Derivatives

1. DERIVATIVES
Finance for Non-Finance Managers
-Dr. Rana Singh
www.ranasingh.org
1

2. Corporate Training and
Consulting
2

3. Futures & Options
3

4. Derivatives
Part-I
An Introduction
4

5. 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.
5

6. 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.
6

7. Broad Categories of Derivatives
 Forward Contracts
 Futures Contracts
 Options Contracts
 Swaps
7

8. 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
8

9. 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.
9

10. 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.
10

11. 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. 11

12. 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.
12

13. 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.
13

14. 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.
14

15. 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.
15

16. 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.
16

17. 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.
17

18. 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.
18

19. 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.
19

20. 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.
20

21. 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.
21

22. 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.
22

23. 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.
23

24. Comparison of Futures/Forwards
versus Options
Instrument Nature of Nature of
Long’s Short’s
Commitment Commitment
Forward/Futures Obligation to Obligation to
Contract buy sell
Call Options Right to buy Obligation to sell
Put Options Right to sell Obligation to
buy
24

25. 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.
25

26. 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. 26

27. 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.
27

28. 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.
28

29. 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. 29

30. 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.
30

31. Actors in the Market
 There are three broad categories of market
participants:
 Hedgers
 Speculators
 Arbitrageurs
31

32. 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.
32

33. 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.
33

34. 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.
34

35. 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.
35

36. 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.
36

37. 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.
37

38. 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.
38

39. 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.
39

40. 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.
40

41. 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.
41

42. 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.
42

43. 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.
43

44. Food grains & Oil seeds
 Corn
 Oats
 Soybeans
 Wheat
44

45. Livestock & Meat
 Hogs
 Feeder Cattle
 Live Cattle
 Pork Bellies
45

46. Food & Fibre
 Cocoa
 Coffee
 Cotton
 Sugar
 Rice
 Frozen Orange Juice Concentrate
46

47. Metals
 Copper
 Silver
 Gold
 Platinum
 Palladium
47

48. Petroleum & Energy Products
 Crude Oil
 Heating Oil
 Gasoline
 Propane
 Electricity
48

49. 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
49

50. Foreign Currency Futures
 Australian Dollars
 Canadian Dollars
 British Pounds
 Japanese Yen
 Euro
50

51. Major Stock Index Futures
 The DJIA
 S&P 500
 Nikkei
 NASDAQ-100
51

52. Interest Rate Futures
 T-bill Futures
 T-note Futures
 T-bond Futures
 Eurodollar Futures
 Federal Funds Futures
 Mexican T-bill (CETES) Futures
52

53. 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.
53

54. 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
54

55. 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.
55

56. 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
56
Korea SE NT 193,829

57. 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.
57

58. 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.
58

59. 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.
59

60. 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.
60

61. 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.
61

62. 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.
62

63. 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.
63

64. 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.
64

65. 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.
65

66. 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.
66

67. 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.
67

68. 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.
68

69. 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.
69

70. 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.
70

71. 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.
71

72. Brokerage Rates
Brokerage Commission Commissions
Type on Stock on Futures
Options
Deep-discount $1 per contract; $7 per contract
minimum $15
per trade
Discount $29 + 1.6% of $20 per contract
principal
Full Service $50-$100 per $80-$125 per
trade contract 72

73. 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.
73

74. 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.
74

75. 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.
75

76. 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.
76

77. 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.
77

78. 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. 78

79. 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.
79

80. 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.
80

81. 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.
81

82. 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.
82

83. 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
83

84. 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.
84

85. 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.
85

86. 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?
86

87. 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.
87

88. 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.
88

89. 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.
89

90. 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.
90

91. 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.
91

92. 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. 92

93. 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.
93

94. 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.
94

95. 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.
95

96. Thank You
 Questions / doubts /queries are most
welcome.
96