carry Cost-Carry Return) F=S0+CC-CR Spot Price = Current Price Carry Cost = Holding Cost, Interest Charges on Borrowing.- Insurance,Storage Costs etc. Carry Return= Dividends

59 Forward Pricing Formulae
We will develop three formulae for pricing forward transactions. These formulae vary depending on the nature of the income steam generated by the underlying financial asset during the period of time to the forward expiry date. The three forms considered are assets that pay No income Constant income Lumpy Income

60 No Income Financial Asset Pays No Income F= S * {1+r * (f/D)}
F=Forward Price S=Cash or Spot price of the underlying instrument. r= interest rate to forward rate (preferably zero-coupon rate) Accurate pricing requires Zero-coupon yields. D= Day count basis (365 or 360) f= Number of days to the forward expiry date.

61 Constant Income Financial Asset Pays Constant rate of income
F=S * {1+(r –q)* (f/D)} F=Forward Price S=Cash or Spot price of the underlying instrument. r= interest rate to forward rate q= Asset Income expressed as a % pa. D= Day count basis (365 or 360) f= Number of days to the forward expiry date.

62 Lumpy Income Financial asset pays income only at certain points over its life. F=S * {1+(r1* (f1/D))} – c* (1 +(r2*(f2/D)) F=Forward Price S=Cash or Spot price of the underlying instrument. r1 = interest rate to forward rate r2= interest rate between the income payment and forward expiry dates c= Asset Income expressed in the same units as the cash price. D= Day count basis (365 or 360) f1 = Number of days to the forward expiry date. f2= Number of days between the income payment and forward expiry dates.

63 Forward Price Example

64 Valuation on the Forward
Forward value= Forward bond value- Forward contract price Forward bond value is the value of all of the cash flows created by the bond after the forward expiry date.(Forward Spot Value) Forward contract price is the price agreed under the forward contract. It is described as the “pay-off” of the forward contract and the graphical representation as a “pay-off diagram”.

65 Long futures position

66 Long Futures Position

67 FORWARD Vs FUTURE OTC in nature Customised contract terms hence
Less Liquid No Secondary market No margin Payment Settlement happens at end of period Trade on an organised exchange Standardised contract terms hence More liquid Secondary market Requires margin requirement Follows daily settlement

68 Valuation Differences between Forward & Futures
An OTC and a Futures contract with the same forward expiry date should have the same forward price. The differences between OTC and ET futures contracts arise from the fact that futures contracts are subject to daily mark-to-markets (the price is calculated based on the daily market price) and upfront initial margins.

69 FOREX FORWARDS Foreign Exchange (FX) transaction represents the largest OTC market with daily turnover in excess of one trillion dollars a day. FX transaction represents an agreement to exchange one currency for another. Instruments; Short-term FX Forwards Long-term FX forwards Par Forwards Currency Futures

70 FOREX QUOTATION In any FX quotation it is essential to know which currency is the base currency and which is term currency. In a quote , the base currency is the unit or the currency that is held constant and the terms currency is the variable part of the quote. To put it another way, the exchange rate quotation is the price of the base currency in “terms” of the term currency.

71 Short-term Forward FX Transactions
It represents the bulk of FX turnover They are an agreement between two parties on an exchange of currency cash flows at some date after the cash,or spot, FX transactions settle. The market for forward FX is very liquid and has been in existence since the floating of the exchange rates in the 1970s.

72 Short-term Forward FX Transactions
Forward FX transaction are comprised of the simultaneously execution of a spot FX transaction and a money market borrowing and lending. Synthetic Forward Purchase Example:A company will receive US$ in 6 months’ time that it wants to convert immediately into JPY. It is concerned that JPY will rise against the US$. It is not permitted to use derivatives so it must create the forward using only cash instruments. To do this the Company buys JPY against the US$ at a spot rate of 103.

73 Short-term Forward FX Transactions
The settlement of this spot transaction in two days requires the company to pay its counter-party US$ and receive JPY. To fund the US$ settlement, the company borrows in the US$ money market for 6 months and it invests the JPY received for six months. At the end of six months the US$ are received and use to repay the money market borrowing and JPY money market investment matures. The implied forward FX rate is then given by the respective currency balances at the end of six months. Since the interest rate in US is higher than the Japan the premia is at discount.


75 A model for Forward FX Prices
Short –Term Forward Exchange Price: F=(S*(1+rT)*f/DT)/((1+ rB)*f/DB) F=Forward Exchange Rate S=Spot Exchange Rate. rT = Terms Currency interest rate to forward rate rB= Base currency interest rate to forward rate DT = Term Currency Day count basis (365 or 360) DB = Base Currency Day count basis (365 or 360) f1 = Number of days to the forward expiry date. f= Number of days to the forward expiry date from the spot settlement date.


77 Assumptions Simple Interest: There is assumed to be no compounding in the interest calculation. Zero-coupon:The interest rate assumed to be zero coupon rates.This is generally an appropriate assumption for forward FX deals of up to six months; most interest rates longer than that contain reinvestment risk.

78 Long –Term Forward FX Transactions(LTFX)
It is a longer term version of the Forward FX transaction. Any Forward contract longer than six months are LTFX. LTFX contracts are a relatively small proportion of total FX market volume. Typically ,LTFX contracts are associated with hedging FX exposures created by long-term borrowing.

79 LTFX (Assumptions) Zero-coupon yield:The forward pricing and valuation models assume that there are no interest cash flow during the forward period-hence the interest rates are zero-coupon rates.This is a reasonable assumption when using money market interest rates. However, the quoted yields in most currencies that have a term to maturity of more than one year are usually coupon-paying interest rates. The difficulty with coupon-paying interest rates is that there is a reinvestment risk associated with each coupon payment.To price LTFX, this risk has to be removed by deriving zero coupon interest rates.

80 LTFX (Assumptions) Compounding: Longer term interest rates are expressed typically as compound interest rates; accordingly , compounding also needs to be incorporated into the model.

81 LTFX (Price) F=(S*(1+rT)*f/mT)nT /((1+ rB)*f/mB)nB
F=Forward Exchange Rate S=Spot Exchange Rate. rT = Terms Currency zero-coupon interest rate to forward rate rB= Base currency zero-coupon interest rate to forward rate mT = Term Currency payment frequency (1,2,3,…) mB = Base Currency payment frequency (1,2,3,…) nT = Terms currency of payment periods to the forward date. nB = Basis currency of payment periods to the forward date.



84 PAR FORWARDS Another form of LTFX is the Par-Forward.
It is a series of LTFX contracts. In terms of the present value of these transactions , the economics of a par –forward & series of LTFX are same. In terms of the FX transaction, there have little added value than LTFX. The advantage is that they can very useful for cash flow management and tax planning.

85 PAR FORWARDS A Swiss based distribution company is about to commence importing equipment from the US. It has signed a 5-year contract that will require it to buy US $ 10 million of equipment every quarter.



88 INTEREST RATE FORWARDS What is a Forward Rate Agreement (FRA) ?
FRA is an off-balance sheet contract between two counterparties to exchange interest payments for a specified period starting in future the interest payments are calculated on the notional principal the specified period is from the start date to the maturity date the floating rate is the actual rate on the start date of the swap and available for the entire specified period Convention of FRA : 3 X 6 month FRA, at 9.35% against 91-day T-Bill rate on a notional principal of Rs. 25 crores 3 X 6 implies specified period : start dates and maturity dates Fixed rate payer pays 9.35% for 3 months from start date to the maturity date Floating Rate payer pays 91-day T-Bill rate which would be determined on the start date of the swap the net amount would be settled on the start date Start Date Trade date Maturity date Specified Period t=0 t+3m t+6m

FRA are the predominant form of OTC forward on short- term interest rate securities. The party that benefits from a fall in interest rate is defined as the lender or seller of the FRA. The party that benefits from a rise in interest rate is defined as the borrower or buyer of the FRA.

90 FRA (PRICE) FRAs are instruments in which the underlying asset is cash providing a constant income in the form of interest payments. The Future value of this cash flow is given by FV=S*(1+(q*d/D)) S=Cash Flow q=YTM d=number of days from today ,until maturity of the asset.

91 FRA (PRICE) From the basic formula we know that F=S*(1+(r-q)*(f/D))
Our aim is to express this same concept in terms of a forward interest rate calculation. The interest rate on the forward security will be equivalent to the difference between the interest earned between today and the forward settlement date and the interest earned between today and the maturity date of the underlying security. Forward Interest= S*((q*d/D)-(r*f/D))

92 FRA (PRICE) The forward interest rate can then be expressed as:
Forward rate=(Forward interest/Forward Price) x (D/(d-f)) rf= (((q x d/D) – (r x f/D))/(1+(r-q) x (f/D))) x (D/(d-f)) We know that the future value of using a continuous rate is a follows FV=S x exp(q x d/D)

93 FRA (PRICE) Therefore S x exp(q *d/D)=S*exp(r x f/D+rf x(d-f)/D)
If we cancel S and take the natural logarithm of both sides of this equation, this simplifies to: rf= (q x d/D – r x f/D)/(d/D-f/D) Where rf= forward interest rate % pa r= interest rate to the forward settlement date %pa q=interest raet to the maturity date % pa D= day count basis (360 or 365) f= number of days to the forward expiry date. d= number of days to the maturity date of the underlying security.


95 FRA Settlement If rs> rc, then the settlement sum is
Seller pays buyer If rs< rc, then the settlement sum is Buyer pays Seller Where rc= contract rate % pa rs= settlement rate % pa

Short-term interest rate futures represent standardized , exchange –traded forward contracts on money market instruments. The pricing and valuation of these instruments is very similar to FRAs and the two markets can often be viewed as direct substitutes. The global volume in these instruments is enormous, representing the largest single category of futures contract.

97 Eurodollars contract The Eurodollar contract was the first global short-term futures contract listed in 1981 at Chicago Mercantile Exchange(CME). The Eurodollar is a cash-settled contract on a 3-Month Eurodollar time deposit. The name “Eurodollar” derives from the fact it is a forward contract on a US dollar money market instrument traded in Europe. The CME lists contracts to expire in quarterly resets in March,June,September and December.Currently , there are 40 consecutive quarters listed. The Eurodollar is mainly traded by corporations,banks and fund managers with short term interest rate exposures. It expires on 3rd Monday of the month.

98 Eurodollars contract The price of a contract is expressed as:
Futures Price=100-(Interest rate *100)+ Funding Adjustment Eg. If the current interest rate for a Eurodollar deposit starting on the futures expiry date is 5% pa, then the futures price is 95. The aim of quoting in terms of price rather than yield is primarily to keep interest rate contracts in line with other price-based contracts on bonds,shares and commodities. A buyer of a Eurodollar contract gains, if the futures price rises ( interest rate falls) above the price at which they purchase it and the seller gains if price falls .

99 Short-Term Interest Rate Contract

100 Short-Term Interest Rate Contract (PRICE)
The short-term futures contract price is primarily determined by the prevailing forward rate. There is, however an element of the interest rate that will not be known, until expiry of the contract. Futures Price = 100- (Forward Rate + Funding adjustment)

101 Short-Term Interest Rate Contract (PRICE)
Hedge Ratio and Convexity Adjustment: Short Term Interest Rate Futures to Hedge FRA. For a futures contract and an FRA with same maturity , the forward interest rate is very similar. The difference arises only in the funding consequences of the futures contract.


103 Short-Term Interest Rate Contract (PRICE)
A complete Futures Pricing Model: Futures Price=100-(Forward rate + Funding adjustment + convexity adjustment) In Practice , the convexity adjustment is ignored for forward period of up to 1 year. For longer forward terms the adjustment is in the order of one or two basis points, gradually rising as the forward period increases.

104 FORWARD BONDS Forward Bonds are an OTC forward contract on fixed – interest rate security. In a forward bond agreement , two parties agree to deliver a specified bond prices at at future date. F=S x (1 + r1 x f1/D)-c x (1x r2 x f2/D)

105 FORWARD BONDS Where F= forward price per face value including accrued interest S=Cash bond price including accrued interest r1= interest rate to the forward expiry date r2= interest rate between the coupon payment and forward expiry dates D= Day count basis (360 or 365) f1= number of days to the forward expiry date f2= number of days between the coupon payment and forward expiry dates c= periodic coupon payment


107 BOND FUTURES Bond futures represent a standardized, exchange-traded forward bond contract. Like short-term interest rate futures contracts, they have become an integral part of most financial markets , and they typically represents a benchmark for long-term interest rate transaction.

108 BOND FUTURES The price of most bond futures contracts is quoted as the current price per 100 units of face value. The other alternative is the yield method. Futures prices are quoted as 100 minus the YTM of the underlying asset. The futures quotation method is usually the local bond market convention. There are two alternative methods with which bond contracts are terminated: physical delivery and cash settlement. Future Price= Forward Price+ Funding adjustment +convexity adjustment.

109 EQUITY FORWARDS Equity forwards have gained a reputation as being a highly risky instrument in their relative short existence. Despite the bad press, share price index futures and all other equity derivatives volume growth has been an outstanding success since they were introduced in the US in 1982.

110 Share Price Index Futures(SPI)
A share price index (SPI) future is an exchange-traded contract based on a broad-based share price index. A buyer benefits from a rise in the value of the underlying index and loses from a fall in the index. They are cash settled.

111 Share Price Index Futures(SPI)
A Pricing Model for SPI Futures F= S x (1+(r-q) x f/D) F= Forward SPI price S= cash price of the share price index r= interest rate to the forward expiry date D= day count basis f= number of day to the forward expiry date q= dividend yield expressed as a % pa on the same day count basis as the interest rate.

112 Pricing of Future Contract
Case1- Securities Providing No Income F=S0ert S0=Spot Price r=Risk Free Return t=time to maturity Example: Spot Price of Non-payable dividend XYZ Share=Rs.70, Contract matures after 3months. Risk-free return=8% (For 3 months) e=2.7183 F=70e(0.25)(0.08) =70x1.0202 = Rs71.41 Premium=2.014%

113 Pricing of Future Contract
Case2- Securities Providing a known cash Income F=(S0-I)ert S0=Spot Price r=Risk Free Return t=time to maturity I=Present Value of the Income Example: Spot Price of dividend payable XYZ Share=Rs.38, Contract matures after 6months. Contract size=100 shares Risk-free return=10% (For 6 months) Dividend=Rs.1.50 per share after 4 months Present Value of the Dividend I= (100x1.50)e-(4/12)(0.10)=Rs F=( )e(0.5)(0.10) = x =Rs Premium=1.113%

114 Pricing of Future Contract
Case3- Stock Index Futures F=(S0-I)ert S0=Spot Price r=Risk Free Return t=time to maturity I=Present Value of the Income Example: Two month futures contract on NIFTY Let us assume that M&M will be declaring a dividend of Rs.10 per share after 15 days of purchasing the contract. Current Value of NIFTY=1200 r=15% Multiplier = x1200=240,000 If M&M has a weight of 7% in NIFTY,its value in NIFTY is Rs.16,800 i.e(240,000 x 7/100). If the market price of M&M is Rs.140, then a traded unit of NIFTY involves 120 shares of M&M. Present Value of the Dividend I= (120x10)e-(15/365)(0.1398) e=2.7183 F=Rs Premium=1.816%

115 Pricing of Financial Contracts
Assumptions: The markets are perfect. All the assets are infinitely divisible. Bid/Ask spreads do not exist so that it is assumed that only one price prevails. There are no restrictions on short selling.

116 Future Strategies Hedging Speculation Long Stock, Short Index Futures
Short Stock, Long Index Futures Have portfolio,Short Index Futures Speculation Bullish Index,Long Index Futures Bearish Index, Short Index Futures

117 Long Stock, Short Index Futures
An Example of Hedging A buyer faces many risks (price risk, liquidity risk, credit risk, operating risk) in equity investment. Price risk is made of two parts: Price movement due to market sentiments Price movement due to company-specific factors Say beta of Infosys is 1.5 Assume that Infosys equity is selling at Rs.4000 Say over a day, Infosys equity price moves to Rs when the index moves down by 1% Of this price movement of 100, market sentiment causes Rs.60. Remaining s.40 is due to company-specific factors Continued…

118 Long Stock, Short Index Futures
Suppose that a buyer does not want to assume the price risk of Rs.60 due to market sentiments Assume that the equity index future is selling at He will sell “n” index futures where “n” is calculated as follows: n = (Price of the share*beta)/(value of the index) In this case, n = (4000*1.5)/(2000)=3 If the index goes down by 1% to 1980 (that is, 20) as the seller he gains Rs.20*3= Rs.60 Continued..

119 Gain/loss when Index down by 1%, Infosys down by 1.5%
Short on Index 3 units: + 60 Long on Share 1 unit: -60

120 Example Stock=Orientbank Beta=0.8% Long Position of Rs.200,000
Which of the following is complete hedge? Sell 200,000 Nifty Buy 200,000 of Nifty Buy 160,000 of Nifty Sell 160,000 of Nifty

121 Example Cont. Answer: Long on Orientbank Rs200,000=Long on Nifty Rs.160,000 To completely Sell Rs.160,000 of Nifty.

122 Short Stock, Long Index Futures
Stock-picker Overvalued Short Infosys Position=Short Index Position Short Infosys +Short Index-Long Index IF bearish on market short index only But bearish on Stock ;short stock and long index. G=Index Fall L=Index Rise

123 Short Stock, Long Index Futures
An Example of Hedging A buyer faces many risks (price risk, liquidity risk, credit risk, operating risk) in equity investment. Price risk is made of two parts: Price movement due to market sentiments Price movement due to company-specific factors Say beta of Infosys is 1.5 Assume that Infosys equity is selling at Rs.4000 and you have sold it. Say over a day, Infosys equity price moves to Rs when the index moves up by 1% Of this price movement of 100, market sentiment causes Rs.60. Remaining s.40 is due to company-specific factors Continued…

124 Short Stock, Long Index Futures
Suppose that a buyer does not want to assume the price risk of Rs.60 due to market sentiments Assume that the equity index future is selling at He will sell “n” index futures where “n” is calculated as follows: n = (Price of the share*beta)/(value of the index) In this case, n = (4000*1.5)/(2000)=3 If the index goes up by 1% to 2020 (that is, 20) as the seller he gains Rs.20*3= Rs.60 Continued..

125 Gain/loss when Index up by 1%, Infosys up by 1.5%
Long on Index 3 units: + 60 Short on Share 1 unit: -60

126 Bullish Index, Long NIFTY Futures
On September , XYZ feels Index will rise. He buys a Future Index with expiration date of 30th September 2001. At this time NIFTY September cost was Rs.1071 so his position is worth Rs.2,14,200. On 14th September NIFTY increase to 1075 The Nifty contract has risen to to Rs.1080 XYZ sells of f his position at Rs.1080 His profit is Rs.1800.

127 Bearish Index, Short NIFTY Futures
On October , XYZ feels Index will fall. He sells a Future Index with expiration date of 30th October 2001. At this time NIFTY September cost was Rs.1060 so his position is worth Rs.2,12,000. On 20th October NIFTY decrease to 1050 The Nifty contract has fallen to to Rs.1055 XYZ buy t his position at Rs.1055 His profit is Rs.1000.

128 Example STOCK =SBI SHORT on SBI of Rs.200,000
LONG on NIFTY of Rs.100,000 Beta=0.8% Which of the following is true? Partial Hedge Complete Hedge Overhedged

129 Example Short on SBI=Rs.200,000=Short on Nifty of Rs160,000.
Long on Nifty=Rs.100,000 Hence is partial hedge.

130 Have Portfolio, Short Index Futures
Have Fund, Long Index Future

131 Have Funds, Lend them to the Market
On 1 August, Nifty is at A futures contract is trading with 27 August expiration for Ashish wants to earn this return (30/1200 for 27 days.) He buys Rs. 3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. He has obtained the Nifty spot for He sells Rs. 3 million of the futures at The futures market is extremely liquid so the market order for Rs. 3 million goes through at near-zero impact cost.

132 Have Funds, Lend them to the Market (contd..)
He takes delivery of the shares and waits. While waiting, a few dividends come into his hands. The dividends work out to Rs. 7,000.Simultaneously he lends security and earn fees on it On 27 August, at 3.15, Ashish puts in market orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207 The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot)

133 Have Funds, Lend them to the Market (contd..)
Ashish has gained Rs. 3 (0.25%) on the spot Nifty and Rs.20(1.63%) on the futures for the return of near 1.88%. In addition, he has gained Rs. 70,000 or 0.23% owing to the dividends plus (0.2% on lending) for a total return of 2.31% for 27 days, risk free. It is easier to make a rough calculation of return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is very close to the actual number.

134 Have Funds, Lend them to the Market (contd..)
1st Aug-NIFTY-1200 27th Aug Future NIFTY on 1st AUG-1230 Expected Return-(1230/1200)=2.1% Long NIFTY on SPOT=Rs.3 Short NIFTY on FUTURE=Rs Ashish Takes Delivery and lends the security On 27th Aug at 3.15 pm Ashish sells NIFTY spot at 1207 and NIFTY Close at 1210 Stock= =3(0.25%) Future= =20(1.63%) Dividend=0.23% Lending=0.2% Total Return= =2.31% Have Funds, Lend them to the Market (contd..)

135 Have Securities, Lend them to the Market
Suppose the Nifty spot is 1100 and the two-month futures are trading at Hence the spot futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stock lending is or 0.71% over the two-month period.

136 Have Securities, Lend them to the Market
Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs. 4 million of the Nifty portfolio which he would like to lend to the market. Akash puts in sell orders for Rs. 4 million of Nifty using the future in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution in 1098.

137 Have Securities, Lend them to the Market (contd…)
A moment later, Akash puts in a market order to buy Rs. 4 million of the Nifty futures. The order executes at At this point, he is completely hedged. A few days later, Akash makes delivery of shares and receives Rs million (assuming an impact cost of 2/11/00). Suppose Akash lend this out at 1% per month for two months.

138 Have Securities, Lend them to the Market (contd…)
At the end of two months, he gets back Rs. 4,072,981. Translated in terms of Nifty, this is 1098* or 1120. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract.

139 Have Securities, Lend them to the Market (contd…)
When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150 – 1110) so he ends up with a clean profit, on the entire transaction, of – 1153 or 7. On a base of Rs. 4 million, there is Rs. 25,400.

140 Have Securities, Lend them to the Market (contd…)
1st Aug-NIFTY-1100 27th Sep Future NIFTY on 1st AUG-1110 Expected Return-(1110/1100)=0.9%, RFR=1% for 2Months Short NIFTY on SPOT=Rs.4 Long NIFTY on FUTURE=Rs Akash gives Delivery Receives RS.3.99 Ml and lend the money for 2 1% and return=Rs.4,072,981=1098*1.01^2=1120 NIFTY On 27th Sep at 3.15 pm Akash buys NIFTY spot at 1153 and NIFTY close at 1150 Return = =7 On a base of Rs. 4 million, there is Rs. 25,400.

141 SPOT THE MISPRICING If for instance F> S(1+r)T, arbitrageurs will borrow funds, buy the spot with these borrowed funds, sell the futures contract and carry the asset forward to deliver against the future contract. This is called cash-and-carry arbitrage. If for instance F< S(1+r)T: It is reverse cash-and-carry arbitrage.


143 SPOT THE MISPRICING If the fair value of the contract is higher than the ask, the contract is underpriced and should be bought at the ask price. If the fair value of the contract is lower than the bid, the contract is overpriced and should be sold at the bid price. In the example December is overpriced. Hence the investor can sell 200 units and close the contract when it come back to its fair value.

144 SPREAD TRADING The observe spread is 6. Since the spread is narrowed we can profit by selling the near month contract and buying the far month . Sell F1(1012) and Buy F2 (1018) After some time market correct itself and we Buy F1(1010) and sell F We end up making a profit of Rs.4 on the round trip.

145 NSE Data Futures (June 2000-March 2001) Equity (2000-01)
90580 contracts traded Turnover: Rs crores Average daily turnover: Rs crores Equity ( ) Turnover:Rs. 1339,510 crores Average daily turnover: Rs cr.

146 Assets Underlying Options Contracts
Historically most of the action has been in stock options. Commodity options do exist but do not trade in the same volumes as commodity futures. Options on foreign currencies, stock indices, and interest rates are also available.

147 Major Global Futures Exchanges & Trading Volumes in 2001
VOLUME in Millions CME 316.0 CBOT 210.0 NYMEX 85.0 EUREX 435.1 LIFFE 161.5 Tokyo Commodity Ex. 56.5 Korea Stock Ex. 31.5 Singapore Exchange 30.6 BM&F 94.2

148 Chicago versus Frankfurt
EUREX is a relatively new exchange. However it is a state of the art electronic trading platform. The Chicago exchanges have traditionally been floor based, or what are called open-outcry exchanges. Competition is now forcing them to embrace technological innovations.

149 Equity Options Markets & Trading Volumes in 2000
EXCHANGE Stock Options Volume in 1,000s Index Options Volume in 1,000s AMEX 205,716 1,998 CBOE 281,182 47,387 CBOT NT 200 CME 5089 ISE 7,716 EUREX 89,238 44,200 OM 30,692 4,167 Korea SE 193,829

150 Currency Futures Currency Futures are an exchange-traded forward FX instrument. The volume in currency futures is low compared to interest rate futures . The Pricing model underlying currency futures is the short-term forward FX model. However like all exchange –traded contracts there are funding cost associated with initial margin and mark-to market requirement, which is unknown when the futures contract is executed.As a result, the effective forward FX rate of a currency rate of a currency futures contract will not be known until the contract is terminated. This can expressed as follows: Effective forward price=Future Price+Funding Adjustment

151 Currency Futures

152 Indian Foreign Exchange Markets
INR trades in a managed floating exchange rate regime INR is fully convertible on India’s current account, but not on the capital account Foreign institutional investors can fully repatriate their investments Resident Indian individuals have been permitted to invest offshore All foreign currency spot and forward transactions need to be routed through schedule commercial banks (Authorized Dealers) Access is restricted to banks and entities having a commercial exposure Volumes and tenor is restricted to underlying exposure Only banks have open position limits

153 Indian Foreign Exchange Markets
Daily average turnover of the Indian FX markets stands at USD 34 billion Flows driving the USDINR rate include; Trade and capital flows Hedging of these flows by corporate and institutional clients Remittances by non resident Indians Investments by offshore institutions in India Investment by Indian companies offshore Directional views of market participants India’s total imports: USD 250 billion, exports USD 160 billion (FY ) Capital flows, FIIs USD 31 billion, Foreign Direct Investment USD 15 billion, Bank Capital USD 11 billion

154 Indian Foreign Exchange Markets - Participants

155 Why do they participate in the FX market ?
Directional Views Positioning for INR appreciation or depreciation Hedging existing exposure Importers & Exporters hedging future payables or receivables Borrowers hedging FCY loans – Interest or Principal payments NRIs looking to hedge their investment in India Resident Indians looking to hedge investments offshore FIIs hedging their investments in India Trade and Capital Flows Remittances for trade or services and capital transactions Arbitrage Entities who can access onshore and non deliverable forward markets

156 What factors affect trading decisions ?
Macro economic views Monetary Policy RBI intervention Flow information Performance of other Asian currencies Performance of equity markets USD sentiment Performance of key commodities affecting trade Policy announcements affecting flows – trade or capital REER – Real Effective Exchange Rate Data announcements

157 Trading Strategies – Directional views
1991: BOP crisis 1998: Nuclear tests 2001: Nasdaq crash 2003: Strong FII flows 2004: BJP election loss 2006: Drop in RBI intervention 2008: Oil spikes

158 Trading Strategies – Directional views
View: INR will depreciate against USD, caused by India’s sharply rising import bill and poor FII equity flows Trade: USDINR 31 July contract: Current Spot rate (9 July 08): Buy 1 July contract: Value Rs. 43,500 (USD 1000 * ) Hold contract to expiry: RBI fixing rate on 29 July 08 – Economic return: Profit, Rupees 500 (44,000 – 43,500) A Currency Futures contract is exactly like a futures contract on the NIFTY or on INFOSYTCH. A futures price “F” is traded on screen. The price is the USDINR exchange rate at a future date.

159 Trading Strategies - Hedging
IT exporter - contract earning USD 1 million per month for 12 months Risk to INR appreciation Trade - Sell 1000 contracts of each expiry out to 12 months On each expiry sell the USD remittance in the spot market and match the rate to the fixing rate on the futures contract Follow this principal if you continue to hold the same view through the life of the service contract

160 Trading Strategies - Hedging
Individual investor invested USD 100,000 in equities offshore Purchased USD by paying INR 4,300, ) At the end of 12 months; offshore portfolio valuation is USD 110,000 and USDINR is trading at Net INR proceeds INR 4,400,000 USD return of 10%, your INR return is only 2.33% Alternate strategy: hedge the initial investment, by selling the 12 month futures contract at the time of trade inception

161 Trading Strategies - Arbitrage
Arbitrage can potentially exist between, currency futures, OTC forwards and the non-deliverable forwards traded offshore An arbitrage can be executed by an entity having access to any two of the above Corporate entities with an underlying exposure, can straddle both markets Sell 1st month in currency futures Buy 1 month forward in OTC markets This scenario can exist when currency futures are trading higher than forwards which will also be governed by interest rate differentials and USD supply with banks Restricted access to the OTC and NDF markets could translate to the arbitrage gap not closing

162 OTC vs Futures OTC Market Exchange Traded Futures Accessibility Low
High Price Transparency Liquidity Subject to credit limits Agreements Customized Standard Credit Exposure Yes Mitigated through the clearing corporation Settlement Physical Delivery Net Settled in INR Underlying exposure Required Not required

163 OTC vs Futures Will it trade like OTC forwards
INR not fully convertible Regulatory restrictions on borrowing in foreign currency Delivery vs net settlement Wider set of market participants RBI intervention The Non Deliverable Forwards market does not always track onshore OTC forwards, especially at the short end Sharp moves in spot Expectations of immediate INR appreciation / depreciation Flow information

164 What is in it for YOU ? A new asset class which was earlier not permitted for trading to all Indian residents Number of market participants will increase dramatically. More client business Permitting NRIs and FIIs at a future date could shift a substantial portion of the NDF business to the exchange Potential for arbitrage in the OTC vs Futures market could increase volumes in both markets

165 Trading Get Connected NEAT Plus NOW CTCL NOW website NEAT Plus

166 Contract specifications
Category Description Underlying Rate of exchange between 1 USD and INR Contract Size USD 1000 Contract Months 12 near calendar months Expiration Date and Time Last business day of the month Min Price fluctuation 0.25 paise or INR Settlement Cash settled in INR on relevant RBI reference rate Market timings would be 09:00 to 17:00 Order driven market Contract fixing two days prior to Contract Expiration date, settlement on contract expiry date

167 Risk Management Real time Upfront portfolio based margins
Based on 99% VaR Client level monitoring Initial Margin Margins calculated using SPAN Minimum Initial margin 1.75% on day 1, 1% thereafter Calendar spread margins defined at Rs. 250/- Monitored at Trading and Clearing Member level

168 Risk Management Extreme Loss Margin
1% on value of gross open positions Monitored at Clearing Member level Positions Limits Client : 6% of total open interest or USD 5 million whichever is higher Trading member : 15% of total open interest or USD 25 million whichever is higher

169 Clearing & Settlement Daily Clearing and Settlement Trades processing
Position computation Daily settlement price Mark to market settlement Client margin reporting Final Clearing and Settlement Expiry day processing Final settlement price Final settlement of futures contracts

170 Membership Separate membership for the Currency Derivatives Segment
Balance sheet networth: Trading member Rs. 1 Crore; Clearing member Rs 10 crores Minimum Liquid Networth for clearing members Rs. 50 Lakhs Separate Certification required Members to be approved by SEBI Foreign Institutional Investors and Non Resident Indians not permitted to trade in the initial phase

171 Trading and Clearing Member
Membership Deposits for Existing Members: In Rupees Lakhs Trading Member Trading and Clearing Member Interest free cash security deposit with NSEIL 10 Interest free cash security deposit with NSCCL NIL 25 Collateral Security Deposit with NSCCL For every trading member, clearing member needs to provide Cash 5 Non - Cash


173 Why The Brouhaha? Derivatives as a concept have been around for a long time. In fact there is a hypothesis that such contracts originated in India, a few centuries ago. But they have gained tremendous visibility only over the past two to three decades.

174 Why? (Cont…) The question is, what are the possible explanations for this surge in interest. Till the 1970s, most of the trading activities were confined primarily to commodity futures markets. However, financial futures have gained a lot of importance, and the bulk of the observed trading, is in such contracts.

175 Why ? (Cont…) The simple fact is that over the past few decades, the exposure to economic risks, especially those impacting financial securities, has increased manifold for most economic agents. Let us take the case of commodities first. There was a war in the Middle East in 1973.

176 Commodities Subsequently, Arab nations began to use crude oil prices as a policy instrument. This lead to enormous volatility and unpredictability in oil prices. The result was an enhanced volatility in the prices of virtually all commodities.

177 Commodities (Cont…) The is because the transportation costs of all commodities is directly correlated with the price of crude oil. Since commodity prices became volatile, instruments for risk management became increasingly popular. Consequently commodity derivatives got a further impetus.

178 Exchange Rates The Bretton Woods system of fixed exchange rates based on a Gold Exchange standard was abandoned in the 1970s and currencies began to float freely against each other. Volatility of exchange rates, and its management, lead to the growth of the market for FOREX derivatives.

179 Interest Rates Traditionally, central banks of countries have desisted from making frequent changes in the structure of interest rates. However, beginning with the early 1980’s, the U.S. Federal Reserve under the chairmanship of Paul Volcker began to use money supply as a tool for controlling the economy.

180 Interest Rates (Cont…)
Interest rates consequently became market dependent and volatile. This had an impact on all facets of the economy since the cost of borrowed funds, namely interest, has direct consequences for the bottom lines of businesses. Hence interest rate derivatives got a fillip.

181 LPG In the 1980s and 1990s, many economies which had remained regulated until then, began to embrace an LPG policy – Liberalization, Privatization, and Globalization. With the removal of controls, capital began to flow freely across borders.

182 LPG (Cont…) As economies became inter-connected, risks generated in one market were easily transmitted to other parts of the world. Risk management therefore became an issue of universal concern, leading to an explosion in derivatives trading.

183 Deregulation of the Brokerage Industry
On 1 May 1975, fixed brokerage commissions were abolished in the U.S. This is called May Day Subsequently, brokers and clients were given the freedom to negotiate commissions while dealing with each other. In October 1986, fixed commissions were eliminated in London, and in 1999 Japan deregulated its brokerage industry.

184 Deregulation (Cont…) Also, from February 1986, the LSE began admitting foreign brokerage firms as full members. The objective of the entire exercise was to make London an attractive international financial market, which could effectively compete with markets in the U.S.

185 Deregulation (Cont…) London has a tremendous locational advantage in the sense that it is located in between markets in the U.S. and those in the Far East. Hence it is a vital middle link for traders who wish to transact round the clock.

186 Deregulation (Cont…) In a deregulated brokerage environment, commissions vary substantially from broker to broker, and depend on the extent and quality of services provided by the firm. A full service broker will charge the highest commissions, but will offer value-added services and advice.

187 Deregulation (Cont…) A deep-discount broker will charge the least but will provide only the bare minimum by way of service. Here is a comparison of fees charged on an average by different categories of brokers in the U.S.

188 Commission on Stock Options Commissions on Futures
Brokerage Rates Brokerage Type Commission on Stock Options Commissions on Futures Deep-discount $1 per contract; minimum $15 per trade $7 per contract Discount $ % of principal $20 per contract Full Service $50-$100 per trade $80-$125 per contract

189 IT Finally, the key driver behind the derivatives revolution has been the rapid growth in the field of IT. From streamlining back-end operations to facilitating arbitrage using stock index futures, computers have played a pivotal role.

190 Revival of Trading in India
Financial sector reforms have been an integral part of the liberalization process. Initially the focus was on streamlining and modernizing the cash market for securities. Various steps were therefore taken in this regard. A modern electronic exchange, the NSE was set up in 1994.

191 India (Cont…) The National Securities Clearing Corporation (NSCCL) was set up to clear and settle trades. Dematerialized trading was introduced with the setting up of the NSDL. The attention then shifted to derivatives, for it was felt that that investors in India needed access to risk management tools.

192 India (Cont…) There was however a legal barrier.
The Securities Contracts Regulation Act, SCRA, prohibited trading in derivatives. Under this Act forward trading in securities was banned in 1969. Forward trading on certain agricultural commodities however was permitted, although these markets have been very thin.

193 India (Cont…) The first step was to repeal this Act.
The Securities Laws (Amendments) Ordinance was promulgated in 1995. This ordinance withdrew the prohibition on options on securities. The next task was to develop a regulatory framework to facilitate derivatives trading.

194 India (Cont…) SEBI set up the L.C. Gupta committee in 1996 to develop such a framework. The committee submitted its report in 1998. It recommended that derivatives be declared as securities so that the regulatory framework applicable for the trading of securities could also be extended to include derivatives trading.

195 India (Cont…) Trading in derivatives has its inherent risks from the standpoint of non-performance of a party with an obligation to perform. For this purpose SEBI appointed the J.R. Varma Committee to recommend a suitable risk management framework. This committee submitted its report in 1998.

196 India (Cont…) The SCRA was amended in December 1999 to include derivatives within the ambit of securities. The Act made it clear that trading in derivatives would be legal and valid only if such contracts were to be traded on a recognized stock exchange. Thus OTC derivatives were ruled out.

197 India (Cont…) In March 2000, the notification prohibiting forward trading was rescinded. In May 2000 SEBI permitted the NSE and the BSE to commence trading in derivatives. To begin with trading in index futures was allowed.

198 India (Cont…) Thus futures on the S&P CNX Nifty and the BSE- 30 (Sensex) were introduced in June 2000. Approval for index options and options on stocks was subsequently granted. Index options were launched in June 2001 and stock options in July 2001. Finally futures on stocks were launched in November 2001.

199 Turnover in Crores Month Index Futures Stock Futures Index Options
Stock Options Total Jun-00 35 - Dec-00 237 Jun-01 590 196 786 Jul-01 1309 326 396 2031 Nov-01 2484 2811 455 3010 8760 Mar-02 2185 13989 360 3957 20490 21482 51516 3766 25163 101925

200 Interest Rate Derivatives
In July 1999 the RBI permitted banks to enter into interest rate swap contracts. On 24 June 2003 the Finance Minister launched futures trading on the NSE on T-bills and 10 year bonds.

201 Why Use Derivatives Derivatives have many vital economic roles in the free market system. Firstly, not every one has the same propensity to take risks. Hedgers consciously seek to avoid risk, while speculators consciously take on risk. Thus risk re-allocation is made feasible by active derivatives markets.

202 Why Derivatives? (Cont…)
In a free market economy, prices are everything. It is essential that prices accurately convey all pertinent information, if decision making in such economies is to be optimal. How does the system ensure that prices fully reflect all relevant information?

203 Why Derivatives? (Cont…)
It does so by allowing people to trade. An investor whose perception of the value of an asset differs from that of others, will seek to initiate a trade in the market for the asset. If the perception is that the asset is undervalued, there will be pressure to buy.

204 Why Derivatives? (Cont…)
On the other hand if there is a perception that the asset is overvalued, there will be pressure to sell. The imbalance on one or the other side of the market will ensure that the price eventually attains a level where demand is equal to the supply.

205 Why Derivatives? (Cont…)
When new information is obtained by investors, trades will obviously be induced, for such information will invariably have implications for asset prices. In practice it is easier and cheaper for investors to enter derivatives markets as opposed to cash or spot markets.

206 Why Derivatives? (Cont…)
This is because, the investor can trade in a derivatives market by depositing a relatively small performance guarantee or collateral known as the margin. On the contrary taking a long position in the spot market would entail paying the full price of the asset.

207 Why Derivatives? (Cont…)
Similarly it is easier to take a short position in derivatives than to short sell in the spot markets. In fact, many assets cannot be sold short in the spot market. Consequently new information filters into derivatives markets very fast.

208 Why Derivatives? (Cont…)
Thus derivatives facilitate Price Discovery. Because of the high volumes of transactions in such markets, transactions costs tend to be lower than in spot markets. This in turn fuels even more trading activity. Also derivative markets tend to be very liquid.

209 Why Derivatives? (Cont…)
That is, investors who enter these markets, usually find that traders who are willing to take the opposite side are readily available. This enables traders to trade without having to induce a transaction by making major price concessions.

210 Why Derivatives? (Cont…)
Derivatives improve the overall efficiency of the free market system. Due to the ease of trading, and the lower associated costs, information quickly filters into these markets. At the same time spot and derivatives prices are inextricably linked.

211 Why Derivatives? (Cont…)
Consequently, if there is a perceived misalignment of prices, arbitrageurs will move in for the kill. Their activities will eventually lead to the efficiency of spot markets as well. Finally derivatives facilitate speculation. And speculation is vital for the free market system.


213 Contents of the presentation
SCRA(1956) SEBI(1992) SEBI(Brokers and Sub-Brokers Regulation),1992 Regulation for Derivatives trading Regulation for clearing and settlement Risk Management Accounting Issues Taxation Issues

214 Securities Contracts(Regulation)Act,1956 SCRA
Securities: Shares, Scrips, Stocks, Bonds, Debentures, Debentures stock, Government securities or any other Instruments as may be declared by the Central Government to be securities, Units or any other instrument issued by any collective investment scheme to the investors in such scheme, Rights or interest in securities and Derivatives. Derivative: A security from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form security.

215 Securities Contracts(Regulation)Act,1956 SCRA (Cont.)
Derivative:A contract which derives its value from the prices ,or index of prices, of underlying securities. According to SCRA the contracts in derivative shall be legal and valid if such contracts are: Traded on a recognized stock exchange Settled on the clearing house of the recognized stock exchange, in accordance with the rules and bye-laws of such stock exchange.

216 Securities and Exchange Board of India Act,
According to SEBI Act ,the SEBI has powers for 1)Regulating the business in stock exchange and any other securities markets. 2)Registering and regulating the working of stock brokers, sub- brokers etc. 3)Promoting and regulating self-regulatory organisation. 4)Prohibiting fraudulent and unfair trade practices. 5)Conducting inquiries and audits of the stock exchanges, mutual funds ,….

217 Regulation for Derivative Trading
Any Exchange fulfilling the eligibility criteria as prescribed in the LC Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC®A, 1956 to start trading derivatives. The derivatives exchange /segment should have a separate governing council and representation of trading/clearing members shall be limited to maximum of 40% of the total members of the governing council. The exchange shall regulate the sales practices of its members and will obtain prior approval of SEBI before start of trading in any derivatives contract. The Exchange shall have minimum 50 members. The members of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfill the eligibility conditions as laid down by the LC Gupta committee.

218 Regulation for Derivative Trading (cont’d)
The clearing and settlement of derivatives trades shall be through a SEBI approved clearing corporation/house. Clearing corporation/houses complying with the eligibility conditions as laid down by the committee have to apply to SEBI for grant of approval. Derivatives brokers/dealers and clearing members are required to seek registration from SEBI. This is an addition to their registration as brokers of existing stock exchanges. The minimum networth for clearing members of the derivatives clearing corporation/house shall be Rs.300 lakh.

219 Regulation for Derivative Trading (cont’d)
The networth of the member shall be computed as follows: Capital + Free reserves Less non-allowable assets viz., Fixed assets Pledged securities Member’s card Non-allowable securities (unlisted securities) Bad deliveries Doubtful debts and advances Prepaid expenses Intangible assets 30% marketable securities

220 Regulation for Derivative Trading (cont’d)
The minimum contract value shall not be less than Rs.2 lakh. Exchanges should also submit details of the futures contract they propose to introduce. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time. The L.C. Gupta committee report strict enforcement of “Know your customer” rule and requires that every client shall be registered with the derivatives broker. The members of the derivatives segment are also required to make their clients aware of the risks involved in derivatives trading by issuing to the client the Risk Disclosure Document and obtain a copy of the same duly signed by the client The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

221 Regulation for Clearing and Settlement
The LC Gupta committee has recommended that the clearing corporation must perform full novation, i.e. the clearing corporation should interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades. The clearing corporation should ensure that none of the Board members had trading interests.

222 Regulation for Clearing and Settlement (cont’d)
The definition of net-worth as prescribed by SEBI needs to be incorporated in the application/regulations of the clearing corporation. The regulations relating to arbitration need to be incorporated in the clearing corporations regulations. Specific provision/chapter relating to declaration of default must be incorporated by the clearing corporation in its regulations.

223 Regulation for Clearing and Settlement (cont’d)
The regulation relating to investor protection fund for the derivatives market must be included in the clearing corporation application/ regulations. The clearing corporation should have the capabilities to segregate upfront/initial margins deposited by clearing members for trades on their own account and on account of his clients. The clearing corporation shall hold the client’s margin money in trust for the client’s purpose only and should not allow its diversion for any other purpose. This condition must be incorporated in the clearing corporation regulations.

224 Regulation for Clearing and Settlement (cont’d)
The clearing member shall collect margins from his constituents (clients/trading members). He shall clear and settle deals in derivatives contracts on behalf of the constituents only on the receipt of such minimum margin. Exposure limits based on the value at risk concept will be used and the exposure limits will be continuously monitored. Clearing members will be subject to exposure limits not exceeding 20 times their base capital. The exposure limit shall be within the limits prescribed by SEBI from time to time.

225 Regulation for Clearing and Settlement (cont’d)
The clearing corporation must lay down a procedure for periodic review of the networth of its members. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members in the underlying market. Any changes in the bye-laws, rules or regulations which are covered under the “Suggestive bye-laws for regulations and control of trading and settlement of derivatives contracts” would require prior approval of SEBI.

226 Eligibility criteria for membership on F&O segment
Particulars New members Existing members CM and F&O segment CM, WDM and F&O segment Net worth 1 Rs.100 lakh Rs.200 lakh Interest free security deposit (IFSD)2 Rs.125 lakh Rs.275 lakh Rs.8 lakh Collateral security deposit (CSD) Rs.25 lakh - Annual subscription Rs.1 lakh Rs.2 lakh 1. Networth of Rs.300 lakh is required for clearing membership. 2. Additional Rs.25 lakh is required for clearing membership. In addition, the clearing member is required to bring in IFSD of Rs.2 lakh and CSD of Rs.8 lakh per trading member in the F&O segment.

227 Requirement for professional clearing membership
Particulars F&O segment CM segment CM & F&O segment Eligibility Trading members of NSE/SEBI registered custodians/ recognised bk Networth Rs.300 lakh Interest free security deposit (IFSD) Rs.25 lakh Rs. 25 lakh Rs. 34 lakh Collateral security deposit Rs. 50 lakh Annual subscription Nil Rs. 2.5 lakh Rs. 2.5 Lakh Note: The PCM is required to bring in IFSD of Rs. 2 lakh and CSD of Rs.8 lakh per trading member in the F&O segment and IFSD of Rs.6 lakh and CSD of Rs lakh (Rs.9 lakh and Rs. 25 lakh respectively for corporate members) per trading member in the CM segment.

228 Risk containment measures for options on indices
The index option contracts to be traded on the derivative exchange/segments shall have prior approval of SEBI. The contract should comply with the disclosure requirements, if any, laid down by SEBI. Initially, the exchange shall introduce European style index options which shall be settled in cash. The index option contract shall have a minimum contract size of Rs. 2 lakh at the time of its introduction in the market. The index option contract shall have minimum of 3 strikes (in- the-money, near-the-money and out-of-the money).

229 Risk containment measures for options on indices (cont’d)
The initial margin requirements shall be based on worst case loss of a portfolio of an individual client to cover a 99% VaR over a one day horizon. The initial margin requirement shall be netted at the level of individual client and it shall be on gross basis at the level of Trading/Clearing member. The initial margin requirement for the proprietary position of Trading/Clearing member shall also be on net basis. A portfolio based margining approach shall be adopted which will take an integrated view of the risk involved in the portfolio of each individual client comprising of his positions in index futures and index options contracts.

230 Risk containment measures for options on indices (cont’d)
The parameters for such a model should include: Worst scenario loss Short option minimum margin (3%) Net option value (NW-SO+LO) Cash settlement of premium Unpaid premium Cash settlement of futures mark to market Position limits Real time computation

231 Guidance Note on Accounting for Equity Index and Equity Stock Futures and Options

232 Derivatives Types of derivatives instruments:-
1. Futures and forward contracts Equity index futures Equity stock futures 2. Options and Swaps contracts Equity stock options Equity index options These are also called as “Equity Derivative Instrument” (EDI)

233 Applicability Applicable to all contracts entered into for EDI irrespective of the motive

234 Forward contracts Agreement between two parties i.e. buyer and seller
At a future time For an agreed price (Contract price) Settled by actual delivery at maturity

235 Futures contract An agreement between two parties to buy and sell an asset At a certain time in future At an agreed price No actual delivery Both parties are under obligation Premium is lower then in the options

236 Options Option is a contract which gives the buyer/holder the right, but not obligation, to buy or sell a specified underlying asset at a predetermined price on or before the specified future date. The person who gets such rights is called “option buyer/holder” The person against whom the buyer can exercise his right is called” option seller/writer” Unlike as buyer the option seller has no right to exercise the option but has an obligation to sell/buy the underlying asset as and when option buyer exercise his option. Every option contract is for a specified period of time.

237 Classification of options
American style options: the buyer can exercise his right at any time before the contract expires or on the expiry date European style options: buyer can exercise his option only on expiry date

238 Premium is higher then in the futures.
Option premium In order to acquire the right of option the buyer pays to the seller a price paid for the right Premium is higher then in the futures.

239 Types of options Call option: buyer/holder gets the right to purchases the underlying asset on or before the expiry date Put option: buyer/holder gets the right to sell the underlying asset Long call/put: buying a option Short call/put: selling a option

240 summary Option type Buyer/ holder Seller/writer Call
Right but not an obligation to buy the underlying asset Obligation but no right to sell the underlying asset Put Right but not an obligation to sell the underlying asset Obligation but no right to buy the underlying asset

241 Strike or Exercise price
The price at which the buyer/ holder has the right to buy or sell and the seller/writer has right to sell or buy or, The price specified in the option contract at which the underlying asset may be purchased or sold by buyer/Holder.

242 Option contract At the money: current market value=strike price
In the money: call option: current market value>exercise price put option: current market value<exercise price Out of money: call option: current market value<exercise price put option: current market value>exercise price

243 Trading Area There can be futures and options on commodities, currencies, securities, stock index, individual stock, etc. Future and options are permitted in india in two equity indexes viz. BSE SENSEX and S&P CNX NIFTY(NSE)

244 Equity Index Future It is a contract to buy / sell equity index
at an agreed amount on a specified future date.

245 Equity Stock Future It is a contract to buy / sell security
at an agreed amount on a specified future date.

246 Difference Type EIF ESF Underlying asset BSE SENSEX,S&P CNX NIFTY
Equity shares of a company Mode of settlement By cash payment of difference between contract price and index value on maturity date Either delivery settled or cash settled. Presently only in cash in india

247 Equity Index Options Whereby a person gets the right to buy or sell
An agreed number of units of equity index On a specified future date

248 Equity Stock Options Whereby a person gets the right to buy or sell
An agreed number of units of a security On or before a specified future date

249 Difference between EIO & ESO
Type EIO ESO Underlying asset BSE SENSEX,S&P CNX NIFTY Equity shares of a company Time of settlement European style On expiry day American Style Any time before expiry. Mode of settlement By cash payment of difference between contract price and index value on maturity date Either delivery settled or cash settled. Presently in India cash settlement only

250 Daily settlement price
The closing price of the equity index/stock futures contract for the day.

251 Contract month In relation to futures contract:
the month in which the contract is to be finally settled In relation to options contracts: the month in which the expiry date falls.

252 Accounting Issues: A discussion
Accounting at the inception of a contract Accounting at the time of daily settlement Accounting for open positions Accounting at the time of final settlement Accounting in case of a default Disclosure requirements

253 Taxation issues: A discussion
The only provisions which have an indirect bearing on derivative transactions are sections 73(1) and 43(5). Section 73(1) provides that any loss, computed in respect of a speculative business carried on by the assessee, shall not be set off except against profits and gains, if any, of speculative business. Section 43(5) of the Act defines a speculative transaction as a transaction in which a contract for purchase or sale of any commodity, including stocks and shares, is periodically or ultimately settled otherwise than by actual delivery or transfer of the commodity or scrips.

254 Taxation issues: A discussion (cont’d)
It excludes the following types of transactions from the ambit of speculative transactions: A contract in respect of stocks and shares entered into by a dealer or investor therein to guard against loss in his holding of stocks and shares through price fluctuations; A contract entered into by a members of a forward market or a stock exchange in the course of any transaction in the nature of jobbing or arbitrage to guard against loss which may arise in ordinary course of business as such member. From the above, it appears that a transaction is speculative, if it is settled otherwise than by actual delivery.

255 Major Recommendations of LCGC
Introduction of Financial Derivatives There is need of equity derivatives, interest rate derivatives and currency derivatives. Phased Introduction: Index Futures, followed by options on Index and then options on Stock. Two level regulatory framework,exchange level and SEBI level. The derivative segment will have separate segment with separate governing council and it will have on-line trading with surveillance. Creation of Derivative cell, a derivatives Advisory committee, and Economic Research wing by SEBI

256 JRVC Recommendation Open positions
Calendar spreads and margins to be levied on them Non-spread positions and margins to be levied on them Clearing member initial margin Clearing member net worth and deposits Intra-day monitoring limits End of day initial margins

257 Terminology Short=Sell
Spot Price : The price at which an asset trades in the spot market. Future Price: The price at which the futures contract trades in the futures market. Basis: Basis is usually defined as the spot price minus the future price. Contract Cycle: The period over which a contract trades. The index futures contract on the exchange have 1,2,3 months expiry cycles which expires on the last Thursday of the month. Expiry Date: It is the maturity date of the contract. Long= Buy Short=Sell

258 Terminology Initial Margin:The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Maintenance Margin:This is somewhat lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. Marking-to-Market:In the futures market, at the end of each trading day , the margin account is adjusted to reflect the investor’s gain/loss depending upon the future closing price. This is called marking-to-market.

259 Presented By CA Swatantra Singh, B.Com , FCA, MBA
ID: New Delhi , ,

260 Thank You

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