Rajesh B. Yadav

RAJESH B. YADAV June 14, 2009

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CAPITAL MARKETS

Cash Segment

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Derivatives

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Bradman of Capital Markets Warren Buffet “I do not deal much into Derivatives as I do not quite understand them”

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Titanic = Derivatives Over Confidence, Entertainment, etc

•Sell the Taj Mahal •Also the neighbor’s House June 14, 2009

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1. Disaster is not immediately visible 2. Salesman said it was unsinkable, yet it was under water on day 1 3. Structure seemed strong enough, but collapsed the moment it hit trouble 4. Not too many people bother about the risk of the transaction 5. Its destiny that not many people are able to be saved June 14, 2009

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6. Disaster happens when you sleep over it and do nothing about it 7. Living there itself is a risk and that is what is the most important 8. Too much time & money is spent to salvage something highly insignificant 9. The only people who made money with the transactions were the people who were no way connected with the original transaction. 10. Still people venture and will continue… ….. June 14, 2009

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Derivatives is a boon for CA’s because Indian mind is a speculative mind ex. Yudhishtira Derivatives are not a tool of speculation. It is a hedging tool June 14, 2009

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Brief History of Derivatives *Omnipresent since 16th & 17th Century *Tulip futures in the 17th Century *Financial Concept – 1970’s *Became immensely popular – 1990’s Introduced in June, July 2000 on Indian Stock Exchanges June 14, 2009

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DEVELOPMENT *Initial turnover 5, 10, 25,50 Crores *Today about 40000 crores *Double of Cash Segment *Expectation to be 6 times

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Derivatives by their nature are not tough. It is easy to understand. Problems are deep within with issues in accounting, Taxation & Valuation June 14, 2009

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Derivatives is a ZERO Sum Game. If somebody makes a loss, other has to make a loss. This is not the case of cash segment.

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Reasons for success of Derivatives 1. 2. 3. 4. 5. 6. 7. June 14, 2009

Increased Volatility Integration of financial markets Standardization & High Volumes Good Communication Facilities Better Risk management Tools Innovations & higher returns Reduced Transaction costs Rajesh

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Usage of Derivatives 1. 2. 3. 4. 5.

Discovery of Current & Future Prices Helps Transfer risk from one to other Hence, higher volumes Participation of more people Shift of Speculators into a more organized sector and this facilitates Control over them (Contd. ..)

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Usage of Derivatives 6. Attracts new Talent – a Global feature 7. New business opportunities 8. Increase savings 9. Boost Investment 9. Helps maintain Balance.

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Derivatives in India 1. 2. 3. 4. 5. 6.

Nov 96: SEBI set up L.C.Gupta committee Mar 98: Committee submits Framework J.R. Verma comm. Gives report Withdrawal of Prohibition of Options May 00: SEBI Gives approval Finally trading started on Bombay Stock Exchange & National Stock Exchange

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DEFINITION The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a. security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; b. a contract which derives its value from the prices, or index of prices, of underlying securities;

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Features of Derivatives ♦ No value of its own ♦ Depends on the value of the

Underlying ♦ It is in the nature of a Contract ♦ Not covered by the Contract Act. ♦ It is covered by Securities Contracts (Regulations) Act June 14, 2009

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RISKS Systematic Risk

Non Systematic Risks

Risks that affect the economy, market and the world at large.

It is also called unique risk It is a scrip and company specific risk

It can be hedged by the selling Index futures.

Best way to hedge is to diversify portfolio.

Example of index future June 14, 2009

Example of diversified portfolio Rajesh

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Speculators

Arbitrageurs

Hedgers

VARIOUS MARKET PARTICIPANTS June 14, 2009

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SPECULATORS They are willing to take bets on the future Trade on a daily basis Appetite for high risk Help create volumes Target high profits and face risk. June 14, 2009

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HEDGERS Want to transfer risk to speculators Aim to make profits @ minimum risk Do not mind to settle with small gains Are willing to protect themselves at an extra cost also Hedgers want to transfer the risks and the speculators want to take the risks June 14, 2009

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ARBITRAGEURS Lend reliability to prices in the market Ensures consistency Assist in price discovery Correct the abnormalities in the market mechanism Back themselves with huge volumes and funding June 14, 2009

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Various Types of Derivatives

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Forward is a contract between two parties which deal directly with each other on the basis of a price of the underlying that is decided today, the quantity and quality is also decided today for the settlement to be taken at a future date that will be by and large mentioned on the contract and on signing of which neither of the parties will be required to pay any difference or margin money to the other. June 14, 2009 Rajesh 25

Issues under Forwards Why are these considered Derivatives (Because they depend upon the value of underlying)

Example of Forward Technical Definition Risk Element in Forward contracts June 14, 2009

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Analysis of Definition 1. 2. 3. 4.

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Two parties to the contract Price, Quantity & Quality is determined at the time of entering into the contract Contract is settled at a future date There are no margins paid by one party to the another Rajesh

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Counter party risk of non fulfillment of contract

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Lack of transparency DISADVANTAGES on the part of Institutions

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Standard & Traded on Stock Exchange

Attach a right

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Features of Futures Contract between two parties Transparency Stock Exchange as a legal counter party Secured by Stock Exchange to all parties Quality & Quantity is decided today Settlement at a prescribed date Both parties are supposed to pay margins June 14, 2009

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What makes an ideal futures mkt Standardisation (Availability of Contracts, pricing, lot size, periods, etc)

Fungibility (Electronic mode & Demat)

Volumes (Large number of buyers & sellers)

Volatility (Wave of uncertainty, movement)

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There is a circular from the SEBI that the minimum contract size at the time of introducing the contract should not be less than Rs. 200,000. Concept of Lot size It is the number of shares being traded per single unit of Future and it is always in lots of 100. Example June 14, 2009

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There are three series: 1. Near Month 2. Next Month 3. Far Month June 14, 2009

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KEY TERMINILOGIES USED IN FUTURES CONTRACT June 14, 2009

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Spot price Futures price Expiry date Contract size

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Margin Money Marking to market Maintenance Margin

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• Long Position: It means making a buy transaction in the market. It is said that I have taken a Long position in the market when I have bought Futures Contract.   • Short Position: It means making a sell transaction in the market. It is said that I have taken a Long position in the market when I have sold Futures Contract. June 14, 2009

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Squaring up of a Futures Contract Bid Ask Bid Ask Spread or Impact Cost June 14, 2009

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Cash Settlement v/s Delivery based Settlement June 14, 2009

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FUTURES

V/S.

FORWARDS

Traded on Stock Exchange Traded on OTC basis. in an organised & Not at all transparent sophisticated manner.More Manipulations are Transparent. possible by dealers Standardised, Easy to deal Customised Solutions Not possible to customise possible Greater liquidity & daily Less Liquiduity, difficult settlement system to get out of contract Simple entry and exit. June 14, 2009

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Various Terminologies used in Options Trading Call Options Teji

Put Options Mandi

Index Options Stock Options June 14, 2009

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American Options European Options Buyer of Options Writer of Option Option Premium June 14, 2009

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Expiration Date In the Money (Spot price > Strike price )

Out of the money (Spot price < Strike Price)

At the Money (Spot Price = Strike Price)

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Option Strikes 2 In the Money 1 At the money 2 Out of the Money Total = 5 * 2 * (Call,put) * 3 cycles June 14, 2009

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Buying Options is like buying insurance by paying a premium Selling Insurance is like Selling insurance against premium One can keep on earning a premium Options have a non linear pay off June 14, 2009

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Options are denoted as under “DATE – EXPIRY MONTH – CALL / PUT – AMERICAN /EUROPEAN – STRIKE. For example: the European style call option on the Nifty index with a strike price of 1500, expiring on the 28th June 2004 is specified as “28 JUN 2004 CE”. June 14, 2009

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In the normal course of business, options have a short life, however there are certain options that have a longer life as high as one year and these are known as

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Options that have a still longer maturity period of as high as 3 years are known as Long term Equity Anticipation Series. In short they are known as

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These are options on portfolios of underlying assets. The underlying assets are usually a moving average of a basket of assets. Equity index options assets are a form of basket options. June 14, 2009

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These are private over the counter contracts to future cash flows in accordance with the following formula.

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SWAPS + OPTIONS

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