A derivative is a financial instrument whose value depends on the value of the underlying asset. This underlying asset can be stock, currencies, commodities, indices,interest rates etc. It is a risk management tool used commonly to protect from risk of unknown future value.
For example, a buyer of gold faces the risk that gold prices may not be stable. When one needs to buy gold on a day far into the future, the price may be higher than today. The fluctuating price of gold represents risk.
With the help of derivatives this risk can be minimized by fixing a price today of the asset at a future date. Even if future prices rise, buyer will pay the fixed price. A derivative product can be structured to enable a pay-off and make good some or all of the losses if gold prices go up as feared.
Managing risks with derivatives
A derivative market is formed when players with different risk management needs come together to secure themselves from the respective risky events that they fear in the future.
In the above example, if gold prices were to rise buyer was at a risk and if it would fall seller was at risk because he will have to sell gold at a lower price.
In order to protect from the risk associated with the asset “gold” in this case, buyer and seller can come into a contract and decide a price they are ready to pay in “future” for the same asset, this is called future contract a part of derivative contracts.
If gold price increases, buyer benefits from the contract. If gold prices decreases, seller gets better prices on account of future contract. The risk being managed here pertains to the price of the gold, measurable in money terms. Derivative markets are structured to deal with risk arising out of changes in value of something else in monetary terms. In our example it was gold. This is known as the underlying asset. The underlying asset is subject to risk that is being managed using the derivative. Therefore the derivative, its price and value, is intricately linked with the underlying asset.
Concepts of underlying Derivatives
Zero Sum Game: In a derivative contract, the counter parties who enter into the contract have opposing views and needs. The seller of gold futures thinks prices will fall, and benefits if the price falls below the price at which he entered into the futures contract. The buyer of gold futures thinks prices will rise, and benefits if the price rises beyond the price at which he has agreed to buy gold in the future. The sum of the two positions is zero. In a derivative market, there is a “long” position of a buyer, and there is a corresponding “short” position of a seller. The willingness of both parties to agree to an exchange at a specific term, on a specific date in the future, creates the derivative position. Therefore by definition, the net economic value of all derivative positions should be zero. There is no new underlying asset created because of derivative contract, rather there is an exchange transaction over a preexisting asset.
Cash Settlement: Most derivative contracts are settled in cash. This is because the actual transfer of the underlying asset has happened in the cash market, and the derivative market only makes good the difference between the agreed price for the derivative and the actual price in the market on that date.
For example, A long position to buy 10gms one year from now (gold future) at Rs. 30,000 is entered into. A buyer will buy gold from cash market for Rs 30000, and say a year later if the price increases to Rs 40000, buyer will sell it in the cash market for a profit of Rs 10000. The contract will thus be settled in derivative market as, bought at agreed futures price of Rs. 30,000 and sold at current market price of Rs. 40,000. If the price one year later falls to Rs. 25,000 however, the holder of the long contract will have to pay the difference (Rs. 5000) to the seller in derivative market while buying in the cash market at Rs. 25000. So net cost remains Rs. 30000.
OTC and Exchange Traded Derivatives: Some derivative contracts are settled between counter parties on terms mutually agreed upon between them. These are called Over The Counter (OTC) derivatives. They are non-standard and they depend on the trust between counter parties to meet their commitment as promised. Such contracts are not regulated by a third party and usually take place between individuals. Exchange-traded derivatives are standard derivative contracts defined by an exchange, and are usually settled through a clearinghouse acting as a third party. Here the transactions are regulated by exchange and the buyer and seller do not know one another (anonymous). Forwards are OTC derivatives; futures are exchange-traded derivatives.
Arbitrage: The law of one-price states that two goods that are identical, cannot trade at different prices in two different markets. It is easy to buy from the cheaper market and sell at the costlier market, and make riskless profits. Arbitrageurs are specialists who identify such price-differential in two markets and indulge in trades that reduce such differences in price. For example, if share price is Rs 175 in NSE and Rs 177 in BSE, the arbitrageur will buy at NSE and sell at BSE simultaneously and pocket the difference of Rs2 per share. Such imperfections in market are not frequent and are extremely short lived. Arbitrageurs cashes upon these short lived opportunities.
Types of derivatives products
Forwards: Forwards are over the counter (OTC) derivatives that enable buying or selling an underlying on a future date, at an agreed price. The terms of a forward contract are as agreed between counterparties and is not stock exchange regulated.
For example: A farmer agrees to sell his produce of wheat to a miller, 6 months later when his crop is ready, at a price that both counterparties agree today. This is a forward contract since it will be completed later (forward).
It is also an OTC contract. It can be settled in cash or result in actual delivery of wheat. The settlement terms such as quantity and quality of wheat to be delivered, the price and payment terms are as decided by the counterparties. As there is no official regulator, It carries counterparty risk. It is therefore mostly entered into between known parties, and depends on informal protection mechanisms to ensure that the contract is honored. The forward markets in commodities in several parts of India are based on mutual trust and are functional despite the risks involved.
Futures: Futures are exchange-traded forwards. A future is a contract for buying or selling a specific underlying, on a future date, at a price specified today, and entered into through a formal mechanism on an exchange. The fundamental principle of forward and futures contract is the same, since both specifies the price today for the delivery of an asset at a future date. The only difference is, Future contracts work as per the stock exchange and hence there is no counter party default risk. The terms of the contract such as quality and quantity of asset, date of delivery etc are specified by the exchange.
For example: Wheat futures traded on the Multi-commodity Exchange (MCX) of India has the following specifications (among others):
- Trading unit: 10MT
- Minimum order size: 500MT
- Maximum position per individual: 5000 MT
- Quality: Standard Mill Quality as specified by the exchange
- Contract begin date: 21st of the month
- Delivery options: Physical delivery only
- Delivery date: 20th of the month
- Delivery centre: Exchange approved warehouses
Futures are thus forward contracts defined and traded on an exchange. Since Buyers and sellers don’t know each other in futures contract the counterparty here is the clearing house or clearing corporation, with whom buyers and sellers need to maintain a margin amount. This is done to ensure that there is no default in payment by either buyer or seller.
Options: Options are contracts that grant the right, but not the obligation to buy or sell an underlying asset at a set price on or before a certain date. This means if one opts for an options contract either call or put one is not obliged to buy/sell. For example Somebody sells a futures contract for cattle is obliged – compulsorily deliver physical cows to a buyer. An options contract does not carry the same obligation, which is precisely why it is called an “option”. The one who buys an option has the right to receive delivery but is not obliged to compulsorily accept delivery. The seller or “writer” of the call option is obliged to make the delivery and because buyer does not demand the delivery on a future date, he receives an upfront amount from buyer called as “premium” when he sells the contract to buyer. This means buyer of option will pay a premium and strike a deal (option contract). If buyer ends up being in profit on day of expiry of contract, buyer will demand the delivery and make the payment. The seller in case of payment not being made bags the pre-received premium which acts as his profit.
Options are of two types.
Call Option: A “call” option represents a right to buy a specific underlying on a later date, at a specific price decided today.
Put Option: A “put” option represents a right to sell a specific underlying on a later date, at a specific price decided today
For example: Arvind buys a call option on the Nifty index from Salim, to buy the Nifty at a value of Rs. 8000, three months from today. Arvind pays a premium of Rs 100 to Salim. What does this mean?
- Arvind is the buyer of the call option. (call buyer)
- Salim is the seller or writer of the call option.
- The contract is entered into today, but will be completed three months later on the settlement date.
- Arvind is willing to pay Rs 8000 for Nifty, three months from today. This is called the strike price or exercise price.
- Arvind may or may not exercise the option to buy Nifty at Rs. 8000 on the settlement date.
- If he exercises the option, Salim is under the obligation to sell Nifty at 8000 to Arvind.
- Arvind pays Salim Rs.100 as the upfront payment. This is called the option premium. This is also called as the price of the option.
- On settlement date, Nifty is at Rs. 8200. This means Arvind’s option is “in-the-money.” He can buy the Nifty at Rs.8000, by exercising his option.
- Salim earned Rs.100 as premium, but lost as he has to sell Nifty at Rs.8000 to meet his obligation, while the market price was 8200.
- On the other hand, if on the settlement date, the Nifty is at 7800, Arvind’s option will be “out-of-the-money.”
- There is no point paying Rs.8000 to buy the Nifty, when the market price is 7800. Arvind will not exercise the option. Salim will pocket the Rs.100 he collected as premium.
Swaps: A swap is a contract in which two parties agree to a specified exchange on a future date. Swaps are common in interest rate and currency markets. e.g..a company that has a variable-rate debt, for example, may anticipate that interest rates will rise, and thus he will have to pay more. Another company with fixed-rate debt may anticipate that interest rates will fall and since his debt is at fixed rate he will be paying more interest than the market. The second company therefore contracts to make variable-interest rate payments to the first company and in exchange is paid interest at a fixed rate. In this way when interest rate falls the second company is not paying more and incase the interest rates rise, the first company will be paying fixed and nothing more. Interest rate swaps may be undertaken simultaneously on a variety of debt instruments, thereby enabling corporate treasurers to lower the company’s total interest payments. By using the swap market, the borrower has converted his floating rate borrowing into a fixed rate obligation. Swaps are very common in currency and interest rate markets. Though swap transactions are OTC, they are governed by rules and regulations accepted by swap dealer associations.
Structure of Derivative markets
Equity derivative markets: An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative’s value will fluctuate with changes in its underlying asset’s equity, which is usually measured by share price. An investor that purchases a stock, can protect against a loss in share value by purchasing a put option(selling at higher even though in future market price may fall). Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds or stock index futures.
Derivative products for trading: Following are the equity derivative products available on the Indian exchanges:
NSE: Index futures and options on: CNX Nifty, CNX IT Index, Bank Nifty Index, Nifty Midcap50 Index, CNX Infrastructure Index, CNX PSE Index, India VIX, Dow Jones Industry Average, CNX 500, FTSE 100,
Options and futures on 158 individual stocks as on August 03, 2015.
BSE: Index futures and options on: BSE Sensitive index (Sensex), BSE 100 Index, BSE TECK, Index, BSE Bankex, BSE Oil & Gas Index, Hang Seng Index, MICEX Index, FTSE, IBOVESPA
Options and futures on 41 individual stocks as on August 03, 2015
Trading and Settlement process: EQUITY FUTURES:
Contract Specification: A futures contract is specified in terms of the underlying and the expiry date. The exchange at which the contract is traded also provides other specifications about how it will be traded and settled. For example Specifications of the NSE for futures contracts are as below:
- Expiry Date: The contracts expire on the last Thursday of every calendar month. At any time there would be three contracts available to trade: NEAR month contract expiring on the last Thursday of the current month, NEXT month contract expiring on the last Thursday of the next month, FAR month contract expiring on the last Thursday of the third month. If the Thursday of a month is a trading holiday for the exchange where the contract is traded, it expires on the previous trading day.
- Trading Lot: The lot is the number of shares you purchase in one transaction. The trading lot for a futures contract is specified such that the value of the lot at the time of introduction is not less than Rs.5 lakhs. This means the trading lot is different for each contract and can also vary over time depending on the value of the underlying especially for single stock
- Base Price and Price steps: When a contract is introduced for the first time, its base price is given by the exchange. It is usually decided by taking the future price of the underlying asset including the interest cost for the period until expiry. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. The price step (also called the tick size) for futures contracts is Re.0.05. The change in prices from one trade to another has to be at least 5 paise or multiple of 5 paise. For example, if one trade was executed at 5610.50, then the next trade cannot be executed at 5610.52, but at 5610.55 or 5610.45.
- Price and Quantity Freeze: There are no day minimum/maximum price ranges applicable for futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/-10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. The exchange may not allow an order under quantity freeze if it exceeds the exposure limit of the member, or traded volume for the contract is too low. If traders want to buy or sell large quantities beyond the freeze limits, then they will have to slice it into smaller orders
- Derivatives can be traded on all weekdays (Monday to Friday). The Exchange also announces a list of trading holidays when it would be closed. Trading holidays may be modified, if a need arises. On all trading days, the market timing for derivative contracts on the NSE is: 09:15 hrs to 15:30 hrs with trade modification and exercise market time at 16:15 hrs. Setup cutoff time for Position limit/Collateral value: 16:15hrs
- Orders -Trades are entered in the F&O segment of the trading screen of the trading member and are electronically stamped by the exchange. It is executed as soon as a match is found. The various types of orders are: Regular order, Stop Loss Order and Immediate or Cancel Order. A regular lot order can be a market or limit order. A market order is executed at the prevailing price. A limit order is executed only if the indicated price or better is available in the market. Stop Loss Orders is indirectly a sell order placed against a an already executed buy order which helps limit losses in case falls way below the buy price which the investor may not notice. Placing a buy order along with a stop loss ensures that the position is closed before the loss becomes steeper. Immediate or cancel order- These type of orders are cancelled if not executed immediately.
Settlement of traded contracts: Trades are settled and cleared with the clearing corporations by the clearing member, who has the responsibility of determining the settlement position of all their trading members. There are three types of clearing members in the derivatives market:
- Trading member clearing member (TM-CM): They trade as well as clear, their own trades as well as trades of other trading members.∙
- Professional clearing member (PCM): These are not trading members. They are banks or custodians who only function as clearing members.∙
- Self-clearing Member (SCM): They are TM-CMs who settle only their own trades.∙
There are two types of settlements in a derivative contract.
- Daily Settlement (MTM)-All derivative contracts are settled in cash on t+1 basis by computing the difference between the traded price and the daily settlement price. The daily settlement price is announced by the exchange. It is the weighted average price of the last 30 minutes of trading. For Example, Purchase of Nifty Futures 8000. Settlement Price: Rs 7900. This position is at a loss on a MTM basis. The purchaser of Nifty Futures at 8000 will end up with a loss of Rs.100 if his position were to be settled at the price at the end of the day. Therefore there is a pay in obligation of Rs.5000 (100 times lot size of 50 contracts) for this member. He has to credit the clearing bank account of the clearing member with this amount.
- Final Settlement-The final settlement of a futures contract happens on its expiry date when all open positions are closed. The only difference between the MTM settlement and final settlement is the price. The final settlement happens at the closing price of the relevant underlying index or security in the cash market on the final trading day of the futures contract. Clearing Bank-A clearing bank is a designated bank empanelled by the clearing corporation to receive and make payments for settlement of securities transactions. Every clearing member has to open a specific clearing account with the clearing bank, at specific branches as designated by the clearing corporation. These clearing accounts have to be used only for the purposes of settlement with the clearing corporation.
Trading and settlement in Option Contract
Equity option contracts are specified by the exchange in the same manner as futures contracts(above). However, two additional features are specified for option contracts. Option type: A European option can be exercised only on expiry date; an American option can be exercised any time before the expiry date. In the Indian markets only European options are traded at this time. A contract specified as CE is a Call European option; PE is a Put European option. The settlement system for options is similar to that of futures except for the following:
- Daily settlement is for the premium amount and is settled on T+1 basis. The premium due is paid to the clearing bank before 10.30 a.m. on the next trading day and is settled into the account of the seller at 10.30 a.m.
- FINAL EXERCISE SETTLEMENT FOR OPTIONS- Final exercise settlement is effected for all open long in-the-money strike price options existing at the close of trading hours, on the expiration day of an option contract. All such long (buy) positions are exercised and automatically assigned to short (sell) positions in option contracts with the same series, on a random basis. The investor who has long in-the-money options on the expiry date will receive the exercise settlement value per unit of the option from the investor who is short on the option.
Risk Management in Derivative Markets
Exchanges uses following tools to ensure fulfillment of obligations by each trading party.
Base Capital and Liquid Net worth: The Exchange and Clearing House specifies the amount of capital and net worth that members have to maintain. The margins that have to be maintained with the clearinghouse are also specified. A part of the net worth and margin requirements has to be in liquid assets including cash and cash equivalents. This is called the liquid net worth. The rest of the capital is called base capital. This acts as a guarantee for settlement obligations by members in case of any default payment. Depending on their settlement volumes and obligations, members can request a release of collaterals . This is managed through an electronic interface between the exchange and the member so that a balance is achieved between funding all settlements and the cost to members from keeping assets idle.
Margins: Margins represent the amount the clearing corporation will collect from its members to ensure that trades settle without default. In the futures market segment, two kinds of margin are collected:
- Initial Margin-It is the amount to be deposited by the market participants in their margin account with clearing house before they can place order to buy or sell future contract. This must be maintained throughout the time their position is open and returnable on final settlement of contract. Initial margin is collected using a formula that estimates the risk to an open position over a 2- day horizon.
- Exposure Margin-Exposure margin is the margin charged over and above the initial margin. Exposure margin is collected as a percentage of the notional value of an open position. Not paying the margin requirement attracts penalties including suspension of trading facility, disciplinary action, or closing out of open positions. Clearing members have to send a daily report to the clearing corporation with the details of margins due and collected by them, based on the trades executed and open positions of all clients and trading members who clear their trades through them.
Margins for OPTIONS: The buy and sell trades in options is for the premium of an option position. The initial margins are levied on the premium value of open option positions. The exposure margin is levied on notional contract value computed in terms of value of underlying representing the option position. Exposure margin is collected only on short option positions (sellers). b. In addition to initial and exposure margins, premium margins and assignment margins are collected. Premium Margin means premium amount due to be paid to the Clearing Corporation towards premium settlement, at the client level. Premium margin is levied till the completion of pay-in towards the premium settlement. Assignment margin is collected for the final settlement obligation of the option. It is levied till the completion of pay-in towards the exercise settlement.
Purpose of Derivatives
Hedging: A hedge is an investment to reduce the risk of adverse price movements in an asset. It is an investment technique designed to offset a potential loss on one investment by purchasing a second investment that you expect to perform in the opposite way. For example, you might sell short one stock, expecting its price to drop. At the same time, you might buy a call option on the same stock as insurance against a large increase in value.
Speculation: Derivative securities’ prices are dependent on the price of underlying assets and are merely contracts between parties. Speculators do not own the underlying assets; they own the right to buy or sell the underlying asset, in the case of options. It is the act of buying or selling an asset in hopes of generating a profit from the asset’s price fluctuations.
For example, assume a speculator believes that Reliance stock price will increase to Rs1400 within the next two months. Reliance’s stock price opened at Rs1290 on May 15, 2017. Since the speculator does not want to tie up his capital in one stock by buying 1,000 shares of Reliance, he buys 10 call option contracts with a strike price of Rs 1300 and an expiration date on July 17, 2017. Therefore, if the stock price increases above Rs1300, the speculator could exercise his right to buy 1,000 shares of Reliance at Rs1300 but if it does not increase more than Rs1300 he isn’t obliged to buy the shares and can let the will not exercise the call option. Assume Reliance’s stock price increases to Rs1400 on July 16, 2017. The speculator could exercise his right to buy 1,000 shares and sell those shares for Rs1400 and net a profit of Rs 1,00,000 (Rs100 * 1000shares).
Open Interest: Open Interest is the total number of outstanding contracts that are held by market participants at the end of the day. It can also be defined as the total number of futures contracts or option contracts that have not yet been exercised (squared off), expired, or fulfilled by delivery. For each seller of a futures contract there must be a buyer of that contract. Thus a seller and a buyer combine to create only one contract. Therefore, to determine the total open interest for any given market we need only to know the totals from one side or the other, buyers or sellers, not the sum of both. Each trade completed on the exchange has an impact upon the level of open interest for that day. For example, if both parties to the trade are initiating a new position ( one new buyer and one new seller), open interest will increase by one contract. If both traders are closing an existing or old position ( one old buyer and one old seller) open interest will decline by one contract. The third and final possibility is one old trader passing off his position to a new trader ( one old buyer sells to one new buyer). In this case the open interest will not change. Open interest is compared with the volume of trading in the derivatives market. The larger the open interest as a percentage of traded volume, the greater is the liquidity in the market. An increase in open interest is seen as an indicator of liquidity as it means fresh money is flowing into those contracts. Higher liquidity reduces the transactional costs of a trade and ensures smoother movement in prices.
Put Call Ratio: The ratio of outstanding put options to outstanding call options is called the put-call ratio or PCR = Number of Put options outstanding/Number of call options outstanding If the number of call options is higher than the number of put options, the PCR is lesser than one. If the PCR is greater than one, the number of puts is greater than the number of calls.