History of derivatives
Derivatives trading began in 1865 when the Chicago Board of Trade (CBOT) listed the first "exchange traded" derivatives contract in the USA. These contracts were called "futures contracts". In 1919,the Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME).
The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on the Standard & Poor's 500 Index, traded on the CME. In April 1973, the Chicago Board of Options Exchange was set up specifically for the purpose of trading in options. The market for options developed so rapidly that by early 80s the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange. And there has been no looking back ever since.
Derivatives in India
The Securities and Exchange Board of India (SEBI) allowed trading in equities-based derivatives on stock exchanges in June 2000. Accordingly the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) introduced trading in futures on June 9, 2000 and June 12, 2000 respectively. Currently futures and options turnover on the NSE is Rs7,0008,000 crore approximately. In India stock index options were introduced from July 2, 2001.
Derivatives in India: chronology
December 14, 1995 November 18, 1996 May 11, 1998 July 7, 1999 May 24, 2000 May 25, 2000 June 9, 2000 June 12, 2000 September 25, 2000 The NSE sought Sebi's permission to trade index futures. The LC Gupta Committee set up to draft a policy framework for index futures. The LC Gupta Committee submitted a report on the policy framework for index futures. Reserve Bank of India gave permission for OTC forward rate agreements and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. Sebi allowed the NSE and the BSE to trade in index futures. Trading of the BSE Sensex futures commenced on the BSE. Trading of Nifty futures commenced on the NSE. Nifty futures trading commenced on the SGX.
What are derivatives?
Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (simply known as underlying). These contracts are legally binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future. The asset can be a share, index, interest rate, bond, rupee/dollar exchange rate, sugar, crude oil, soyabean , cotton, coffee etc.
How are derivatives useful?
Leveraged positions Lower margins than the margin funding Index trading--market directional trading Hedging of portfolio Through index, covered calls, options buying Structured products for higher yields Allows to take position in any market condition--bullish, bearish, volatile or neutral.
What are forward contracts ?
A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today.
What are futures ?
Futures are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be a share, index, interest, bond, rupee-dollar exchange rate, sugar, crude oil, soya bean, cotton, coffee etc.
Terms in futures
Quantity of the underlying assets Unit of price quotation (not the price) Expiration dates Minimum fluctuation in price (tick size) Settlement cycles
Example : when you are dealing in March 2004 Satyam futures contract the market lot, i.e. the minimum quantity that you can buy or sell, is 1,200 shares of Satyam; the contract would expire on March 28, 2004; the price is quoted per share; the tick size is 5 paise per share or (1,200 * 0.05) = Rs60 per contract/market lot; the contract would be settled in cash; and the closing price in the cash market on the expiry day would be the settlement price. Features Leveraged positions--only margin required Trading in either direction--short/long Index trading Hedging/Arbitrage opportunity
Advantages of futures over cash trading
In futures the investor can short sell/buy without having the stock and carry the position for a long time, which is not possible in the cash segment. An investor can buy and sell index components instead of individual securities when he has a general idea of the direction in which the market may move in the next few months. The investor is required to pay a small fraction of the value of the total contract as margin. This means trading in stock index futures is a leveraged activity since the investor is able to control the total value of the contract with a relatively small amount of margin. Example: suppose the investor expects a Rs100 stock to go up by Rs10. One option is to buy the stock in the cash segment by paying Rs100. He will then make Rs10 on an investment of Rs100, giving about 10% returns. Alternatively he can take futures position in the stock by paying Rs30 towards initial and mark-to-market margin. Here he makes Rs10 on an investment of Rs30, i.e about 33% returns. In the case of individual stocks, the positions, which remain outstanding on the expiration date will have to be settled by physical delivery, which is not the case in futures. Regulatory complexity is likely to be less in the case of stock index futures compared to the other kinds of equity derivatives, such as stock index options, individual stock options etc.
What are options ?
Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under obligation to perform the contract (buy or sell). The underlying asset can be a share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soya bean, cotton, coffee etc. Example: suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd (HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000 shares of HLL at Rs250 per share on or before March 28, 2004. The seller of this call option who has given you the right to buy from him is under the obligation to sell 2,000 shares of HLL at Rs250 per share on or before March 28, 2004 whenever asked. There are two types of options: Call options and Put options Features Limited risk, unlimited profit-call options Higher returns, higher risk-put options Positions in all market conditions/views
What are call options?
The option that gives the buyer the right to buy is called a call option. Example: suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd (HLL) at a strike price of Rs250 per share. This option gives you the right to buy 2,000 shares of HLL at Rs250 per share on or before March 28, 2004. The seller of this call option who has given you the right to buy from him is under the obligation to sell 2,000 shares of HLL at Rs250 per share on or before March 28, 2004 whenever asked.
What are put options?
The option that gives the buyer the right to sell is called a put option Example: suppose you bought a put option of 2,000 shares of HLL at a strike price of Rs250 per share. This option gives its buyer the right to sell 2,000 shares of HLL at Rs250 per share on or before March 28, 2004. The seller of this put option who has given you the right to sell to him is under obligation to buy 2,000 shares of HLL at Rs250 per share on or before March 28, 2004 whenever asked.
What is a strike price?
The price at which you have the right to buy or sell is called the strike price.
What are American style options?
Option contracts ,which can be exercised on or before their expiry are called American options. All stock option contracts are American in style.
What are European style options?
The options on the Nifty and Sensex are European style options--meaning that the buyer of these options can exercise his options only on the expiry day. He cannot exercise them before the expiry of the contracts as in case with options on stocks. As such the buyer of index options needs to square up his positions to get out of the market. In India all stock options are American style options and index options are European style options.
What is the difference between futures and options?
Futures Obligation Options Both the buyer and the seller are The buyer of the option has the right and under obligation to fulfill the not the obligation whereas the seller is contract. under obligation to fulfill the contract. The seller is subject to unlimited risk of The buyer and seller are subject losing whereas the buyer has a limited to unlimited risk of losing. potential to lose. The seller has limited potential to gain The buyer and seller have while the buyer has unlimited potential to unlimited potential to gain. gain. It is unidimensional as its price It is bi-dimensional as its price depends depends on the price of the upon both the price and the volatility of the underlying only. underlying.
Profit Price Behavior
Who are the participants in the derivatives market?
The participants in the derivatives market are broadly classified into three groups: Hedgers Speculators Arbitrageurs Hedgers have a position in the underlying asset or are interested in buying the asset in the future. For example, a hedger could be an investor who has got funds to invest in stocks. Hedgers participate in the derivatives market to lock the prices at which they will be able to do the transaction in the future. Thus they are trying to avoid the price risk. Speculators participate in the futures market to take up the price risk, which is avoided by the hedgers. Arbitrageurs watch the spot and futures markets and whenever they spot a mismatch in the prices of the two markets they enter to get the extra profit in a risk-free transaction.