Unit - I Introduction to Derivatives.ppt

Derivatives introduction and types of derivatives

1. Unit –I
Introduction to Derivatives
Done by
K.ArjunGoud

2. Derivatives
•Financialderivativesarefinancialinstrumentsthatare
linkedtoaspecificfinancialinstrumentorindicatoror
commodity,andthroughwhichspecificfinancialrisks
canbetradedinfinancialmarketsintheirownright.
•Derivativesisafinancialtermwhichmeansaspecific
investment,whosevalueisderivedfromthe
underlyingassets
–Underlyingassetsare
•Stocks
•Equity
•Debentures
•Commodities
•Etc.

3. Evolution of Derivatives
•InIndia,derivativesmarketshavebeenfunctioningsincethenineteenth
century,withorganizedtradingincottonthroughtheestablishmentofthe
CottonTradeAssociationin1875.
•Derivatives,asexchangetradedfinancialinstrumentswereintroducedin
IndiainJune2000.
•TheNationalStockExchange(NSE)andBombayStockExchange(BSE)are
thelargestexchangesinIndiainderivativestrading.
•ThefirstderivativecontractinIndiawaslaunchedonNSEwastheNifty50
indexfuturescontract.
•TheequityderivativessegmentinIndiaiscalledtheFutures&Options
SegmentorF&OSegment.
•Aseriesofreformsinthefinancialmarketspavedwayforthe
developmentofexchange-tradedequityderivativesmarketsinIndia.

4. Contdd…
•Areportonexchangetradedderivatives,bytheL.C.GuptaCommittee,set
upbytheSecuritiesandExchangeBoardofIndia(SEBI),recommendeda
phasedintroductionofderivativesinstrumentswithbi-levelregulation
(i.e.,self-regulationbyexchanges,withSEBIprovidingtheoverall
regulatoryandsupervisoryrole).
•Anotherreport,bytheJ.R.VarmaCommitteein1998workedoutthe
variousoperationaldetailssuchasmarginingandriskmanagement
systemsfortheseinstruments.
•In1999,theSecuritiesContracts(Regulation)Actof1956,orSC(R)A,was
amendedsothatderivativescouldbedeclaredas“securities”.
•Thisallowedtheregulatoryframeworkfortradingsecuritiestobe
extendedtoderivatives.TheActconsidersderivativesonequitiestobe
legalandvalid,butonlyiftheyaretradedonexchanges.
•Atpresent,theequityderivativesmarketisthemostactivederivatives
marketinIndia.
•Tradingvolumesinequityderivativesare,onanaveragemorethanthree
andahalftimesthetradingvolumesinthecashequitymarkets.

5. Features of Derivatives
•Valueofafinancialderivativeisderivedfrom
someotherasset.
•Derivativesareusedfortransferringriskfrom
riskadverseinvestorstoriskbearinginvestors.
•Financialderivativesprovidecommitmentsto
pricesorratesforthefuturedatesorgiven
protectionagainstadversemovementsof
pricesorexchangeratesandtherebyreduce
themagnitudeoffinancialrisk

6. Development of Indian derivative market
Sl.
No. ProgressDate ProgressofFinancialDerivatives
1 1952 Enactmentoftheforwardcontracts(Regulation)Act.
2 1953 Settingupoftheforwardmarketcommission
3 1956 EnactmentofSecuritiesContractRegulationAct1956
4 1969 Prohibitionofallformsof forwardtradingundersection16ofSCRA
5 1972 InformalcarryforwardtradesbetweentwosettlementcyclesbeganonBSE.
6 1980 KhusoCommitteerecommendsreintroductionoffuturesinmostcommodities
7 1983
Govt.amendsbye-lawsofexchangeofBombay,CalcuttaandAhmedabadandintroduced
carryforwardtrading inspecifiedshares
8 1992 EnactmentoftheSEBI Act
9 1993 SEBIProhibitscarryforwardtransactions
10 1994 KabraCommitteerecommendsfuturestradingin9commodities
11 1995 G.S.PatelCommitteerecommendsrevisedcarryforwardsystem.
12 14th Dec.1995NSEaskedSEBIforpermissiontotradeindexfutures
13 1996 RevisedsystemrestartedonBSE
14 18thNov.1996SEBIsetupLCGuptacommitteetodraftframeworkforindexfutures
15 11thMay1998LCGuptacommitteesubmittedreport
16 1stJune1999Interestrate swaps/forwardrateagreementsallowedatBSE
17 7th July1999RBIgavepermission toOTCforinterestrateswaps/forwardrateagreements
18 24thMay2000SIMEXchoseNiftyfortradingfuturesandoptionsonanIndianindex
19 25thMay2000SEBIgavepermissiontoNSE&BSEtodoindexfuturestrading
20 9thJune2000EquityderivativesintroducedatBSE

7. Contd…
21 12thJune2000 Commencementofderivativestrading(indexfutures) atNSE
22 31stAug. 2000Commencementoftradingfutures&optionsonNiftyatSIMEX
23 1stJune2001 IndexoptionlaunchedatBSE
24 June.2001 TradingonequityindexoptionsatNSE
25 July.2001 TradingatstockoptionsatNSE
26 9th July2001 StockoptionslaunchedatBSE
27 July.2001 Commencementoftradinginoptionsonindividualsecurities
28 1stNov.2001 StockfutureslaunchedatBSE
29 Nov.2001 Commencementoftradinginfuturesonindividualsecurity
30 9thNov.2001 TradingofSinglestockfuturesatBSE
31 June.2003 TradingofInterestratefuturesatNSE
32 Aug.2003 Launchoffutures&optionsinCNXIT index
33 13thSept. 2004Weekly optionsofBSE
34 June.2005 Launchoffutures&optionsinBankNiftyindex
35 Dec. 2006 'DerivativeExchangeoftheYearbyAsiariskmagazine
36 June.2007 NSElaunchesderivativesonNiftyJunior& CNX100
37 Oct.2007 NSElaunchesderivativesonNiftyMidcap-50
38 1stJan.2008 TradingofChhota(Mini)SensexatBSE
39 1stJan.2008 Tradingof mini-indexfutures& optionsatNSE
40 3rdMarch2009 LongtermoptionscontractsonS&PCNXNiftyindex
41 NA
Futures & options on sectoralindices (BSE TECK, BSE FMCG, BSE Metal, BSEBankex&BSEoil&
gas)
42 29thAug.2008 TradingofcurrencyfuturesatNSE
43 Aug.2008 Launchof interestratefutures
44 1stOct.2008 CurrencyderivativeintroducedatBSE
45 10th Dec.2008 S&PCNXDeftyfutures&optionsatNSE
46 aug.2009 Launchof interestratefuturesatNSE

8. Factors contributing to the growth and
development of derivative market in India
•1. Price volatility
•2. Globalization
•3. Technological innovations
•4. Introduction of ICT
•5. Concept of risk hedging and mitigating
•6. Applications of financial theories
•7. As an avenue of speculation

9. Challenges
•1. Market stability and development
•2. Ware housing and standardization
•3. Cash vs physical settlement
•4. Regulator
•5. Lack of economies of scale
•6. Tax and legal bottlenecks

10. Players in Derivatives
•Speculator
•Arbitrageurs
•Hedger
•Margin Trader

11. Speculators
•Speculatorsaretraderswhotakehugerisksbymakingpredictions
aboutvalueofassets.
•Speculatorsmakespeculationsaboutmarketpricemovementsand
enterintoderivativescontractsbasedonthesespeculations.
•Speculatorshaveahigh-riskappetiteandaredrivenbythedesireto
makehigherreturns.
•Theybelievethatthehighertheriskinvolved,thegreaterthe
chancesofmakinghighreturns.
•Speculatorsarekeyinprovidingliquiditytothemarketastheyare
high-risktakers.
–Examplesofspeculatorsincludedaytradersandposition
traders.Asthenamesuggests,daytradersmakereturns
throughpricefluctuationswiththetradinghoursinaday.
Positiontraders,ontheotherhand,makelong-term
speculationsthattakeplaceoverweeksorevenmonths.

12. Arbitrageurs
•Arbitrageursaretraderswhopurchasesecuritiesfromone
marketandselltheminanother.
•Arbitrageursaretraderswithlow-riskappetites.Arbitrageurs
makeuseofsecuritiesthataresimultaneouslybeingsoldin
morethanonemarketatdifferentprices.
•Arbitrageurstakeadvantageofthepricinginefficienciesthat
arepresentinonemarket,whereinanassetispricedeither
higherorlowerthanitshouldbe.
•Whensuchapricedifferenceexists,arbitrageurspurchase
themfromthemarketwheretheyarepricedlowerandsell
theminthemarketwheretheassetispricedhigher.
•Inthismanner,arbitrageurshelptolimitsuchinefficiencies.
•Arbitrageursarecommonlyexperiencedinvestorswith
experienceandknow-howaboutvariousassetsandmarkets.

13. Hedgers
•Hedgersaretraderswhoinvestinthederivativesmarkettomitigate
risk.
•Hedgersarerisk-averseinvestorswhousederivativeinstrumentsto
reducethelossesthatmarketvolatilityentails.
•Hedginghelpstocounterbalancetherisksinvolvedininvestingin
assetssuchasstocks,bonds,commodities,orcurrencies.
•Throughhedging,theinvestorsprotecttheirassetsbyenteringinto
anexactoppositetradeinthederivativemarket.
•Inthismanner,thehedgertransferstherisktoothermarket
participantswhoarerisk-seekersandhedgeagainstlosses.
•Therisk-seekers,inturn,arethoseinvestorsandtraderswillingto
takeontherisk.
•Hedgerscommonlyincludeproducers,farmers,andwholesalers
whofacelossesiftheircommodities’pricesfall.

14. Margin Traders
•Margintradersarespeculatorswhoaimtomakequickprofits
throughthederivativesmarket.
•Margintradersuseleveragingtomakepurchasesthatarebeyond
themeansoftheircurrentfinancialstatus.
•Theirtradingtechniqueisknownasmargintrading.
•Margintradingreferstothetradingtechniquewheretheinvestors
onlypayafractionofthetotalamountpayableinitially.
•Asmallfractionofthetotalamountpayableisasadeposit,known
asthemarginbalance.Usingmargintrading,investorscanmake
moresignificanttradesthanwhattheirfinancialcapacitycanafford.
•Margintradingisatechniquethatisdistinctivetothederivatives
market.
–Examplesofmargintradersincludedaytradersandposition
traders.

15. Types of derivatives
•Forwards
•Futures
•Options
•Swaps

16. Forwards
•Forwardcontractsarederivativesthataresimilartofuturecontractsbutaresoldoverthe
counterratherthanthroughanexchange.
•Forwardcontractsarecustomizedagreementswhosetermsaremadetocatertotheneeds
ofthebuyersandsellers.
•Sincetheyaresoldoverthecounter,theyencompassmorerisktoboththeinvolved
parties.
•Forwardcontractsdonotfallunderthejurisdictionofregulatoryauthoritiessuchasthe
SEBIinIndiaandtheSECintheUnitedStates,therebymakingthemriskierthanfutures
contracts.
•Forwardscontractsinvolvecounterpartyriskswhenonepartycannotfulfilltheir
obligationsasdeemedbythecontract.
•Forwardcontracts,likefuturescontracts,helphedgeaswellasspeculate.
•Forwardcontractsshieldholdersfromincurringhugelossesapartfromofferingthetwo
partiesthemeanstocustomizethecontractaccordingtotheirspecificneeds.
•Sincefuturescontractsareexchangebased,theycannotbealteredtosuittheneedsofthe
twoparties.
•Insituationswherethere’saneedtocustomizethederivativescontract,theforward
contractworksbetter.
•Forwardcontractsaretradedonallmajorstockexchanges,includingtheIndianstock
exchange.

17. Example
•acompanycanpurchaseaforwardcontractforoil
forRs3800abarrelwithanexpirydateofNovember
23,2020,fromanoilseller.Thiscontractensures
thatregardlessofthepricefluctuations,the
companycanbuyoilforRs3800abarrelontheset
date.However,sincethecontractisnotexchange-
based,thereisaslightchancethatthesellerwillnot
sticktothetermsofthecontract.

18. Futures
•Futurescontractisanagreementbetweentwopartiesthatgivesthe
holdertherighttopurchaseorselltheunderlyingassetforaspecified
priceonaspecificdate.
•Futurescontractsareobligatory,andthereforebindingonthetwoparties.
•Futurescontractsarestandardizedderivativecontractsthattradeon
exchanges.
•Tradersusefuturescontractstohedgeagainstrisksduetoprice
fluctuationsintheunderlyingassets.
•Futurescontractspromisetheholderapredeterminedbuyingorselling
price,whichremainsunalteredirrespectiveofthemarketvolatility,and
thereforeshieldsthemfromrisk.
•Futurescontractsaretradedinallmajorstockmarkets,includingthe
IndianStockMarketsliketheBombayStockExchangeandtheNational
StockExchangeofIndia.
•TheSecuritiesandExchangeBoardofIndia(SEBI)regulatesallthefutures
contractsinIndia.

19. Example
•Futurescontractsarebasedonanytypeofassetor
commodity,includingagriculturalgoods,energy-based
commodities,stocks,bonds,etc.
•Forexample,anagriculturalfuturecontractisbasedonan
agriculturalcommoditysuchaswheatorcotton.Abakery
ownerbuysafuturescontractforwheat,for100kgatRs
40,000,withanexpirydateofDecember23,2022.Thebakery
ownermakesthispurchasebecausehefearsthewheatprice
willincrease.Bypurchasingthisfuturescontract,heisassured
100kgatRs40,000irrespectiveofthepricechanges.

20. Options
•Optionscontractsarederivativecontractsthatgivebuyerstheright
tobuyorselltheunderlyingassetonorbeforeaspecifieddate.
•Optionscontracts,however,arenotobligatorywhereinthebuyeris
boundtofulfillthetermsofthecontract.
•Likefuturescontracts,optionscontractsalsoformanagreement
betweentwoparties.
•Theonlydifferencebetweenafuturescontractandanoptions
contractisthattheholdersofoptionscontractsarenotunderany
obligationtobuyorselltheassetasdeemedbythecontract.
•Optionscontractsonlyprovidetheirholderswiththeopportunity
tobuyorsellanassetataspecificprice,shouldtheysodesire.
•Optioncontractsprotecttradersfromriskswhileallowingthemto
avoidfallingthroughwiththecontractifthecontracttermsdonot
seemattractivelater.
•Optionshelptraderstohedgeagainstmarketpricefluctuations.

21. Types of Options
•Call Option
–Call means Buy
•Buyer will have right and seller will have obligation
•Put Option
–Put means Sell
•Seller will have right and buyer will have Obligation
Kinds of Options
•European Option
–In this option contract, Buyer or seller has to wait till the expiry date
and need to exercise or cancel the contract
•American Option
–InthisOptionContract,BuyerorSellercanexerciseorcancelthe
contractonanydatebetweentheperiodofthecontract.

22. Example
•Aninvestor,X,owns100sharesinacompany,AB.Letusassumethatthe
priceofeachshareisRs100.Xisworriedaboutpricefluctuationsthatcan
causeadeclineinhisstockprice,sohedecidestobuyanoptionscontract.
Throughanexchange,Xbuysanoptionthatallowshimtosellthe100
sharesforRs100eachonorbeforeaspecifieddate.Letusassumethat
thestockpricefallstoRs80persharebeforethecontract’sexpirydate.
Usingtheoption,theoptionholdergetstosellhissharesatthe
predeterminedpriceofRs100pershare.Assumingthattheoptions
contractcoststhebuyerRs1000,thisistheonlycostincurredbythe
optionholder.Withouttheoptionscontract,hewouldhavehadtosellhis
sharesforRs80each,incurringalossofRs2000.

23. Swaps
•Swapsarederivativecontractswithtwoholderswho
exchangetheobligatoryfinancialtermsofthe
contract.
•Swapsarenotsoldthroughexchangesastheyare
tailor-madetosuittherequirementsofthetwo
participatingparties.
•Commonlyusedswapcontractsincludeinterestrate
swaps,currencyexchangerateswaps,mortgage
bondswaps,etc.
•Swapcontractshelpinvestorsandtradersto
exchangeonetypeofcashflowwithanother.

24. Types of Swaps
•Interest Rate Swaps
•Currency Swaps

25. Example
•Forexample,letusassumethatacompany,AborrowsaloanofRs20
lakhsatavariableinterestof5%now.Sincetheloanisofvariableinterest,
Aworriesabouttheincreasinginterestratesandthuswishestoswitchto
afixedinterestrate.Insuchasituation,Acanapproachanothercompany
B,whichhasafixed-interestloanat6%.Biswillingtoexchangethe
paymentsfromthefixedrateloanof6%forthepaymentsfromthe
variableinterestloanof5%.AwillhavetopayBthepercentagedifference
of2%ontheprincipalamountof20lakhsifthevariableinterestrate
dropsto4%.However,BwillhavetopayAthepercentagedifferenceof
1%ifthevariableinterestrateincreasesfrom5%to7%.Inthismanner,A
canswitchfromavariable-interestloantoafixed-interestone

26. Uses of Derivatives
•Risk management
•Hedging
•Arbitrage Between Markets
•Speculation

27. Fundamental linkage between the
Spot Market and Derivative Market
•ArbitrageandthelawofOneprice
–Arbitrage
•Arbitrageistheprocessofsimultaneousbuyingandsellingofanasset
fromdifferentplatforms,exchangesorlocationstocashinonthe
pricedifference(usuallysmallinpercentageterms).Whilegettinginto
anarbitragetrade,thequantityoftheunderlyingassetboughtand
soldshouldbethesame.
–Thelawofoneprice
•TheLawofOnePrice(sometimesreferredtoasLOOP)isaneconomic
theorythatstatesthatthepriceofidenticalgoodsindifferentmarkets
mustbethesameaftertakingthecurrencyexchangeinto
consideration(i.e.,ifthepricesareexpressedinthesamecurrency).
•Thestoragemechanism:SpreadingConsumptionacross
Time
•DeliveryandSettlement

28. Role of Derivative markets
•Price Discovery of the Underlying Asset
•Techniques of Risk management
•Operational Advantage
•Market Efficiency

29. Importance of Derivatives
•Risk Sharing
•Implementation of Asset Allocation Decisions
•Information gathering
•Price Discovery and Liquidity

30. Uses / Advantages of Derivatives
•Low Transaction costs
•Used in Risk management
•Market Efficiency
•Determines the Price of an underlying Asset
•Risk is transferable

31. Misuses / Disadvantages
•Involves High Risk
•Counterparty Risk
•Speculative in Nature