DERIVATIVES

-Dr. Rana Singh

www.ranasingh.org

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Futures & Options

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Derivatives

Part-I
An Introduction

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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.

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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.

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Broad Categories of
Derivatives
 Forward Contracts
 Futures Contracts
 Options Contracts
 Swaps

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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

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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.

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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.
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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.
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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.

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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.
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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.

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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.
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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.

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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.

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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.
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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.

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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.
 If a call holder were to exercise his
right, the seller of the call would have
to make delivery of the asset.

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Options (Cont…)
 If the holder of a put were to exercise
his right, the seller of the put would
have to accept delivery.
 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.
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Options (Cont…)
 These are known as European Options.
 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.

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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.

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 Comparison of
Futures/Forwards versus
Options
Instrument Nature of Nature of
Long’s Short’s
Commitment Commitment
Forward/Future Obligation to Obligation to
s Contract buy sell
Call Options Right to buy Obligation to
sell
Put Options Right to sell Obligation to
buy
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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.

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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.

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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.
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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.

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Currency Swaps
 These are also known as cross-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.

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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.
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Actors in the Market
 There are three broad categories of
market participants:
 Hedgers
 Speculators
 Arbitrageurs

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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.
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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.

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Hedgers (Cont…)
 Price risk is the risk that the price of the
asset may move in an unfavourable
direction from their standpoint.
 What is adverse depends on whether they
are long or short in the spot market.
 For a long, falling prices represent a
negative movement.

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Hedgers (Cont…)
 For a short, rising prices represent an
undesirable movement.
 Both longs and shorts can use
derivatives to minimize, and under
certain conditions, even eliminate
Price Risk.
 This is the purpose of hedging.

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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.

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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.

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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.

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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.
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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.

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

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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.
 Among commodities, we have contracts
on agricultural commodities, livestock
and meat, food and fibre, metals,
lumber, and petroleum products.
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Food grains & Oil seeds
 Corn
 Oats
 Soybeans
 Wheat

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

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

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Metals
 Copper
 Silver
 Gold
 Platinum
 Palladium

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

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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

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

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

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

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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.
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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
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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.

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Equity Options Markets &
Trading Volumes in 2000
EXCHANGE Stock Options Index Options
Volume in Volume in
1,000s 1,000s
AMEX 205,716 1,998
CBOE 281,182 47,387
CBOT NT 200
CME NT 5089
ISE 7,716 NT
EUREX 89,238 44,200
OM 30,692 4,167
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Korea SE NT 193,829
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.
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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.

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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.
 Let us take the case of commodities first.
 There was a war in the Middle East in 1973.

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Commodities
 Subsequently, Arab nations began to
use crude oil prices as a policy
instrument.
 This lead to enormous volatility and
unpredictability in oil prices.
 The result was an enhanced volatility
in the prices of virtually all
commodities.
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Commodities (Cont…)
 The is because the transportation costs
of all commodities is directly correlated
with the price of crude oil.
 Since commodity prices became
volatile, instruments for risk
management became increasingly
popular.
 Consequently commodity derivatives
got a further impetus.
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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.
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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.

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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.

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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.
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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.

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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.

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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.
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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.

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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.
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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.

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

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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.
 Various steps were therefore taken in this
regard.
 A modern electronic exchange, the NSE was
set up in 1994.

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India (Cont…)
 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.
 The attention then shifted to derivatives, for it
was felt that that investors in India needed
access to risk management tools.

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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.

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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.
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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.

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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.

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India (Cont…)
 The SCRA was amended in December
1999 to include derivatives within the
ambit of securities.
 The Act made it clear that trading in
derivatives would be legal and valid
only if such contracts were to be traded
on a recognized stock exchange.
 Thus OTC derivatives were ruled out.

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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.
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India (Cont…)
 Thus futures on the S&P CNX Nifty and
the BSE-30 (Sensex) were introduced in
June 2000.
 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.
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 Turnover in Crores
Month Index Stock Index Stock Total
Futures Futures Options Options

Jun-00 35 - - - 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
2001-02 21482 51516 3766 25163 101925
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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.

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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.
84
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.
 How does the system ensure that prices
fully reflect all relevant information?

85
Why Derivatives? (Cont…)
 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.
 If the perception is that the asset is
undervalued, there will be pressure to
buy.
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Why Derivatives? (Cont…)
 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.
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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.
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Why Derivatives? (Cont…)
 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.
89
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.

90
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.
 Also derivative markets tend to be very liquid.

91
Why Derivatives? (Cont…)
 That is, 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.

92
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.
 At the same time spot and derivatives
prices are inextricably linked.

93
Why Derivatives? (Cont…)
 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.
 Finally derivatives facilitate speculation.
 And speculation is vital for the free
market system.

94
Thank You
 Questions / doubts /queries are most
welcome.

95