Derivatives And Financial Innovations

DER IV ATI VES A ND FIN ANC IA L INNO VATIONS SIP, 2009 Bangalore

INTRODUCTION TO DERIVATIVES Welcome to the Fascinating world of Derivatives!

THE TERM DERIVATIVE…. Indicates that the product/contract has no independent value, i.e. it derives its value from some underlying asset.  The underlying assets can be securities, commodities, bullion, currency, livestock and so forth 

DERIVATIVE CONTRACTS 

Are primarily of two kinds

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Contracts that are traded on the exchanges called Exchange-Traded Derivatives

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Contracts that are traded outside the exchanges called Over-the-counter derivatives

Derivative Contracts • World-wide large volume is traded in both exchange-traded and OTC derivative products. • India also trades in both exchange-traded and OTC derivative products on different asset classes

Derivative Contracts • Although, commodity derivatives (forwards, futures and options) have been in existence for a long time, derivatives on financial assets like securities, currencies etc. are relatively new phenomenon in global markets.

Derivative Contracts • Although, commodity derivatives (forwards, futures and options) have been in existence for a long time, derivatives on financial assets like securities, currencies etc. are relatively new phenomenon in global markets.

THE FIRST FINANCIAL DERIVATIVE The first derivative on financial asset was traded on currencies (currency futures) in the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME), U.S. in 1972  Since then, the growth of derivatives on financial assets has been unprecedented 

The First Financial Derivative • Beginning with currency futures in 1972, stock options in 1973 at Chicago Board Options Exchange (CBOE), U.S.A. • And Interest rate futures in 1975, the derivative market has come a long way • Swaps, which started in 1981-82, accounts today for a trillion dollar business opportunity at the international level.

DERIVATIVES IN INDIA An Overview

EQUITY DERIVATIVES 

India joined the league of exchange-traded equity derivatives in June 2000, when futures contracts were introduced at its two major exchanges name the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE)

Equity Derivatives • The BSE sensitive index, popularly known as the SENSEX (comprising 30 scrips), and S & P CNX NIFTY index (comprising 50 scrips), commenced trade in futures on June 9, 200 and June 12, 2000 respectively.

Equity Derivatives • Index options and individual stock options on 31 selected stocks were subsequently added to the derivative basket, in 2001. • November 2001 witnessed the introduction of single stock futures in the Indian market. • The list of stocks were selected, based on a pre-defined eligibility criterion linked to the market capitalization of stocks, floating stock, liquidity, etc.

Equity Derivatives • As on July 26, 2006, the NSE’s Futures and Options Segment (F & O Segment) trades futures and options on 118 stocks and the Derivatives segment of BSE trades in 77 stocks. • This differentiation in the number of stocks at the BSE and at the NSE is because the eligibility criterion for a stock to figure in the derivatives list is linked to various measures at the respective exchanges.

Equity Derivatives • It is important to note that most of the derivatives business is concentrated in the NSE which accounts for almost 100% of the equity derivatives business. • The growth of the equity derivatives business on Indian bourses has been an unprecedented one • A modest start of an average daily volume of Rs. 10 crores has developed into a business of approximately of Rs. 30,000 crores per day.

Equity Derivatives • Interestingly, over a period of time, there also has been a shift in the market share of various competing products (index futures, index options, single stock futures, and single stock options) available for trading. • Today the most preferred product on the exchanges is single stock futures, which account for around 55% of total volumes • NIFTY futures are the second most traded product with a business share of around 35% • Options account for approximately 10 % of the total business with 2/3rd in Index options and 1/3rd in single stock options.

Equity Derivatives • There seems to be lack of clarity among market participants about OTC about OTC products on equity. • Some market participants hold that OTC derivatives are illegal. • Others believe that they are not illegal but that they are not legally enforceable in the country as per the existing regulatory infrastructure. • In 2005-06 some market participants were in the process of seeking legal opinion as to whether OTC equity derivatives can be offered in the Indian Jurisdiction and if so how can it be done?

Commodity Derivatives • The Forward Contract Regulation Act (FCRA) governs the commodity derivatives in the country. • The FCRA specifically prohibits OTC commodity derivatives. • Accordingly we have only exchange-traded commodity derivatives. • Furthermore, FCRA does not even allow options on commodities. Therefore, at present, India trades only exchange traded commodity futures.

Commodity Derivatives • Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to the regional nature of the commodity exchanges. • Further all these offered only a single product. For example pepper exchange in Cochin trades only in pepper. Soya exchange in Indore trades only soya • In the last quarter of 2003 India began trading in commodity derivatives through Nation-wide online commodity exchanges – The National Commodities and Derivative Exchange (NCDEX) and the Multi Commodity Exchange (MCX)

Commodity Derivatives • Though commodity derivatives in the country have existed for a long time, trading has been regionally concentrated due to the regional nature of the commodity exchanges. • Further all these offered only a single product. For example pepper exchange in Cochin trades only in pepper. Soya exchange in Indore trades only soya • In the last quarter of 2003 India began trading in commodity derivatives through Nation-wide online commodity exchanges – The National Commodities and Derivative Exchange (NCDEX) and the Multi Commodity Exchange (MCX)

Commodity Derivatives • They started functioning with the introduction of futures contracts on various assets such as gold, silver, rubber, steel, mustard seed, etc. • Major banks and financial institutions in the country (SBI, ICICI, Canara Bank, NSE, LIC, etc.) have promoted both these exchanges. • Business on these exchanges has increased remarkably over a short period of time with monthly volumes of business reaching as high as Rs. 140000 crores in May 2006 for NCDEX while it went upto as high as RS. 200000 crores at MCX.

Commodity Derivatives • It is important to mention here that both exchanges are developing a niche for themselves • For instance, bullion and energy products contribute around 75-80 per cent of MCX business. • On the other hand the primary business for the NCDEX is agri-products, which contribute around 80% of the total volume of this exchange. • It is interesting to note that the growth in volumes of commodity derivatives has been achieved without institutional participation in the market.

Commodity Derivatives • At present, banks, financial institutions, mutual funds, pension funds, insurance companies and FIIs are not allowed to participate in the commodities market. • However the subject is under consideration by respective regulators. • Furthermore, both exchanges are now focusing their attention on addressing issues like collateral management, quality and quantity certification of commodities, settlement price, methodology etc.

Commodity Derivatives • Substantial progress these has been made on these issues by the exchanges. • For example, warehousing receipts have been made electronic with the help of depositories – National Securities Depositories Limited (NDSL) and Central Depository Services Limited (CDSL)

Commodity Derivatives • The commodity exchanges are also concentrating on the introduction of: • Options on various agricultural, energy, metal and bullion products, whenever this is permitted by the government. • Futures and options on various commodity indices • Introduction of exchange-traded funds (ETFs) linked to commodities. • Carbon credit derivatives (in association with Chicago Climate Exchange. • Weather Derivatives

Commodity Derivatives

Commodity Derivatives

Currency Derivatives • Indian has been trading forward contracts in currency, for the last several years. • The RBI has allowed options in the over-the-counter market. • The OTC currency market in the country is considerably large and well-developed. • However the business is concentrated with a limited number of market participants, mainly banks – both international and local as the corporates deal with these banks for derivative contracts on various currencies. • Some market participants are making a case for trading currency derivatives (futures and options) on the exchanges. • Generally speaking, business in currency derivatives is expected to grow in the near future.

Interest Rate Derivatives • The National Stock Exchange (NSE) introduced trading in cash settled interest rate futures in the year 2003. • However, due to some structural issues the product did not attract market participants. A new version of the product is till pending.

Other Derivatives • The Indian market participants have also shown some interest in credit and weather derivatives. • Slowly but surely, these products too are making strides in the Indian Financial markets. • Securitisation and exchange-traded funds(ETF) linked to currencies and bullion are being widely discussed.

Generic Derivative Products • The emergence of a market for derivative products can be traced to the requirement of risk-averse economic agents, to guard themselves against uncertainties arising out of fluctuations in asset prices. • It is possible to create certainty by partially or fully, transferring the price risk in assets from one entity to another through use use of

Generic Derivative Products • The emergence of a market for derivative products can be traced to the requirement of risk-averse economic agents, to guard themselves against uncertainties arising out of fluctuations in asset prices. • It is possible to create certainty by partially or fully, transferring the price risk in assets from one entity to another through use use of

Generic Derivative Products • As instruments of risk management, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situations of risk-averse market participants. • The factors which have driven the growth of financial derivatives in India

Generic Derivative Products • Increased volatility in asset prices in the financial markets • Increased integration of domestic financial markets with global markets • Development of more sophisticated risk management tools, which provide economic agents with a wider choice of risk management strategies.

Generic Derivative Products • Innovation in the derivative markets which optimally combine the risks and returns over large number of financial assets. This leads to higher returns and reduced risk, as well as low transaction costs when compared to individual financial assets. • A marked improvement in communication facilities with a sharp

Generic Derivative Products • Without getting into the complexities of Derivatives at this stage, it is important to understand the following three generic products/contracts in detail: 2.Forward Contract 3.Futures Contract 4.Option Contract

Forward Contract • A Forward Contract is one-to-one, bipartite/tripartite contract which is performed mutually by the contracting parties, in future, at the terms decided upon, on the contract date. • In other words, a forward contract is an agreement to buy or sell an asset at a specified future date for a specified price.

Forward Contract • One of the parties to the contract assumes a long position i.e. agrees to buy the underlying asset while other assumes a short position, i.e. agrees to sell the asset. • As this contract is traded off the exchange and settled mutually by the contracting parties, it is called the over-the-counter product.

Forward Contract – An Illustration • Assume there are two parties – Mr. A (buyer) and Mr. B (seller) – who enter into a contract to buy and sell 100 units of asset X at Rs. 350 per unit, at a predetermined time of two months from the date of contract • In this case, the product (asset X), the quantity (100 units), the product price (Rs. 350 per unit) and the time of delivery (2 months from the date of contract) have been determined and well understood, in advance, by both the contracting parties.

Forward Contract – An Illustration • Delivery and payment (settlement of transactions) will take place as per the terms of the contract on the designated place as per the terms of the contract on the designated date and place • This is a simple example of a Forward Contract. • Forward contracts are extensively used in India in the foreign exchange market

Forward Contract – An Illustration • Forward contracts are negotiated by the contracting parties on a one-to-one-basis and hence offer tremendous flexibility in terms of determining contract terms such as price, quantity, and quality (in case of commodities), delivery time and place. • The parties may freely decide upon all these terms, based on the circumstances and negotiation powers. They may also carry out subsequent alterations in the contract terms, by mutual consent.

Forward Contract – Drawbacks • Like other over-the-counter products, forward contracts offer tremendous flexibility to the contracting. • However as they are customized, they suffer from poor liquidity. • Furthermore, as these contracts are mutually settled and generally not guaranteed by any third party, the counter party risk/default risk/credit risk is considerable in such contracts need to be understood in detail.

Liquidity Risk • Liquidity is generally defined as the ability of a market to buy or sell the desired quantity of an asset, at any time. • Since forward contracts are traded one-to-one basis, they are tailor made contracts and cater to the specific needs of the contracting parties. • Therefore, others may not be interested in these contracts • Further as these contracts are not listed and traded on the exchanges, other market participants do not have easy access to the contracts or to the contracting parties.

Liquidity Risk • In other words, it is very difficult for the contracting parties to withdraw from a forward contract before the contract matures. Hence the liquidity is these contracts is poor. • Interestingly, in order to address the issue of poor illiquidity of forward contracts, contracting parties have started listing forward contracts on the exchanges in some international markets. • The display of products on the exchange creates visibility and accessibility of products to other market participants. • Thus an interested party may trade the product with the contracting parties.

Default Risk/Credit Risk/Counter Party Risk • Forward Contracts, as defined, are transacted on a one-toone basis. Each party is, therefore, exposed to the counter party’s credit risk i.e. risk of default. •

Market participants across the globe are trying to address the issue of counter party risk in forward contracts. One option chosen by market participants is the third party guarantee to these contracts.

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For instance having entered into a forward contract, the contracting parties may go to a third party who will immunise their positions, through a guarantee.

Default Risk/Credit Risk/Counter Party Risk • This third party – essentially a risk taker ( such as a clear corporation) – may collect some margin from both the parties and immunise them against the risk of default against each other •

Market participants across the globe are trying to address the issue of counter party risk in forward contracts. One option chosen by market participants is the third party guarantee to these contracts.

•

For instance having entered into a forward contract, the contracting parties may go to a third party who will immunise their positions, through a guarantee. The third party – essentially a risk taker (such as a clearing corporation) and may collect from both the parties and immunize them against the risk of default by each other.

Futures Contract

• Although forward contracts provide a great deal of flexibility to the contracting parties, they suffer from two important problems – illiquidity and counter party risk. • These two issues concerning forward contracts have offered the exchanges a tremendous business opportunity and the have started trading these forward contracts; but with a difference. • In order to make the contracts attractive to a large set of market participants, they have standardized these contracts. • To further generate liquidity in these contracts by engendering confidence among market participants, exchanges have persuaded their clearing corporations to guarantee these trades.

Futures Contract

• Trading of forward contracts on the exchanges was considered a means for addressing the issues in the forward contracts. • Further, in order to differentiate between the exchange-traded forward and the OTC forward, the market renamed the exchangetraded forwards as Futures Contracts. • Hence, futures contracts are essentially standardised forward contract, which are traded on the exchanges and settled through the clearing agency of the exchanges • The clearing agency also guarantees the settlement of these trades. In other words, futures contracts are standardised forward contracts or the futures market is simply the extension of the forward market.

Futures Contract

• As future contracts are organised/standardised, they cater to a wider range of market participants. • Further, their availability on the exchanges makes them accessible to market participants scattered throughout the country and perhaps the world. • Therefore, the liquidity problem, which persists in the forward market, does not exist in the futures market. • The clearing agency of the exchange becomes the counter party to all the trades or provides the unconditional guarantee for their settlement, i.e. assumes the financial integrity of the entire system. Hence, the market participants are not exposed to counter party risk.

Difference between Forward and Futures Contract • The contracting parties negotiate forward contracts, on a one-to-one basis. This offers tremendous flexibility in articulating in terms of the price, quantity, quality (in case of commodities), delivery time and place.

• Future contracts do not have this flexibility as such contracts have standard terms viz. quantity, quality (in case of commodities) , delivery time and place, which are decided by the exchanges.

Difference between Forward and Futures Contract • In the forward market, one party may be at an abundant disadvantage due to non-availability of information regarding the underlying factors. • A typical example of this may be the exploitation of poor farmers in remote areas as they do not have current information on their commodities. They generally sell their produce to the Zamindar at a price which is substantially lower than the expected cash price of the produce at the time of the availability in the market. • In the futures market, geographically segmented areas are integrated, as futures market provide a common platform to all market participants. • It consolidates all orders through a common consolidated book and reflects a better price, as price is the result of interaction of the collective wisdom of a large number of market participants.

Difference between Forward and Futures Contract • Therefore, in case of futures, every bit of price information is quickly reflected on the prices of assets. • This results in elimination of non-availability of information risk, which exists in the forward market.

Difference between Forward and Futures Contract •

Another problem in forward contracts is that of the final settlement, which becomes quite cumbersome if forward contracts are traded subsequently.

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To understand the concept, let us go back to the earlier example. Assume, that after 15 days, Mr. A (the buyer) enters into a fresh transaction to sell asset X to Mr. C on the same delivery date. Mr. B (the seller) is stranger to the transaction between Mr. A and Mr. C. On settlement, Mr. A will take delivery of asset from Mr. B and give it to Mr. C and then take the money from Mr. C to pay Mr. B

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Similarly, Mr. B may enter into a contract with another party, Mr. D which will be unknown to Mr. A

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Now, assume a situation when there are 4-5 subsequent deals during the life of the contract. Each of these subsequent deals will complicate the final settlement of the trade.

A

B

C

C Money Asset

Difference between Forward and Futures Contract •

In the futures markets, the clearing agency maintains the account of all participants on the exchange.

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Hence on the last trading day of the contract, it is in a position to declare which of the two entities are the counter parties to each other

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It thus provides solution to the settlement problem, which is very acute in the case of the forward market.

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Indeed at any point in time the clearing agency is in a position to indicate which participants have open positions, i.e. outstanding/unsettled long (buy) or short 9sell) positions

Difference between Forward and Futures Contract •

Operational risks generated through human error, fraud, systems failure, etc. exist in both forward and futures markets. These cannot be addressed in any way other than by training, competence building, proper monitoring and insurance .

DIFFERENCES BETWEEN FUTURES AND FORWARD CONTRACTS SUMMARISED Feature

Forward Contracts

Futures Contracts

Operational mechanism

Traded directly between contracting parties (not traded on the exchange)

Traded on the exchanges

Contract specifications

Differ from trade to trade

Contracts are standardised contracts

Counter Party risks

Exists but sometimes jettisoned to a guarantor

Liquidation profile

Low, as contracts tailormade contracts catering to the needs of the of the parties involved. Further, they are not easily accessible to other market participants.

Exists but assumed by the clearing agency, which becomes the counter party to all trades or unconditionally guarantees their settlement High, as contracts are standardized exchangetraded contracts

Differences Between Futures and Forward Contracts - summarised Feature

Forward Contracts

Futures Contracts

Price Discovery

Not efficient as markets are scattered

Quality of information and its dissemination

Quality of information may be poor. Speed of information dissemination is weak.

Examples

Currency market in India

Efficient, as markets are centralised and all buyers and sellers come to a common platform to discover the price through a common order book. As futures are traded on a nation-wide basis, every bit of decision related information gets disseminated very fast Exists but assumed by the clearing agency, which becomes the counter party to all trades or unconditionally guarantees their settlement

OPTION CONTRACTS In both forward and futures contracts, the contracting parties undertake an obligation to perform in accordance with the contract.  Thus, for the buyer of the contract, profit is generated in the price of the underlying asset goes up.  On the other hand, for the seller of the contract, the profit proposition requires a fall in the price of the underlying asset.  However, unfavourable movements in price of the underlying asset will create loss for the contracting parties 

Option Contracts •Let us now consider a situation. •Assume that Mr. X needs to honour an obligation of a million U.S. dollars after three months from a given date.

OPTION CONTRACTS 

His first choice may be to do nothing at present and buy the dollars after three months, at the time when the payment is due.

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The second option may be to buy the dollars right away and keep them in safe custody.

Option Contracts • Thirdly he can buy the dollars in the forward or futures markets for delivery in three months.

Option Contracts • If he buys 1 million dollars at Rs. 47 per dollar (prevailing forward market prices) in the forward market for three months. • He is, therefore, locked in to buy the dollars at the contracted price.

Option Contracts • This situation leads to another thought. Is it possible to design a contract, which offers Mr X an opportunity to buy the underlying asset only if he desires, with no compulsion whatsoever? • This essentially means that the contract needs to confer a right on Mr. X to buy the asset (US $ in this example) with no obligation, to ensure that he is free to decide on buying the underlying asset.

Option Contracts • A similar concept may be thought of on the sell side, wherein the seller may just need a right, rather than a obligation to sell the underlying asset. • As a whole, this contract must offer the position takers an opportunity to exercise the right (buy or sell the underlying asset) only if it is favourable to them, or else, they let it expire. • These contracts are called Options.

OPTION CONTRACTS 

As in any other contract, the market also needs the sellers of these rights

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But then why should someone sell these rights?

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The answer to the question is that this is done “in pursuit of money”.

Option Contracts • Fundamentally, the seller of these rights has an obligation under the contract and so will want compensation in monetary terms, from the buyer of the rights • As long as there is counter party who is prepared to pay the seller of the rights/option who is prepared to pay the seller of the rights/options, there will be market for options.

Option Contracts • Thus, one can say that an option is a right given by the option writer/seller to the option buyer/holder to buy or sell an underlying asset at a pre-determined price, within or at the end of a specified period. • The option buyer, who is also called long on option, long premium or holder of the option, has the right but no obligation.

Option Contracts • On the other hand, the option seller/writer, who is also called the short on option or short on premium, has an obligation but no right, with regard to buying or selling of the underlying asset. • The option buyer may or may not exercise the option given. However if he decides to exercise the option the option seller/writer is bound to honour the contract.

Option Contracts • Options can be categorised as Call and Put options. • An option which gives the buyer a right to buy the underlying asset, is called a Call Option and an option which gives the buyer a right to sell the underlying asset, is called a Put Option. • Further , an option, which is exercisable any time on or before the expiry date/day is called an American Option • An option which is exercisable only at expiry, is called an European Option.

OPTION CONTRACTS  The

price at which the option is exercisable is called the Strike price or Exercisable Price

 The

date/day on which the option expires is called the Expiration date/day.

 The

expiration date/day is the date on which the contract ceases to exist.

Option Contracts • The date/day on which the option is exercised is called the Exercise date/day of the option • The date/day on which the option expires is called the Expiration date/day. • It may be noted that the expiration date/day and the exercise date/day may differ in case of an American option but will be the same in case of an European Option, in the event that the option is exercised at all, by the option buyer.

Option Contracts • When the option writer gives a right to the option buyer he will charge for that right. The price that the option buyer pays to the option/right is called the Option premium. • The option premium is the inflow to the option he option writer irrespective of whether the option holder exercises his option or not.

Option Contracts – A simple example • Assume that Mr A goes shopping and likes a painting that costs Rs 15,000. As he does not have the money required to make the full down payment , he offers the shopkeeper Rs 2000, with a proposal to take delivery within 2 days, on the payment of balance amount. • Further, assume that the shopkeeper makes it clear that if painting was not bought within 2 days the contract will expire. This is a typical example of a forward contract.

Option Contracts – A simple example • As the shopkeeper is not confident about the counter party, he takes some money in advance and this is treated as collateral or a good faith deposit. • It is also clear that if Mr A does not return in 2 days, the shopkeeper will have the right to sell the painting to someone else but would refund advance payment made by Mr A.

Option Contracts – A simple example • Another way to structure the deal is for Mr A to offer the shopkeeper Rs 200 and reserve the painting for two days. • If Mr A does wishes, he may pay the full price and purchase the painting during these two days. Otherwise, he will lose the right to buy it. • In this case Mr. A is the option buyer and the shopkeeper is the option seller.

CONTRACT OPTIONS  As

an option buyer, Mr. A has a right to buy painting but no obligation.

 If

he finds another shop selling the same painting at a price lower than Rs 15,000, he has the option to ignore the first shop and buy the painting from the second shop.

 In

other words, Mr A may let his right expire if he finds it unattractive to exercise his option.

Contract Options • It must be understood however, that even if Mr A does not exercise his right, the Rs 200. which he paid as the price for reserving the painting for 2 days will not be refunded. • This money, viz. Rs 200 may be called the cost of the right or price of option. • There is no difference in nomenclature for options traded in OTC markets and exchange traded markets.

SUMMARY 

The term Derivative indicates that the product/contract has no independent value, i.e. its value from some underlying asset. This may be securities, commodities, bullion, currency, livestock and so forth.



Products/contracts are traded on the exchanges that are called exchange-traded derivatives. Products/contracts traded outside the exchanges are called over-thecounter products/contracts. The generic term used for the market outside the exchanges is

Summary • Although, commodity derivatives (forward, futures and options) have been exercise for long, derivatives on financial assets such as securities, currencies etc. is a relatively new phenomenon in global markets.

• In June 2000, India’s two major stock exchanges – the BSE and the NSE introduced futures contracts on BSE SENSEX (comprising 30 scrips) and S & P CNX Nifty index (comprising 50 scrips) respectively.

Summary • India added index options and individual stock options to the derivatives basket, in 2001. November 2001 witnessed the introduction of single stock futures in the Indian market. The growth in the equity derivatives business on Indian bourses has been an unprecedented one. • India started trading commodity derivatives through two major nation-wide commodity exchanges – National Commodities and Derivatives Exchange (NCDEX) and Multi Commodity Exchange (MCX) on various assets such as gold, silver, rubber, steel, mustard seed etc. in the last quarter of 2003. • In July 2006, the combined average daily volume on these two exchanges was around Rs 15,000 crores.

Summary • There are only three generic derivative products/contracts – forward, futures and option contracts. • A forward contract is a one-to-one bipartite/tripartite contract, which is performed mutually by contracting parties, in the future, at the terms decided on the contract date. • In other words, a forward contract is an agreement to buy or sell an asset on a specified future date at a specified price. One of the parties to the contract assumes a long position i.e. agree to buy the underlying asset and the other party assumes a short position, i.e. agrees to sell the asset. A forward contract is an OTC product.

Summary • Forward contracts, despite having a great deal of flexibility in terms of structuring the contracts to customised needs of individual players needs of individual players, suffer from two main risks – illiquidity (lack of sufficient volumes for trading) and counter party or credit/default risk. • Futures came into existence in order to address the issues of illiquidity and counter party risk in forward contracts. Basically, futures contracts are standardised forward contracts traded on exchanges. The clearing agency also guarantees the settlement of these trades. • In both forward and futures contracts, the contracting parties undertake an obligation to perform the contract.

Summary • So, for the buyer of the contract, profit is generated if the price of the underlying asset goes up and for the seller of the contract, the profit proposition requires a fall in the price of the underlying asset. • However, unfavourable movements in the price of the underlying asset will create losses for the contracting parties. • An option is a right given by the option writer/seller to the option buyer/holder to buy or sell an underlying asset at a predetermined price within or at the end of the specified period. • Therefore, an option is a contract that offers the buyers an opportunity to exercise the right (buy or sell the underlying) only if it is favourable to them. Otherwise, they may let the right expire.

Summary • Options can be categorised as call and put options. An option, which gives the buyer a right to buy the underlying asset, which gives the buyer a right to sell the underlying asset, is called a put option. • Further, an option, which is exercisable at any time on or before the expiry date/day, is called an American option and the option, which is exercisable only on its expiry, is called a European option. • The price at which the option is exercisable is called the strike price or exercise price. The date/day on which the option expires is called the expiration date/day. The date/day on which the option is exercised is called the exercise date/day of the option.