Part-16

An Introduction to Derivatives

1
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.

2
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. 3
Broad Categories of
Derivatives
 Forward Contracts
 Futures Contracts
 Options Contracts
 Swaps

4
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

5
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.

6
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.

7
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.
8
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.

9
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.
10
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.

11
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.
12
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.

13
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.

14
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.

15
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.

16
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.

17
Options (Cont…)
 If a call holder were to exercise his
right, the seller of the call would have
to make delivery of the asset.
 If the holder of a put were to exercise
his right, the seller of the put would
have to accept delivery.

18
Options (Cont…)
 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.
 These are known as European Options.

19
Options (Cont…)
 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.

20
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. 21
 Comparison of
Futures/Forwards versus
Options
Instrument Nature of Nature of
Long’s Short’s
Commitment Commitment
Forward/Futur Obligation to Obligation to
es Contract buy sell
Call Options Right to buy Contingent
obligation to
Put Options Right to sell sell
Contingent
obligation to
buy 22
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.

23
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. 24
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.
25
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. 26
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.
27
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.
28
Actors in the Market
 There are three broad categories of
market participants:
 Hedgers
 Speculators
 Arbitrageurs

29
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.
30
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.

31
Hedgers (Cont…)
 What is price risk?
 Price risk is the risk that the price of the
asset may move in an unfavourable
direction from their standpoint.

32
Hedgers (Cont…)
 What is adverse depends on whether
they are long or short in the spot
market.
 For a long, falling prices represent a
negative movement.
 For a short, rising prices represent an
undesirable movement.

33
Hedgers (Cont…)
 Both longs and shorts can use
derivatives to minimize, and under
certain conditions, even eliminate
Price Risk.
 This is the purpose of hedging.

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

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

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

37
Arbitrageurs

 These are traders looking to make

costless and risk-less profits.
 Since derivatives by definition are
based on markets for an underlying
asset, it is but obvious that the price
of a derivatives contract must be
related to the price of the asset in the
spot market.
38
Arbitrageurs (Cont…)
 Arbitrageurs scan the market
constantly for discrepancies from the
required pricing relationships.
 If they see an opportunity for
exploiting a misaligned price without
taking a risk, and after accounting for
the opportunity cost of funds that are
required to be deployed, they will
seize it and exploit it to the hilt. 39
 IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £

Borrow $18,000. Sell on LSE for

Buy 100 shares £10,000
on NYSE
Transfer
$20,000 back to NY

Profit = $2000
This transaction is costless and risk-less in a perfect setting 40
These opportunities cannot persist for long
IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £

Buy on NYSE Sell on LSE Price

Price rises falls

Exchange rate will come down from 2 $/ £

Equilibrium is restored 41
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.

42
Arbitrageurs (Cont…)
 Market participants, like brokerage
houses and investment banks have an
advantage when it comes to arbitrage
vis a vis individuals.
 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. 43
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.

44
Assets…(Cont…)
 Among commodities, we have
contracts on
 agricultural commodities
 livestock and meat
 food and fibre
 Metals
 Lumber
 and petroleum products.
45
Food grains & Oil seeds
 Corn
 Oats
 Soybeans
 Wheat

46
Livestock & Meat
 Hogs
 Feeder Cattle
 Live Cattle
 Pork Bellies

47
Food & Fibre
 Cocoa
 Coffee
 Cotton
 Sugar
 Rice
 Frozen Orange Juice Concentrate

48
Metals
 Copper
 Silver
 Gold
 Platinum
 Palladium

49
Petroleum & Energy Products
 Crude Oil
 Heating Oil
 Gasoline
 Propane
 Electricity

50
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

51
Foreign Currency Futures
 Australian Dollars
 Canadian Dollars
 British Pounds
 Japanese Yen
 Euro

52
Major Stock Index Futures
 The DJIA
 S&P 500
 Nikkei
 NASDAQ-100

53
Interest Rate Futures
 T-bill Futures
 T-note Futures
 T-bond Futures
 Eurodollar Futures
 Federal Funds Futures
 Mexican T-bill (CETES) Futures

54
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.

55
Major Global Futures
Exchanges & Trading
Volumes in 2001
EXCHANGE VOLUME in Millions
CME 316.0
CBOT 210.0
NYMEX 85.0
EUREX 435.1
LIFFE 161.5
Tokyo Commodity Ex. 56.5
Korea Stock Ex. 31.5
Singapore Exchange 30.6
BM&F 94.2
56
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.
57
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.
58
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.
59
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.

60
Commodities
 Let us take the case of commodities
first.
 There was a war in the Middle East in
1973.
 Subsequently, Arab nations began to use
crude oil prices as a policy instrument.

61
Commodities (Cont…)
 This lead to enormous volatility and
unpredictability in oil prices.
 The result was an enhanced volatility in
the prices of virtually all commodities.
 The is because the transportation costs of
all commodities is directly correlated with
the price of crude oil.

62
Commodities (Cont…)
 Since commodity prices became
volatile, instruments for risk
management became increasingly
popular.
 Consequently commodity derivatives got
a further impetus.

63
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.

64
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.
65
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.
66
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.
67
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.

68
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.

69
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.
70
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.

71
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.

72
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.

73
 Brokerage Rates
Brokerage Commission Commissions
Type on Stock on Futures
Options
Deep-discount $1 per $7 per
contract; contract
minimum $15
Discount per
$29 + trade
1.6% of $20 per
principal contract
Full Service $50-$100 per $80-$125 per
trade contract 74
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.

75
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.

76
India (Cont…)
 Various steps were therefore taken in
this regard.
 A modern electronic exchange, the NSE
was set up in 1994.
 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.
77
India (Cont…)
 The attention then shifted to
derivatives, for it was felt that that
investors in India needed access to
risk management tools.

78
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.

79
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.
80
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.
81
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. 82
India (Cont…)
 The SCRA was amended in December
1999 to include derivatives within the
ambit of securities.

83
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.
 Thus futures on the S&P CNX Nifty and the BSE-
30 (Sensex) were introduced in June 2000.

84
India (Cont…)
 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.

85
 Turnover in Crores
Period Index Stock Index Stock Total
Future Future Option Option
Jun-00 s
35 s- s- s- 35
Dec-00 237 - - - 237
Jun-01 590 - 196 - 786
Jul-01 1309 - 326 396 2031
Nov-01 2484 2811 455 3010 8760
Mar-02 2185 13989 360 3957 20490
2001- 21482 51516 3766 25163 101925
02 86
Turnover in Crores (Cont…)
Period Index Stock Index Stock Total
Futures Futures Options Options
2002- 43952 286533 9246 100131 439862
03
2003- 554446 130593 52816 217207 213061
04 9 0
2004- 772147 148405 121943 168836 254698
05 6 2
2005- 151375 279169 338469 180253 482417
06 5 7 4
87
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.

88
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.
89
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.

90
Why Derivatives? (Cont…)
 How does the system ensure that
prices fully reflect all relevant
information?
 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.

91
Why Derivatives? (Cont…)
 If the perception is that the asset is
undervalued, there will be pressure to buy.
 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.

92
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.
93
Why Derivatives? (Cont…)
 Why is it cheaper to transact in
derivatives?
 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.
94
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.

95
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.
 Consequently derivative markets tend to96
Why Derivatives? (Cont…)
 What do we mean by liquid markets?
 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.

97
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.

98
Why Derivatives? (Cont…)
 At the same time spot and derivatives
prices are inextricably linked.
 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.

99
Why Derivatives? (Cont…)
 Finally derivatives facilitate
speculation.
 And speculation is vital for the free
market system.

100