Derivatives Operations In National Stock Exchange

Derivatives Operations in National Stock Exchange Submitted to Prof. K.M. Bhattacharya

What is a Derivative? Derivative is a product whose value is derived from the value of the underlying asset. Underlying asset can be equity, forex, commodity, or any other asset say an agreement with your neighbour for 2 bags of sugar next week. Financial transaction whose value depends on the underlying value of the reference asset concerned. A contract that specifies the rights and obligations between two parties to receive or deliver future cash flows (or exchange of other securities or assets) based on some future event.

Derivatives – Perception & Reality Perception • Derivatives are risky and short term • Peripheral to genuine investment • Funds and investors who use them have something to hide (unregulated, offshore and complicated) Reality • Derivatives are flexible, efficient and open up new investment opportunities • The extraordinary growth of derivatives markets tells its own story • Mainstream funds wish to increase their derivatives usage to meet their investment objectives. Domicile of new funds determined principally by regulatory and tax environment

The Derivatives Revolution – The Big Questions Why are they so important to investors?

The Derivatives Revolution: The Big Numbers (US$ trillion)

Derivative Concepts • Forwards - A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price • Futures - A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures are refined forward contracts .Main differences: •Future contracts are standard in terms of quality, quantity and delivery •Future are traded on organized exchanges whereas Forwards are traded on Over the counter

Basic terminology

Call-option to buy an asset put-option to sell an asset Exercise price-price at which option holder can buy or sell maturity date-date when the option expires or matures Exchange traded option-options traded on exchange Over the counter options –options not traded on exchange

Options :

tools which provides owner the right to sell or buy an underlying asset on a pre-

agreed Price within a certain period

CALL :Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. PUT :Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date. • Warrants. Longer -dated options are called warrants and are generally traded over-the-counter (OTC)

•

Baskets : Basket options are options on portfolios

of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options.

• Swaps

are private agreements between two parties to exchange cash flows in the future – Agreement on formula to be used for exchange of cash-flows is determined in advance • Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Swaption is nothing but an option on a forward swap. – Receiver Swaption is an option to receive fixed and pay floating. – Payer Swaption is an option to pay fixed and receive floating.

• Options Options are of two types: – Calls & Puts Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right but not the obligation to sell a given quantity of the underlying asset, at a given price on or before a given future date. • Warrants. Longer -dated options are called warrants and are generally traded over-the-counter (OTC) • LEAPS Long-Term Equity Anticipation Securities. These are options having a maturity of up to three years. • Baskets Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. • Swaps are private agreements between two parties to exchange cash flows in the future – Agreement on formula to be used for exchange of cash-flows is determined in advance • Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Swaption is nothing but an option on a forward swap. – Receiver Swaption is an option to receive fixed and pay floating. – Payer Swaption is an option to pay fixed and receive floating.

Economic functions of Derivative market • Derivatives help in discovery of future as well as current prices. • The derivatives market helps to transfer risks from those who have them but may not like them in comparison to those who have an appetite for them. • Speculative trades shift to a more controlled environment of derivatives market. • Act as a catalyst for new entrepreneurial activity.

Uses of Derivatives • Hedging • Speculating • Arbitrage • Accessing remote markets • Distribution of risk as securities i.e. “Securitisations” 1. Hedging • Done by parties who seek to offset their existing risks by entering into a derivatives transaction. • Existing risks could be an investment portfolio, price changes in oil for a petroleum mining company or perhaps investments in a foreign country. 2. Speculating • Speculation is more commonly used by hedge funds or traders who aim to generate profits with only a marginal Investment 3. Arbitrage • Arbitragers work at making profits by taking advantage of discrepancy between prices of the same product across different markets. • Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets

Are Derivatives Dangerous? -"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." - Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the derivatives market. -Are derivatives dangerous? -That's almost like asking if water is dangerous. -Derivatives can be dangerous if used incorrectly - as several large companies and individuals have found out in recent history. •Derivatives contribute to the 'completeness' of the global markets, and without them, loopholes within the financial industry would exist. • Even through numerous financial disasters ala Barings, LTCM, Enron and others related to the mismanagement of derivatives • It is key to consider that it has not been the use of derivatives as a tool which has led to the downfall of these companies - but rather, the misuse and compromise of such instruments.

Growth Driving Factors • Increased volatility in asset prices in Financial Markets • Increased integration between International Markets • Exponential improvement in communication at exceptionally reduced costs • Development of more sophisticated Risk Management tools, providing economic agents a wider choice of Risk Management strategies • Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions cost as compared to individual financial assets

Participants in Derivatives Market Hedgers Speculators Arbitrageurs

OTC Derivatives OTC Derivatives Characteristics of OTC Derivatives market: – The management of counter-party (credit) risk is located within individual institutions. No formal limit on individual positions, leverage, or margining. – No formal rules of risk and burden sharing – No formal rules for ensuring market stability and integrity – Lack of regulator, although they are affected indirectly by national legal systems, banking supervision and market surveillance.

Exchange Traded Derivatives Market • Individuals trade standardized contracts that have been defined by the exchange. (First Futures contract were traded in 1865 in CBOT) (www.cbot) NSE’s derivatives market Commencement of derivative trading with S & P CNX Nifty Index futures on 12/06/2000. Trading in index options commenced on 04/06/2001. Single Stock trading in options started on 02/07/2001 Single Stock trading in futures started on 09/11/2001.

NSE’s Derivatives Market 2 tier Membership Structure

Trading Mechanism NEAT F&O Features Fully Automated Screen Based F&O Trading Anonymous order driven Market Transparency in Operations Operates on Price – Time priority

NEAT Corporate Hierarchy

Corporate Manager Branch Manager Dealer

Futures Terminology

Spot Price Futures Price Contract Cycle Expiry Date Contract Size Basis Cost of Carry Initial Margin MTM Maintenance Margin

Options Terminology Index Options Stock Options Buyer of an option Writer of an option Call Option Put Option Option Price / Premium Expiration Date Strike price American Option European Option In the money Option At the money Option Out of the money Option Time Value of an option

Payoff Model Long Futures Short Futures Long Call Short Call Long Put

Derivative Greeks Delta - measure of how option value changes with changes in underlying asset e.g. share price Theta - measure of change in option value with change in time to maturity Vega - change in option value with change volatility of underlying asset Rho - change in option with respect to interest rates (in the case of a share option where delta relates to stock) Gamma - Delta is not static. Gamma is a measure of how the delta itself changes with changes in

Types of Orders Time Conditions •Day Orders •Immediate or Cancel (IOC) Price Conditions •Stop Loss Other Conditions •Market Price •Trigger Price •Limit Price •Pro •Cli

Contract Details Present Month Next Month Far Month

Criteria for Stock qualifying for Derivative segment Trading Top 500 stocks in terms of Average Daily market capitalisation and Average daily Traded value in previous 6 month on rolling basis Quarter Sigma order size over the last six months should not be less than Rs. 1 Lakh Market wide position limit in stock should not be less than Rs. 50 crore Disqualification Failure to meet the above criteria for 3 consecutive months

Criteria for Index qualifying for Derivative segment Trading 80% of the stocks contributing to the index are eligible for derivative trading No single ineligible stock in the index should have a weight age of more than 5% in the Index Disqualification Failure to meet the above criteria for 3 consecutive months

Clearing and Settlement

Clearing Members SCM TM – CM PCM

NSCCL Functions Clearing Settlement Risk Management

Clearing Mechanism Tables – 6.1, 6.2 & 6.5

Settlement of futures Contract MTM – Table 6.6 Settlement for Futures

Settlement for Options Daily Premium Settlement Exercise Settlement Interim Exercise Settlement Interim Exercise Settlement Exercise Process Assignment Process Exercise Settlement Computation

Special Facilities for Settlement of the institutional Deals

Adjustments for Corporate actions Strike Price Position Market lot / Multiplier

Risk Management Financial Soundness of the members Specific Initial Margin Requirements for all Open Positions Upfront Initial Margin for all the open positions MTM Based contract Settlement MTM Settled in Cash on T+1 Predefined limits Settlement Guarantee Funds PRISM SPAN

Factors Affecting SPAN Underlying Strike Price Volatility Expiry Interest Rate

Types of Margins Initial Margin Premium Margin Assignment Margin Client Margin

Overall Portfolio Margin Requirements

Derivative Trading Regulations

For Exchanges to Start Derivatives Trading L.C. Gupta Committee SEBI Approval Minimum 50 Members All member should fulfill eligibility conditions SEBI Approved Clearing house Brokers / Dealers and Clearing Members have to be registered with SEBI Minimum Net worth for clearing Members is Rs.300 lakhs Minimum contract values is Rs.2 lakh Strict Know your client norms Derivatives trading to be done by certified professional

Eligibility Criteria for F&O membership Table – 7.1 & 7.2

Position Limit Trading Member Position Limit Client level Position Limit Market wide Position Limit FII and Sub Account Position Limit Mutual Funds Position Limit

Reporting of Client Margins

Accounting for Futures

At the inception of the contract At the time of Daily Settlement Open Positions Final Settlement Default Accounting Disclosure Requirements

Accounting for Options

At the inception of the contract At the time of Payment or Receipt of Margin Open Positions as on balance sheet dates Final Settlement Squaring off Options contract

Taxation of Profit / Loss on Derivative transactions STT on Derivative transactions

Regulatory Framework Securities Contract (Regulation) Act, 1956 Securities Contract (Regulation) Act, 1957 Securities and Exchange Board of India Act, 1992 The Indian Contract Act, 1872

8 Index Derivatives on NSE

233 Stock Derivatives on NSE

The Derivatives Revolution - The Big “Must Knows” Tomorrow (future) versus today (present) “I look to the future because that’s where I’m going to spend the rest of my life” - George Burns Ownership versus exposure