Chapter - 5
Derivatives
Derivatives, as the name indicates are the financial instruments which
derive their value from some other asset of monetary value called as “underlying
asset”. This underlying asset can be gold, currency, stock or any commodity. In
short, derivative is not an asset in itself but an agreement or a contract to transfer
the real asset in future whenever exercised!! The date and price of execution is
mentioned in the contract as per agreement between the parties. There are
varieties of derivatives available at present like futures, options and swaps;
futures and options being the most common ones. Before looking into details
here are few components of a derivative agreement which need to be introduced
first.
• Holder: Holder is the buyer of derivative agreement. By buying an
agreement, the buyer may agree to buy or sell the underlying asset.
• Seller: One who sells the contract to holder
• Expiry date: The date at which agreement will get matured / exercised.
• Strike price: The price at which derivative will get exercised and is decided
at the time of entering into agreement (between buyer and seller).
• Premium: It is the price which buyer pays for buying an option contract.
The premium is not to be paid for futures contract.
The reason of its appeal to investors which makes it different than other
financial instruments is that it is not an asset in itself but an agreement to convey
the transfer of actual assets later in future. The catch here is why to enter an
agreement to buy/sell assets in future?? Why not buy the real asset (underlying
asset referred here) directly from spot market at current levels?? Why making an
agreement to be executed in future date? The answer is; derivates are usually
seen as instruments for bringing in protection against unexpected rise or fall in
the price of underlying asset. Secondly, derivatives are used to yield better
returns with lower capital investment as compared to the amount that will be
invested to buy the shares directly form the spot market.
Types of derivative instruments:
Forward Contract: It is an agreement to buy or sell the derivative at a
known date in the future at a price decided as per negotiation between the
contracting parties. These are not traded in exchanges.
Problems of forward contracts: Forward Contracts are between two
parties, Hence these are individual contracts which are settled between the two
parties to the contracts. However these are not traded on the stock exchange.
Hence they are illiquid. They also suffer from the counterparty risk as in case of
default by one party, there is no settlement guarantee as they are not traded on
the exchange.
Futures Contract: It is an agreement to buy or sell a financial instrument
at a known date in the future at a price as per negotiation between contracting
parties. Future Contracts have come into existence to tide over the problems of
the forward contracts. Future contracts are standardized contracts with standard
conditions and terms. These are traded on stock exchange and settlement of the
contracts takes place through the clearing corporation of the stock exchange,
which assumes the counterparty risk. This it acts as a buyer to the seller and a
seller to the buyer and in case of default of any of the parties, the settlement is
guaranteed by the clearing corporation.
Index future Contract : An Index future contract is where the underlying
security is not an individual share but the Index such as Sensex, Nifty, IT Index,
Bank Index and so on. These contracts derive their value from the value of the
underlying index.
Option Contract: It is a contract that gives holder the right, but not the
obligation to exercise it. Call options give holder the right to buy while put option
give the holder the right to sell at the strike price at stipulated date as per
agreement.
Warrants: These are long term options having 3-7 years of expiration.
Warrants are issued by companies for raising finance with no initial servicing
costs like divided or interest. It is a type of security issued by corporation usually
together with a bond or preferred stock that gives holder the right to buy a certain
amount of common stock at a stated price. So it acts as a “sweetener offered
along with the fixed-income securities”.
Swap Contract: Swaps are agreements between counterparties to
exchange one set of financial obligations for another as per the terms of
agreement.
Swaptions: Swaptions are options on swaps. They give holder the right to
enter into having calls options and put options.
Derivatives: Stock Options
Option
As name implies, an option contract gives the buyer an option to buy or sell an
underlying asset (stock, bond, commodity etc.) at a predetermined price on or
before a specified date. The predetermined price is known as “Strike price” or
“Exercise price” and predetermined date is known as “Expiry date”
Types of Option
There are mainly three types of Option
Call Option:- A call option gives the option holder (Option Buyer) right to BUY
the underlying asset at a predetermined price called “Exercise Price” or “Strike
Price” (Example Option is nothing but a piece of paper on which it is written that
“I will BUY XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to
keep that paper I had paid PREMIUM). The holder of the option always pays
premium to the seller (Writer). Writer is in obligation to sell the underlying without
of any argument.
Put Option:- A call option gives the option holder (Option Buyer) right to SELL
the underlying asset at a predetermined price called “Exercise Price” or “Strike
Price” (Example Option is nothing but a piece of paper on which it is written that
“I will SELL XYZ co.’s share at Rs. 100 on 29th Febuary,2008” and in order to
keep that paper I had paid PREMIUM). Writer is in obligation to buy the
underlying without of any argument.
Double Option: - A Double option gives the option holder both the rights either
to buy or to sell the underlying assets at a predetermined price.
PREMIUM: - Premium is nothing but a price to be paid to buy “Right to buy” or
“Right to sell” Option premium is the fee or the price of option. It is payable by the
buyer of the option to the seller or writer as the writer is under obligation to honor
the terms of option if the buyer insists on the same. Thus buyer of the option has
a right to exercise the option while writer of an option has an obligation to fulfill it.
Index Option Contract: An Index option contract is where the underlying
security is not an individual share but the Index such as Sensex, Nifty, IT Index
and so on. Thus the buyer of a call option on Nifty has a right to buy the Index at
a predetermined price on or before a future date. All future index contracts are
cash settled.
In the Money Option Contract
An In the Money Option contract is when in which the strike price of the
option is less than the current market price of the underlying security (for a call
option) or above the current market price of the underlying security (for a put
option). Such an option has intrinsic value.
Out of the Money Option Contract
An Out of the money call option is a call option whose strike price is higher
than the market price of the underlying security, or a put option whose strike
price is lower than the market price of the underlying security. These contracts
would become worthless and would not be exercised by the option holder.
At the money Option Contract
An At the money contract is when the strike price of an option is equal to
or nearly equal to the market price of the underlying security.
Factors affecting Option Prices
1. The current stock price (S0) Call+ Put -
2. The option strike price (K) Call- Put +
3. The time to expiration (T) Call+ Put +
4. The volatility of the stock price (s) Call+ Put +
5. The risk-free interest rate (r) Call+ Put -
6. The value of dividends expected during the life of option Call - Put +
Advantages of Option
• Help in reducing risk
• Proper portfolio management
• Protection against price fluctuation
• Boon to financial intermediaries
Features of Option
Highly Flexible :- Option contract are highly standardize and hence
traded on exchanges.
Down Payment :- The option holder must pay a certain amount called
“Premium” In case if option holder will not exercise the option, he has to forego
the premium. If he exercises the option, he will get profit after deducting premium
from it. Theoretically, writer of option needs not to pay any down payment (But in
practical sense, even writer needs to keep some margin money with exchange to
avoid risk of defaulter)
Settlement :- Contract terminates on expiry date or even before that as
per discretion of Buyer and type of contract.
Settlement Cycle : Indian securities market follows three month trading
cycle. The near month (one), the next month (two) and the far month (three). You
have an option to buy any of the contracts depending on your choice.
Non- Linearity :- Here Profit or loss is not linear to price movement. For
Example if I am buying call option of XYZ co. ltd. with strike price of Rs. 100 and
pays premium of Rs. 4. Suppose if on expiry date price of XYZ co.’s share is say
Rs. 90 and hence I will not exercise option and will not buy share. Hence my loss
will be Rs. 4 (equals to Premium ). But if price on the date of expiry is say Rs.
110. So I will buy at predetermined price of Rs. 100 and will earn profit of Rs. 6
(Rs. 10 – premium). So, for Rs.10 fluctuation on either side, my profit and loss is
not same (Loss Rs. 4 and Profit Rs. 6). This is known non-linear profit or loss.
Intrinsic value
Intrinsic value is the amount by which a call option or a put option is in the
money, calculated by taking the difference between the strike price and the
market price of the underlying security.
Expiration date
Expiration date is the future date when derivative contract will expire. In
Indian securities market, last Thursday of every month is the expiration day for
derivative contracts.
Open interest
Open interest is the total number of futures contracts or option contracts
that have not yet been exercised, expired, or fulfilled by delivery. These contracts
may be on individual securities or on indices.
To start derivative trading
For starting a derivative trading, an investor has to register with a
stock broker who is registered on the derivative segment of the stock
exchange (NSE or BSE). He will also be required to execute the broker client
agreement as well as give certain details about himself to the broker as a part of
‘know your client’ guidelines. You are also given a Risk Disclosure Document,
specifying the risks of trading in the derivative instruments. As a prudent investor,
you should carefully go through these documents carefully.
Minimum contract size
It has been specified that the value of a derivative contract should not be
less than Rs. 2 lakh at the time of introducing the contract in the market. The
contract size is frequently updated depending upon the current market price of
the underlying.
Lot size of contract
Lot size refers to number of underlying securities in one contract. The lot
size is determined keeping in mind the minimum contract size requirement at the
time of introduction of derivative contracts on a particular underlying. For
example, if shares of ABC Ltd are quoted at Rs.100 each and the minimum
contract size is Rs.2 lakhs, then the lot size for that particular scrips stands to be
200000/100 = 2000 shares i.e. one contract in ABC Ltd. would be for 200 shares.
Thus lot size of the contract is determined by the market price of underlying
security and the minimum contract size at the time of introduction of the
derivative contract on that underlying
Risk management
Risk management of derivatives in India:
Stock exchanges follow robust risk management measures for
derivative trading. These include, initial base minimum capital requirements,
real time and system based monitoring of positions and automatic deactivation of
trading terminals in case of exceeding the limits as imposed by exchanges,
margins and daily mark to market margin system and initial Value at risk (VAR)
based margin system. Apart from that there are various position limits, broker
wise limits and scrip wise limits are also there to avoid building up of huge
positions.
Monitors of derivative trading in securities market
Derivative trading in India is very well monitored by the stock exchanges
(NSE has a pre dominant position as far as derivative trading is concerned
compared to BSE). Besides SEBI also monitors the derivative markets through
appropriate policy measures and frequent inspections.
Advantages of trading in derivatives
Derivative contracts are effective tool for hedging and thereby reducing
the potential of future risk. They also allow investors to take a leveraged position
in the market and thereby increase the possibilities of earning higher returns.
Derivative trading is the logical extension of cash market trading and a healthy
derivative market is a sign of effective and robust economy.
Disadvantages of trading in derivatives
Because of their ability to provide leveraging, derivative disasters are
pretty common in international markets. Just as there is huge potential of earning
higher returns, it also exposes individuals and corporations alike to lose money in
case the market moves against the positions held by them. Too much leverage
has been the cause of worry and pitfalls for many traders and investors alike.
Securities of derivative trading
Stock exchanges have a predetermined criteria for selection of securities
where derivative trading is allowed. The criteria are generally the market
capitalization of the securities, liquidity and the securities are frequently traded on
the stock exchange. Apart from individual securities, derivative trading is also
allowed on Indices such as Nifty, IT Index and Bank Index. The list of securities
on which derivative trading is available is constantly increasing.
Derivative products available in securities markets in India: There are
futures as well as option contracts available on individual securities. Apart from
that one can also buy or sell options as well as futures on certain indices such as
Nifty, IT Index, Bank Index, Sensex etc.