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INTRODUCTION TO FUTURE PRESENTATION BY Dr. Rana Singh Associate Professor

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The Role of Forward Market b 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. b For our purposes, forwards include over- the-counter(OTC) forward contracts and exchange-traded (ET) futures contracts. b Forward contracts represent a starting point for all derivative valuation.

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

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Forward Vs Cash Transactions b We might expects any transaction that settles today to be a cash transaction and anything settling from tomorrow onward to be a Forward. b 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. b A forward transaction does not commence until the settlement day passes the cash settlement date. b 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.

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

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Deriving the Forward Price b Calculating the forward price is the same as asking the question –How much should I pay to buy something in the Future? b A forward transaction can be replicated by purchasing the asset today and borrowing the money to finance it. b 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.

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Deriving the Forward Price b 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. b The interest cost tends to increase the forward price versus the cash price. b Any cash return on the asset over the term of the forward contract tends to decrease the forward price versus the cash price.

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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. b 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.

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Price for Forward and Futures b b The cost of CARRY model: b b Forward(or Futures)=(Spot Price+Carry Cost- Carry Return) – – F=S 0 +CC-CR b b Spot Price = Current Price b b Carry Cost = Holding Cost, Interest Charges on Borrowing.- Insurance,Storage Costs etc. b b Carry Return= Dividends

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Forward Pricing Formulae b 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. b The three forms considered are assets that pay No incomeNo income Constant incomeConstant income Lumpy IncomeLumpy Income

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

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

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Lumpy Income b Financial asset pays income only at certain points over its life. b F=S * {1+(r 1 * (f 1 /D))} – c* (1 +(r 2 *(f 2 /D)) F=Forward PriceF=Forward Price S=Cash or Spot price of the underlying instrument.S=Cash or Spot price of the underlying instrument. r 1 = interest rate to forward rater 1 = interest rate to forward rate r 2 = interest rate between the income payment and forward expiry datesr 2 = interest rate between the income payment and forward expiry dates c= Asset Income expressed in the same units as the cash price.c= Asset Income expressed in the same units as the cash price. D= Day count basis (365 or 360)D= Day count basis (365 or 360) f 1 = Number of days to the forward expiry date.f 1 = Number of days to the forward expiry date. f 2 = Number of days between the income payment and forward expiry dates.f 2 = Number of days between the income payment and forward expiry dates.

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Forward Price Example

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

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Long futures position

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Long Futures Position

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

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Valuation Differences between Forward & Futures An OTC and a Futures contract with the same forward expiry date should have the same forward price. b 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.

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

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FOREX QUOTATION b In any FX quotation it is essential to know which currency is the base currency and which is term currency. b 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. b To put it another way, the exchange rate quotation is the price of the base currency in “terms” of the term currency.

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b It represents the bulk of FX turnover b 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. b The market for forward FX is very liquid and has been in existence since the floating of the exchange rates in the 1970s. Short-term Forward FX Transactions

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b Forward FX transaction are comprised of the simultaneously execution of a spot FX transaction and a money market borrowing and lending. b 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$. It is not permitted to use derivatives so it must create the forward using only cash instruments. b To do this the Company buys JPY against the US$ at a spot rate of 103.

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

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A model for Forward FX Prices A model for Forward FX Prices b Short –Term Forward Exchange Price: b F=(S*(1+r T )*f/D T )/((1+ r B )*f/D B ) F=Forward Exchange RateF=Forward Exchange Rate S=Spot Exchange Rate.S=Spot Exchange Rate. r T = Terms Currency interest rate to forward rater T = Terms Currency interest rate to forward rate r B = Base currency interest rate to forward rater B = Base currency interest rate to forward rate D T = Term Currency Day count basis (365 or 360)D T = Term Currency Day count basis (365 or 360) D B = Base Currency Day count basis (365 or 360)D B = Base Currency Day count basis (365 or 360) f 1 = Number of days to the forward expiry date.f 1 = Number of days to the forward expiry date. f= Number of days to the forward expiry date from the spot settlement date.f= Number of days to the forward expiry date from the spot settlement date.

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Assumptions b Simple Interest: There is assumed to be no compounding in the interest calculation. b 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.

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

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LTFX (Assumptions) b 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.

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

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LTFX (Price) b F=(S*(1+r T )*f/m T ) n T /((1+ r B )*f/m B ) n B F=Forward Exchange RateF=Forward Exchange Rate S=Spot Exchange Rate.S=Spot Exchange Rate. r T = Terms Currency zero-coupon interest rate to forward rater T = Terms Currency zero-coupon interest rate to forward rate r B = Base currency zero-coupon interest rate to forward rater B = Base currency zero-coupon interest rate to forward rate m T = Term Currency payment frequency (1,2,3,…)m T = Term Currency payment frequency (1,2,3,…) m B = Base Currency payment frequency (1,2,3,…)m B = Base Currency payment frequency (1,2,3,…) n T = Terms currency of payment periods to the forward date.n T = Terms currency of payment periods to the forward date. n B = Basis currency of payment periods to the forward date.n B = Basis currency of payment periods to the forward date.

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

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

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Currency Futures b Currency Futures are an exchange-traded forward FX instrument. b The volume in currency futures is low compared to interest rate futures. b 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 AdjustmentEffective forward price=Future Price+Funding Adjustment

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b EXCEL

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INTEREST RATE FORWARDS What is a Forward Rate Agreement (FRA) ? INTEREST RATE FORWARDS What is a Forward Rate Agreement (FRA) ? b 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 b 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 Trade date Maturity date Start Date t=0t+3mt+6m Specified Period

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

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

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FRA (PRICE) b From the basic formula we know that b F=S*(1+(r-q)*(f/D)) b Our aim is to express this same concept in terms of a forward interest rate calculation. b 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. b Forward Interest= S*((q*d/D)-(r*f/D))

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

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

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FRA Settlement b If r s > r c, then the settlement sum is b Seller pays buyer b If r s < r c, then the settlement sum is b Buyer pays Seller b Where r c = contract rate % par c = contract rate % pa r s = settlement rate % par s = settlement rate % pa

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

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Eurodollars contract b The Eurodollar contract was the first global short- term futures contract listed in 1981 at Chicago Mercantile Exchange(CME). b 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. b The CME lists contracts to expire in quarterly resets in March,June,September and December.Currently, there are 40 consecutive quarters listed. b The Eurodollar is mainly traded by corporations,banks and fund managers with short term interest rate exposures. It expires on 3 rd Monday of the month.

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Eurodollars contract The price of a contract is expressed as: Futures Price=100-(Interest rate *100)+ Funding AdjustmentFutures 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.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.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.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.

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Short-Term Interest Rate Contract

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

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

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b EXCEL

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

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FORWARD BONDS b Forward Bonds are an OTC forward contract on fixed –interest rate security. b In a forward bond agreement, two parties agree to deliver a specified bond prices at at future date. b F=S x (1 + r 1 x f 1 /D)-c x (1x r 2 x f 2 /D)

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FORWARD BONDS b Where F= forward price per face value including accrued interestF= forward price per face value including accrued interest S=Cash bond price including accrued interestS=Cash bond price including accrued interest r 1 = interest rate to the forward expiry dater 1 = interest rate to the forward expiry date r 2 = interest rate between the coupon payment and forward expiry datesr 2 = interest rate between the coupon payment and forward expiry dates D= Day count basis (360 or 365)D= Day count basis (360 or 365) f 1 = number of days to the forward expiry datef 1 = number of days to the forward expiry date f 2 = number of days between the coupon payment and forward expiry datesf 2 = number of days between the coupon payment and forward expiry dates c= periodic coupon paymentc= periodic coupon payment

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FORWARD BONDS

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BOND FUTURES b Bond futures represent a standardized, exchange-traded forward bond contract. b 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.

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

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EQUITY FORWARDS b Equity forwards have gained a reputation as being a highly risky instrument in their relative short existence. b 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.

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

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

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Pricing of Future Contract b b Case1- Securities Providing No Income – –F=S 0 e rt – –S 0 =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%

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Pricing of Future Contract b Case2- Securities Providing a known cash Income –F=(S 0 -I)e rt –S 0 =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.145.08 –F=(3800-145.08)e (0.5)(0.10) – =3654.92 x 1.05127 – =Rs3842.31 –Premium=1.113%

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Pricing of Future Contract b Case3- Stock Index Futures –F=(S 0 -I)e rt –S 0 =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 =200 200x1200=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.1221.80 –Premium=1.816%

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

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Future Strategies b Hedging Long Stock, Short Index FuturesLong Stock, Short Index Futures Short Stock, Long Index FuturesShort Stock, Long Index Futures Have portfolio,Short Index FuturesHave portfolio,Short Index Futures b Speculation Bullish Index,Long Index FuturesBullish Index,Long Index Futures Bearish Index, Short Index FuturesBearish Index, Short Index Futures

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An Example of Hedging An Example of Hedging b A buyer faces many r isks (price risk, liquidity risk, credit risk, operating risk) in equity investment. Price risk is made of two parts: Price movement due to market sentimentsPrice movement due to market sentiments Price movement due to company-specific factorsPrice movement due to company-specific factors b Say beta of Infosys is 1.5 b Assume that Infosys equity is selling at Rs.4000 b Say over a day, Infosys equity price moves to Rs. 3900 when the index moves down by 1% b Of this price movement of 100, market sentiment causes Rs.60. b Remaining s.40 is due to company-specific factors Continued … Long Stock, Short Index FuturesLong Stock, Short Index Futures

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

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

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

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

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

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An Example of Hedging An Example of Hedging b A buyer faces many r isks (price risk, liquidity risk, credit risk, operating risk) in equity investment. Price risk is made of two parts: Price movement due to market sentimentsPrice movement due to market sentiments Price movement due to company-specific factorsPrice movement due to company-specific factors b Say beta of Infosys is 1.5 b Assume that Infosys equity is selling at Rs.4000 and you have sold it. b Say over a day, Infosys equity price moves to Rs. 4100 when the index moves up by 1% b Of this price movement of 100, market sentiment causes Rs.60. b Remaining s.40 is due to company-specific factors Continued… Short Stock, Long Index FuturesShort Stock, Long Index Futures

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

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

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Bullish Index, Long NIFTY Futures b On September 8 2001, XYZ feels Index will rise. b He buys a Future Index with expiration date of 30th September 2001. b At this time NIFTY September cost was Rs.1071 so his position is worth Rs.2,14,200. b On 14th September NIFTY increase to 1075 b The Nifty contract has risen to to Rs.1080 b XYZ sells of f his position at Rs.1080 b His profit is Rs.1800.

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Bearish Index, Short NIFTY Futures b On October 8 2001, XYZ feels Index will fall. b He sells a Future Index with expiration date of 30th October 2001. b At this time NIFTY September cost was Rs.1060 so his position is worth Rs.2,12,000. b On 20th October NIFTY decrease to 1050 b The Nifty contract has fallen to to Rs.1055 b XYZ buy t his position at Rs.1055 His profit is Rs.1000.

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

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

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

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Have Funds, Lend them to the Market b On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days.) b 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 1204. b He sells Rs. 3 million of the futures at 1230. The futures market is extremely liquid so the market order for Rs. 3 million goes through at near-zero impact cost.

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Have Funds, Lend them to the Market (contd..) 3. He takes delivery of the shares and waits. 4. 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 5. 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 6. 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)

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7. 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. Have Funds, Lend them to the Market (contd..)

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b 1 st Aug-NIFTY-1200 b 27 th Aug Future NIFTY on 1 st AUG-1230 b Expected Return-(1230/1200)=2.1% b Long NIFTY on SPOT=Rs.3 Ml @1204 b Short NIFTY on FUTURE=Rs.3 Ml @ 1230 b Ashish Takes Delivery and lends the security b On 27 th Aug at 3.15 pm b Ashish sells NIFTY spot at 1207 and NIFTY Close at 1210 b Stock=1207-1204=3(0.25%) b Future=1230-1210=20(1.63%) b Dividend=0.23% b Lending=0.2% b Total Return=0.25+1.63+0.23+0.2=2.31% Have Funds, Lend them to the Market (contd..)

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Have Securities, Lend them to the Market b Suppose the Nifty spot is 1100 and the two- month futures are trading at 1110. 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 2.01-0.9-0.4 or 0.71% over the two-month period.

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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. 1. 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.

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Have Securities, Lend them to the Market (contd…) 2. A moment later, Akash puts in a market order to buy Rs. 4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged. 3. A few days later, Akash makes delivery of shares and receives Rs. 3.99 million (assuming an impact cost of 2/11/00). 4. Suppose Akash lend this out at 1% per month for two months.

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5. At the end of two months, he gets back Rs. 4,072,981. Translated in terms of Nifty, this is 1098*1.01 2 or 1120. 6. 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. Have Securities, Lend them to the Market (contd…)

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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 1120 + 40 – 1153 or 7. On a base of Rs. 4 million, there is Rs. 25,400.

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Have Securities, Lend them to the Market (contd…) b 1 st Aug-NIFTY-1100 b 27 th Sep Future NIFTY on 1 st AUG-1110 b Expected Return-(1110/1100)=0.9%, RFR=1% for 2Months b Short NIFTY on SPOT=Rs.4 Ml @1098 b Long NIFTY on FUTURE=Rs.4 Ml @ 1110 b Akash gives Delivery b Receives RS.3.99 Ml b and lend the money for 2 months @ 1% and return=Rs.4,072,981=1098*1.01^2=1120 NIFTY b On 27 th Sep at 3.15 pm b Akash buys NIFTY spot at 1153 and NIFTY close at 1150 b Return =1120+40-1153=7 b On a base of Rs. 4 million, there is Rs. 25,400.

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SPOT THE MISPRICING b 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. b If for instance F< S(1+r) T : It is reverse cash-and-carry arbitrage.

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SPOT THE MISPRICING

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b If the fair value of the contract is higher than the ask, the contract is underpriced and should be bought at the ask price. b If the fair value of the contract is lower than the bid, the contract is overpriced and should be sold at the bid price. b 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.

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SPREAD TRADING b The observe spread is 6. Since the spread is narrowed we can profit by selling the near month contract and buying the far month. b Sell F1(1012) and Buy F2 (1018) b After some time market correct itself and we b Buy F1(1010) and sell F2 1020. b We end up making a profit of Rs.4 on the round trip.

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NSE Data b Futures (June 2000-March 2001) 90580 contracts traded90580 contracts traded Turnover: Rs. 2365 croresTurnover: Rs. 2365 crores Average daily turnover: Rs.11.59 croresAverage daily turnover: Rs.11.59 crores b Equity (2000-01) Turnover:Rs. 1339,510 croresTurnover:Rs. 1339,510 crores Average daily turnover: Rs. 5337 cr.Average daily turnover: Rs. 5337 cr.

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UTI INSTITUTE OF CAPITAL MARKET REGULATORY FRAMEWORK

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

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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.

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

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Securities and Exchange Board of India Act, 1991 SEBI b According to SEBI Act,the SEBI has powers for 1)Regulating the business in stock exchange and any other securities markets. and any other securities markets. 2)Registering and regulating the working of 2)Registering and regulating the working of stock brokers,sub-brokers etc. stock brokers,sub-brokers etc. 3)Promoting and regulating self-regulatory 3)Promoting and regulating self-regulatory organisation. organisation. 4)Prohibiting fraudulent and unfair trade 4)Prohibiting fraudulent and unfair trade practices. practices. 5)Conducting inquiries and audits of the 5)Conducting inquiries and audits of the stock exchanges,mutual funds,…. stock exchanges,mutual funds,….

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Regulation for Derivative Trading 1. 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. 2. The Exchange shall have minimum 50 members. 3. 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.

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Regulation for Derivative Trading (cont’d) 4. 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. 5. 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.

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Regulation for Derivative Trading (cont’d) The networth of the member shall be computed as follows: bCapital + Free reserves bLess non-allowable assets viz., a)Fixed assets b)Pledged securities c)Member’s card d)Non-allowable securities (unlisted securities) e)Bad deliveries f)Doubtful debts and advances g)Prepaid expenses h)Intangible assets i)30% marketable securities

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Regulation for Derivative Trading (cont’d) 6. 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. 7. 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. 8. 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 9. The trading members are required to have qualified approved user and sales person who have passed a certification programme approved by SEBI.

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Regulation for Clearing and Settlement 1. 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. 2. The clearing corporation should ensure that none of the Board members had trading interests.

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Regulation for Clearing and Settlement (cont’d) 3. The definition of net-worth as prescribed by SEBI needs to be incorporated in the application/regulations of the clearing corporation. 4. The regulations relating to arbitration need to be incorporated in the clearing corporations regulations. 5. Specific provision/chapter relating to declaration of default must be incorporated by the clearing corporation in its regulations.

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Regulation for Clearing and Settlement (cont’d) 6. The regulation relating to investor protection fund for the derivatives market must be included in the clearing corporation application/ regulations. 7. 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.

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Regulation for Clearing and Settlement (cont’d) 8. 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. 9. 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.

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Regulation for Clearing and Settlement (cont’d) 10. The clearing corporation must lay down a procedure for periodic review of the networth of its members. 11. The clearing corporation must inform SEBI how it proposes to monitor the exposure of its members in the underlying market. 12. 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.

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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 Rs.100 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 Rs.1 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.

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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. 34 lakh Collateral security deposit Rs. 25 lakh 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. 17.5 lakh (Rs.9 lakh and Rs. 25 lakh respectively for corporate members) per trading member in the CM segment.

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Risk containment measures for options on indices 1. 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. 2. Initially, the exchange shall introduce European style index options which shall be settled in cash. 3. The index option contract shall have a minimum contract size of Rs. 2 lakh at the time of its introduction in the market. 4. The index option contract shall have minimum of 3 strikes (in-the-money, near-the-money and out-of-the money).

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Risk containment measures for options on indices (cont’d) 5. 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. 6. 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.

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

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

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Taxation issues: A discussion b 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.

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Taxation issues: A discussion (cont’d) It excludes the following types of transactions from the ambit of speculative transactions: 1. 1. 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; 2. 2. 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.

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

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

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Terminology b b Spot Price : The price at which an asset trades in the spot market. b b Future Price: The price at which the futures contract trades in the futures market. b. b Basis: Basis is usually defined as the spot price minus the future price. b b 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. b b Expiry Date : It is the maturity date of the contract. b b Long= Buy b b Short=Sell

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Terminology b b 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. b b Maintenance Margin:This is somewhat lower than initial margin. This is set to ensure that the balance in the margin account never becomes negative. b. b 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.

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Thank You

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