4 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.
5 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.
7 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
8 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.
9 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.
10 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.
11 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.
12 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.
13 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.
14 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.
15 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.
16 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.
17 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.
18 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.
19 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.
20 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.
21 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.
22 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.
23 Comparison of Futures/Forwards versus Options InstrumentNature of Long’s Commitment Nature of Short’s Commitment Forward/Futures Contract Obligation to buy Obligation to sell Call OptionsRight to buyObligation to sell Put OptionsRight to sellObligation to buy
24 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.
25 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.
26 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.
27 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.
28 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.
29 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.
30 Actors in the Market There are three broad categories of market participants: Hedgers Speculators Arbitrageurs
31 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.
32 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.
33 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.
34 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.
35 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.
36 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.
37 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.
38 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.
39 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.
40 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.
41 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.
42 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.
48 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
49 Foreign Currency Futures Australian Dollars Canadian Dollars British Pounds Japanese Yen Euro
50 Major Stock Index Futures The DJIA S&P 500 Nikkei NASDAQ-100
52 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.
53 Major Global Futures Exchanges & Trading Volumes in 2001 EXCHANGEVOLUME in Millions CME316.0 CBOT210.0 NYMEX85.0 EUREX435.1 LIFFE161.5 Tokyo Commodity Ex.56.5 Korea Stock Ex.31.5 Singapore Exchange30.6 BM&F94.2
54 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.
55 Equity Options Markets & Trading Volumes in 2000 EXCHANGEStock Options Volume in 1,000s Index Options Volume in 1,000s AMEX205,7161,998 CBOE281,18247,387 CBOTNT200 CMENT5089 ISE7,716NT EUREX89,23844,200 OM30,6924,167 Korea SENT193,829
56 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.
57 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.
58 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.
59 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.
60 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.
61 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.
62 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.
63 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.
64 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.
65 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.
66 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.
67 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.
68 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.
69 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.
70 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.
71 Brokerage Rates Brokerage Type Commission on Stock Options Commissions on Futures Deep-discount$1 per contract; minimum $15 per trade $7 per contract Discount$29 + 1.6% of principal $20 per contract Full Service$50-$100 per trade $80-$125 per contract
72 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.
73 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.
74 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.
75 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.
76 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.
77 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.
78 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.
79 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.
80 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.
81 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.
82 Turnover in Crores MonthIndex Futures Stock Futures Index Options Stock Options Total Jun-0035--- Dec-00237--- Jun-01590-196-786 Jul-011309-3263962031 Nov-012484281145530108760 Mar-02218513989360395720490 2001-022148251516376625163101925
83 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.
84 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.
85 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?
86 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.
87 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.
88 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.
89 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.
90 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.
91 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.
92 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.
93 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.
94 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.
95 Thank You Questions / doubts /queries are most welcome.