derivatives by HarishNavale


									                 Indian financial system

                                          FIs      Fin.Services
 Fin. Mkts.           Fin. Instruments

                              Bonds        Banks     Banking
Capital       Money           Equities
Mkts.         Mkts.                        NBFCs
History of Indian Stock Mkt.
- Before 1850, shares like commercial bank, bank of bombay &
  mercantile bank were traded

- Trading was conducted under banyan tree in front of town hall(
  horniman circle)

- In 1850, companies act was passed which resulted existence of
  joint stock companies

- Due to american civil war india developed broking business.
  Premchand royalchand was leading broker

- In 1874 dalal street became prominent place for trading
 In 1875 brokers developed association called as Native shares &
  stock brokers which resulted existence of bombay stock exchange

 In 1899 broker shall was inaugrated

 After first world war present new building was occupied on 1 dec

 Due to regulatory compliance, parliament passed SCRA

 Then SEBI was established on 1988 with act 1992

 In 1994 NSE came into existence

 Fortnight trading cycle was reduced to rolling settlement
Common terms used
 Pay in
 Pay out
 Trading Cycle
 Settlement
 Clearing
 Broker
 DPs
 Depository
 Price time priority
Problems with Physical Dealing
 Paper work
 Settlement Risk
 Theft
 Forgery
 Bad delivery
 Loss
Capital Market
 It may be defined as a mkt for borrowing & lending
 long term capital funds required by business

 It mainly comprise two segments:
  Primary mkt & Secondary mkt
   SEBI
   Stock exchanges
   CC / CH
   Depository & DPs
   Custodians
   Stock Broker & Sub brokers
   MFs
   Merchant Bankers
   Rating agencies
   FIs
   FIIs
   Issuer
   Investors
Primary Mkt
 Also known as New Issue Mkt defined as mkt for
 raising fresh capital in the form of shares &

 Ways to raise ;
 - IPOs
 - Private Placement
 - Rights Issue
 - Bonus Issue
Book building
 Issuer nominates merchant banker as book runner
 Issuer specifies number of securities to be issued & price
   Issuer appoints syndicate members with whom orders can
    be placed
   A book remains open for minimum 5 days
   Bidder can revise the bids
   On the close of the period book runner evaluates the bids
   Book runner conclude final price
   Allocation is made to successful bidders
 Is system introduced in 1992, where buyers & sellers
    conduct business economically & efficiently through
    electronic form.

   Nation wide trading
   Investor registration
   Ringless trading
   Transparent
   Exlcusive listing
   Price display
   Trading for unlisted securities
   Faster transfers
   Equities, debt, gilts etc
Trading @ OTCEI
For listed
 Issue of CRs
 Transfer
 Compilation
 Selling securities
 Counter details
 Automatic transfer
 Consolidated statement
For permitted
Settlement procedure
 For listed securities
  pay in on 5th day & pay out on 6th day
 For permitted securities
  5 days trading cycle
Transaction cycle
                                                Placing an order

   Funds &

                                       Clearing of
Settlement process
   Trade details from NSE to NSCCL
   NSCCL confirms to CMs & determines obligations
   Download of obligation by CM
   CM instructs clearing banks for pay in funds
   CM instructs Depositories for pay in shares
   Pay in shares & funds
   Pay out shares & funds
   Depository informs CMs
   Clearing bank informs CMs
Settlement agencies
 Clearing members
 Custodians
 Clearing banks
 Depositories
 Professional CM
How it happens……?
 Trading                          T
 Trade & delivery confirmation   T+1
 Pay in & pay out                T+2
 Auction                         T+3
 Auction settlement              T+5
Market index
 Barometer of market behaviour
 Benchmark portfolio performance

Free float method
Emergence of derivatives
 Financial derivatives came into spotlight in post 1970
 period due to growing instability in the financial

 They are hedging devices against fluctuations in
 commodity prices, & commodity linked derivatives.

 They become popular by 1990 & so major transactions
 accounted due to derivatives
History of derivatives
 Early forward contracts in US addressed merchants
  concern about ensuring that there were buyers & sellers for

 Credit risk remained a serious problem.

 CBOT formed in 1848 to deal problem forward contract of

 In 1865 first exchange traded derivative was introduced by
  CBOT in US called Future contract
 In 1919 CME came into existence , a part of CBOT to
  reorganize trading

 During mid eighties, financial futures became most active
  derivative instruments which gave rise to introduction of
  financial futures in 1970

 Later in 1980 contracts on stocks & indices were introduced
  in US
 It is a instrument whose value is derived from the value
 of one or more basic variables, called bases
 (underlying assets, index) in contractual manner.
 Underlying asset can be equity, forex, commodity etc.

 Example farmers may sell their products at a future
 date to eliminate risk of change in prices
 Forwards – a customized contract between two parties, where
  settlement takes place on specified date in future at today’s pre agreed
  price. Forwards are highly popular on currencies and interest rates. The
  contracts are traded over the counter (i.e. outside the stock exchanges,
  directly between the two parties) and are customized according to the
  needs of the parties. Since these contracts do not fall under the purview
  of rules and regulations of an exchange, they generally suffer from
  counterparty risk i.e. the risk that one of the parties to the contract may
  not fulfill his or her obligation.

 Futures – a standardized contract between two parties to buy or sell an
  asset at certain time in future at certain price. Futures contracts are
  available on variety of commodities, currencies, interest rates, stocks
  and other tradable assets. They are highly popular on stock indices,
  interest rates and foreign exchange.
 Options – calls give the buyer right but not the obligation to buy
  quantity of underlying asset, at given price on or before given future
  date. Puts vice versa

 Warrants – longer dated options are called warrants & generally traded
  over the counter

 LEAPS – long term equity anticipation securities. Warrants having
  maturity up to 3 years

 Swaps – contract between two parties to exchange cash flow in the
  future according to prearranged formula.
  two types interest rate : swapping only interest related cash flow in
  same currency
            currency : swapping both principal & interest, both in
  different currency
Over the Counter (OTC) Derivative Contracts

Derivatives that trade on an exchange are called exchange traded derivatives,
  whereas privately negotiated derivative contracts are called OTC contracts.

 (i) The management of counter-party (credit) risk is decentralized and located
  within individual institutions,
 (ii) There are no formal centralized limits on individual positions, leverage, or
 (iii) There are no formal rules for risk and burden-sharing,
 (iv) There are no formal rules or mechanisms for ensuring market stability and
  integrity, and for safeguarding the collective interests of market participants,
 (v) The OTC contracts are generally not regulated by a regulatory authority
  and the exchange’s self-regulatory organization. They are however, affected
  indirectly by national legal systems, banking supervision and market
Spectrum of Derivative Contracts Worldwide
Underlying      Exchange-        Exchange-       OTC swap         OTC            OTC option
asset           traded           traded                           forward
                futures          options
Equity          Index future     Index option,   Equity swap      Back to back   Warrants
                Stock future     Stock option                     repo
Interest rate   Interest rate    Options on      Interest rate    FRA            Interest rate
                futures linked   futures         swaps                           caps, floors&
                to MIBOR                                                         collars
Credit          Bond future      Option on       Credit default   Repurchase     Credit default
                                 Bond future     swap Total       agreement      option
                                                 return swap
Foreign         Currency         Option on       Currency swap    Currency       Currency
exchange        future           currency                         forward        option
Regulation for derivatives
 The segment should have separate governing council &
  representation of TM/ CM shall be limited to maximum of
  40% of total members of governing council.

 It should have minimum 50 members

 The members would have to comply with conditions laid
  down by LC Gupta committee.

 Clearing & settlement would have to comply conditions laid

 Minimum net worth for CMs shall be Rs 300 lakh
 The minimum contract value shall not be less than Rs
 2 lakh

 Margiin limits, exposure limits & capital adequacy are
 prescribed by SEBI

 Broker would have to disclose risk involved in
 derivatives & obtain copy of disclosure document
 signed by client
Participants in Derivatives
 Exchanges
 Clearing Houses
 Custodians
 Banks
 Market makers
 Brokers
 Arbitrageurs
 Speculators
 Hedgers
Eligibility criteria for stocks
 Stock is chosen from top 500 stocks in terms of avg daily mkt
  capitalization & avg daily traded value in previous six months
  on rolling basis

 Mkt wide position limit in stock should not be less than Rs
  50 cr. Mkt wide position limit of open position( in terms of
  no of underlying stock) on fno contracts on stock should be
  lower of:

 - 30 times avg no of shares traded daily, during previous
  calendar month, in relevant underlying security or
 - 20% of no of shares held by non promoters in relevant
  underlying stock i.e. free float holding
 If an existing stock fails to meet elgibility criteria for 3
  months consecutively, then no fresh contract will be
  issued on that stock
 For unlisted companies coming with IPO, if net public
  offer is Rs 500cr or more then exchange may consider
Introduction to Futures
 Standardized features are
 Quantity of underlying
 Date & month of delivery
 Trade on organized exchange
 More liquid
 Margin payments
 Daily settlement
 Spot price
 Future price
 Contract cycle
 Expiry date
 Contract size
 Basis
 Initial margin
 Maintenance margin
Hedging strategies
 Short hedge: it involves a short position in future contract.
  A short hedge is appropriate when the hedger already owns
  an asset & expects to sell it at some time in future.

 Long hedge: involves taking long position. It is appropriate
  when investor knows he will have to purchase certain asset
  in future & wants to lock in price.

 Future pay offs: it has linear payoffs. It means pfts & losses
  are unlimited for buyer & seller. Includes payoff for long
  futures & short futures
 Hedging: long security , sell futures

 Speculation: bullish security, buy futures

 Speculation: bearish security, sell futures

 Arbitrage: overpriced futures; buy spot , sell futures

 Arbitrage: underpriced futures; buy futures, sell spot
Introduction to options
 An option gives holder right to do something. The holder
    does not have to exercise this right.

Terminology used
   Stock option
   Index option
   Buyer of option
   Writer of option
   Premium / option price
   Expiration date
 Strike price
 American option
 European option
 Intrinsic value of option
 Time value of option
Pay offs
 Pay off profile of buyer: long asset
 Pay off profile of seller: short asset
 Pay off profile for buyer of call: long call
 Pay off profile for writer of call: short call
 Pay off profile for buyer of put: long put
 Pay off profile for writer of put: short put
Hedging strategies
 Hedging : have underlying puts

 Speculation : bullish stock, buy calls or sell puts

 Speculation : bearish stock, sell calls or buy puts
Fno instruments
 Index based futures

 Index based option

 Individual stock option
A spread trading strategy involves taking position in 2 or more
  option of same type i.e calls or puts


- Bull spread: buying call option on stock with certain strike
  price & selling call on same with higher strike price. Both
  options have same expiry.
- Bear spread: investor who prefer bear spread hope that
  stock price will decline. Buying a put with one strike &
  selling put with another strike.
- Box spread: combination of bull call spread with strike k1 &
  k2 and bear put spread with same strike price
 Butterfly spread: involves position in options with 3
  different strike prices. Buying a call with low strike price,
  buying a call with high strike & selling 2 calls with a strike

 Calendar spread: selling call with strike & buying longer
  maturity call with same strike

 Diagnoal spread: bull, bear & calendar spreads can all b
  created from long position in one call & short position in
  another call. In this both expiry & strike price of calls are
  different. This increases range of pft patterns
Introduction to forwards
Is agreement to buy or sell an asset on specified date for
  specified price.

 They are bilateral & hence exposed to risks
 Customized
 On expiry it has to be settled by parties
 Lack of centralized trading
 Less liquid
 No margin payment

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