DERIVATIVES MARKET Derivatives are most modern financial instruments in hedging risk.
The individuals and firms who wish to avoid or reduce risk can deal with the others who are willing to accept the risk for a price.
A common place where such transactions take place is called Derivative Market. Derivatives are those assets whose value is determined from the value of some underlying assets. The underlying asset may be equity, commodity or currency. Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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A derivative is a financial instrument which derives its value from some other financial price. This “other financial price” is called the underlying.
A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the “derivative” and wheat on the spot market is “the underlying”. The terms “derivative contract”, “derivative product”, or “derivative” are used interchangeably. The most important derivatives are futures and options.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Types of Derivatives Forwards, Futures and Future Rate Agreements (FRA’s)
OTC products are : Customised, Written across the counter or struck on telephone, fax, e-mail, etc.
Swaps
By financial institution
Options
Flexible
Types of Derivatives – Based on Characteristics Over the Counter (OTC) Traded Derivatives Exchange Traded Derivatives
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Expensive Limited liquidity
Typical OTC Derivatives are Forwards & FRA’s)
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Types of Derivatives Forwards, Futures and Forward Rate Agreements (FRA’s)
Exchange traded products are : Traded on the floor of physical exchange, Standardised
Swaps
Participation of large number of players
Options
Less Expensive
Types of Derivatives – Based on Characteristics Over the Counter (OTC) Traded Derivatives Exchange Traded Derivatives
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
High liquidity
Typical Exchange Traded Derivatives are Futures
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Difference between OTC & Exchange Traded Derivatives OTC
Exchange Traded
Traded on private basis and bilaterally negotiated
Traded on the floor of physical exchange,
No standard specifications i.e. customised to the needs of individual
Standardised
Prices are less transparent
Prices are transparent
Less Liquid
Highly Liquid
Market players known to each other and based on creditworthiness
Not known to each other
Can not be closed easily
Positions can be easily closed out
Settlement by physical delivery
settlement on cash basis
Each contract is unique
The contracts are standardised
Typical derivative is Forwards
Typical derivative is Futures
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Hedging Hedging is a mechanism to reduce price risk inherent in open position. Its purpose is to reduce the volatility of a portfolio, by reducing the risk. Not maximisation of return. Only reduction in variation of return.
Spot Market Cash Market where the sale and purchase of commodity takes place for immediate delivery. The price at which the exchange takes place is called Cash or Spot Price. On the spot or immediate transfer of ownership and delivery of commodity/instrument.
Forward Contract An agreement made today Between buyer & Seller To exchange the instrument for cash (at forward price) At a predetermined future date At a price agreed upon today (forward price)
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Forward Contract In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon. Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2005 at Rs.5,000/tola. Here, Rs.5,000/tola is the “forward price of 31 Dec 2005 Gold”. The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2005, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2005, and give 100 tolas of gold in exchange
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Futures Contract A future contract is a financial security, issued by an organised exchange to buy or sell a commodity, security or currency at a predetermined future date at a price agreed upon today. The agreed upon price is called the future price. In other words “ Futures are exchange traded contracts to sell or buy financial instruments /physical commodities for future delivery at an agreed price.
Standarised items in Futures : Quantity of the underlying Quality of the underlying (not required in financial financial futures) The date and month of delivery The units of price quotation (Not the price itself) and minimum change in price
Characteristics:
Location of settlement
v)
Contract is standardised
vi)
Trading is centralised – Exchange traded
For the easy and convenient access by a large number of market participants.
vii) Highly liquid
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Types of Futures Contract
Mechanism in Future Contracts :
Commodity Futures : Where the underlying is a commodity or physical asset such as wheat, cotton, butter, eggs, etc.. In India futures on soyabean, black pepper and spices have been trading for long.
In the commodities market the following conventions apply :
Financial Futures : Where the underlying is a financial asset such as foreign exchange, interest rates, Shares, treasury bills or stock index
Buy a future to agree to take delivery of a commodity. This will protect against a rise in price in the spot market as it produces a gain if spot prices rise. Buying a future is said to be going long.
Sell a future to agree to make delivery of a commodity. This will protect against a fall in price in the spot market as it produces a gain if spot prices fall. Selling a future is said to be going short.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Future Contract :
Future Price
Future Price = Spot Price + Cost of Carrying The Spot Price is the current price of a commodity/asset. The cost of carrying of a commodity / asset will be the aggregate of the following : - Storage - Insurance - Transportation - interest payments - Finance cost – interest forgone on funds used for purchase of the commodity/ asset. Apart from the theoretical value, the actual value may vary depending on demand and supply of the underlying at present and expectations about the future.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Functions of Future Markets
Price Discovery Hedging
Participants in Future Markets Hedgers : Hedgers wish to eliminate or reduce the price risk to which they are already exposed. The hedging function solely focuses on the role of transferring the risk of price changes to other holders in the future markets. Speculators :These class of investors willingly take price risks to profit from price changes in the underlying. Arbitrageurs : Making profit from price differential existing in two markets by simultaneously operating in two different markets.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Simple Strategies in Future Markets Commodities Future Markets Buy a future to agree to take delivery of a commodity to protect against a rise in price in the spot market as it produces a gain if spot prices rise. Buying a future is said to be going long. Sell a future to agree to make delivery of a commodity to protect against a fall in price in the spot market as it produces a gain if spot prices fall. Selling a future is said to be going short.
Currency Futures Buying long a currency future protects against a rise in currency value. Selling short a currency future protects against a fall in currency value.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Settlement / Closing Out of Futures Contract :
Stock Index Futures A Stock Index is a composition of selected securities traded on an exchange. e.g. sensex
A futures position can be closed out at any time. This is done by entering a reverse trade.
The value of stock index futures derives its value from a stock index value.
In other words a buy contract is closed out by a sale and vice-versa.
Buyers & sellers agree to buy / sell the entire stock index.
Long position in futures – by selling futures Short position in futures – by buying futures on the exchange.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Options :
Terminology in Options
An option contract gives the holder of the contracts the option to buy or sell shares at a specified price on or before a specific date in the future.
Buyer / Holder / Owner – Who buys the option
Buyer
Right
Obligation
YES
NO
Option Seller
NO
YES
Seller/ Writer – Who sells the option Option Premium – Amount paid by a Buyer to Seller for acquiring the right to buy or sell an underlying or price received by Seller for surrendering his rights in an option contract. Strike Price – The agreed / exercise price at which the right to buy or sell the underlying is exercisable. Expiry Date – The date on which the option contract expires or becomes invalid.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Terminology in Options Call Options : An option acquired to obtain the right to buy/call an underlying in the market. Buyer Holder Long
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Seller Writer Short
Has the right but not the obligation to buy underlying at the strike price
Is obligated on demand to sell underlying at the strike price when the holder exercises
Pays the total premium
Receives the total premium 15
Terminology in Options Call Options : Expectation, Rewards and Risk of Buyer & Seller Buyer Holder Long •
Expectation : Wants the market price of the underlying stock to rise.
•
Reward : Potential unlimited gain when the price of the underlying stock appreciates
•
Risk : Losses only the total premium paid for the call when the market price of underlying stock declines.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Seller Writer Short •
Expectation : Wants the market price of the underlying stock to stay flat.
•
Reward : Limited gain as premium
•
Risk : Potential unlimited loss when the price of the underlying stock rises.
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Terminology in Options
Put Option : Expectation, Rewards and Risk of Buyer & Seller
Put Option : An option acquired to obtain the right to sell/put an underlying in the market. Buyer Holder Long
Seller Writer Short
Has the right but the obligation to sell underlying at the strike price
Is obligated on demand to buy underlying at the strike price when the holder exercises
Pays the total premium Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Receives the total premium
Buyer Holder Long •
Expectation : Wants the market price of the underlying stock to decline.
•
Reward : Maximum profit when the price of the underlying stock declines to zero.
•
Risk : Losses only the total premium paid for the call when the market price of underlying stock rises.
Seller Writer Short •
Expectation : Wants the market price of the underlying stock to stay flat or rise.
•
Reward : Limited gain as premium
•
Risk : More losses when the price of the underlying stock declines lower and lower. 17
Features of Options The option is exercisable only by the owner namely the buyer of the option. The owner has limited liability Options have high degree of risk to the option writers. Options are popular because they allow the buyer profits from favourable movements in exchange rate. Flexibility in investors need.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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Difference between Futures & Options Futures
Options
Both the parties are obliged to perform the contract.
Only the seller (writer) is obligated to perform the contract.
No premium is paid by either parties
The buyer pays the seller (writer) a premium.
The holder of the contract is exposed to the entire spectrum of downside risk and has potential for all the up side return.
The buyer’s loss is restricted to downside risk to the premium paid, but retains upward indefinite potentials.
The parties of the contract must perform at the settlement date. They are not obliged to perform before the date.
The buyer can exercise option any time prior to the expiry date.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
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