derivatives

Indian financial system



FIs Fin.Services

Fin. Mkts. Fin. Instruments



Bonds Banks Banking

Capital Money Equities

Mkts. Mkts. NBFCs

Insurance

Debentures

Primary

Mkt

Secondary

Mkt

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

1930



 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

enterprises.







 It mainly comprise two segments:

Primary mkt & Secondary mkt

Participants

 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 &

debentures.



 Ways to raise ;

- IPOs

- Private Placement

- Rights Issue

- Bonus Issue

- ESOP

Book building

 Issuer nominates merchant banker as book runner

 Issuer specifies number of securities to be issued & price

band

 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

OTCEI

 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

Broker

Investor

Placing an order









Trading

Funds &

execution

securities





Clearing of

Settlement

trades

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

 NSCCL

 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

markets.



 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

commodities.



 Credit risk remained a serious problem.



 CBOT formed in 1848 to deal problem forward contract of

commodities



 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

Derivatives

 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

Products

 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

margining,

 (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,

and

 (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

surveillance.

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

agreement

Interest rate Interest rate Options on Interest rate FRA Interest rate

futures linked futures swaps caps, floors&

to MIBOR collars

Swaptions

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

future

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

fno

Introduction to Futures

 Standardized features are

 Quantity of underlying

 Date & month of delivery

 Trade on organized exchange

 More liquid

 Margin payments

 Daily settlement

Terminology

 Spot price

 Future price

 Contract cycle

 Expiry date

 Contract size

 Basis

 Initial margin

 MTM

 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

 ITM

 ATM

 OTM

 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

Spreads

A spread trading strategy involves taking position in 2 or more

option of same type i.e calls or puts



Types



- 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

price.



 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