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Basics of Derivatives

What are Swaps

Different types of derivatives

Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc. Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas, etc.
wheat, Sugar, Coffee, Cotton, Pulses etc
Shares,Bonds and Foreign Exchange

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Indian Derivatives Market

As the initial step towards introduction of derivatives trading in India, SEBI set up a 24– member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India.

The committee submitted its report on March 17, 1998 recommending that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of derivatives.

Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof. J.R.Verma, to recommend measures for risk containment in derivatives market in India. The committee submitted its report in October 1998.

It worked out the operational details of margining system, methodology for charging initial margins, membership details and net-worth criterion, deposit requirements and real time monitoring of positions requirements.

In 1999, The Securities Contract Regulation Act (SCRA) was amended to include “derivatives” within the domain of ‘securities’ and regulatory framework was developed for governing derivatives trading.

In March 2000, government repealed a three-decade- old notification, which prohibited forward trading in securities.

The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and NSE to introduce equity derivative segment. To begin with, SEBI approved trading in index futures contracts based on Nifty and Sensex, which commenced trading in June 2000.

Later, trading in Index options commenced in June 2001 and trading in options on individual stocks commenced in July 2001.

Futures contracts on individual stocks started in November 2001. Metropolitan Stock Exchange of India Limited (MSEI) started trading in derivative products in February 2013.

Products in Derivatives Market

Forwards

It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of contract.

Both the contracting parties are committed and are obliged to honour the transaction irrespective of price of the underlying asset at the time of delivery.
Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts

Futures

A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Indeed, we may say futures are exchange traded forward contracts

Options

An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While buyer of option pays the premium and buys the right, writer/seller of option receives the premium with obligation to sell/ buy the underlying asset, if the buyer exercises his right.

Swaps

A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula.

Swaps are, broadly speaking, series of forward contracts. Swaps help market participants manage risk associated with volatile interest rates, currency exchange rates and commodity prices.

Market Participants

There are broadly three types of participants in the derivatives market

They face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, investing institutions and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices.
They try to predict the future movements in prices of underlying assets and based on the view, take positions in derivative contracts. Derivatives are preferred over underlying asset for trading purpose, as they offer leverage, are less expensive (cost of transaction is generally lower than that of the underlying) and are faster to execute in size (high volumes market).
Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these transactions, thus closing the price gap at different locations.

Significance of Derivatives

Like other segments of Financial Market, Derivatives Market serves following specific functions:

Derivatives market helps in improving price discovery based on actual valuations and expectations. It is the overall process, whether explicit or inferred, of setting the spot price or the proper price of an asset, security, commodity, or currency. The process of price discovery looks at a number of tangible and intangible factors, including supply and demand, investor risk attitudes, and the overall economic and geopolitical environment. Simply put, it is where a buyer and a seller agree on a price and a transaction occurs. Key takeaways: –

(a).Price discovery is the process of finding out the price of a given asset or commodity.
(b).Price discovery is the central function of a marketplace.
(c).It depends on a variety of tangible and intangible factors, from market structure to liquidity to information flow.
Derivatives market helps in transfer of various risks from those who are exposed to risk but have low risk appetite to participants with high risk appetite. For example, hedgers want to give away the risk where as traders are willing to take risk.
Derivatives market helps shift of speculative trades from unorganized market to organized market. Risk management mechanism and surveillance of activities of various participants in organized space provide stability to the financial system.
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Introduction to forward & futures Contracts

forward Contract

It is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. Forwards are widely used in commodities, foreign exchange, equity and interest rate markets.

Assume on March 9, 2018 you wanted to purchase gold from a goldsmith. The market price for gold on March 9, 2018 was Rs. 30,425 for 10 gram and goldsmith agrees to sell you gold at market price. You paid him Rs. 30,425 for 10 gram of gold and took gold.

This is a cash market transaction at a price (in this case Rs. 30,425) referred to as spot price.
Now suppose you do not want to buy gold on March 9, 2018, but only after 1 month. Goldsmith quotes you Rs. 30,450 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have bought forward or you are long forward, whereas the goldsmith has sold forwards or short forwards.

There is no exchange of money or gold at this point of time. After 1 month, you come back to the goldsmith pay him Rs. 30,450 and collect your gold.

This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the point of delivery.

It is a contract between two parties (Bilateral contract).

All terms of the contract like price, quantity and quality of underlying, delivery terms like place, settlement procedure etc. are fixed on the day of entering into the contract

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Future Contract

They were innovated to overcome the limitations of forwards. A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price. Simply, futures are standardised forward contracts that are traded on an exchange.

The clearing corporation associated with the exchange guarantees settlement of these trades. A trader, who buys futures contract, takes a long position and the one, who sells futures, takes a short position.

The words buy and sell are figurative only because no money or underlying asset changes hand, between buyer and seller, when the deal is signed.
Please check the Futures terminologies column after this block
Contract between two parties through Exchange

Centralised trading platform i.e. exchange

Price discovery through free interaction of buyers and sellers

Margins are payable by both the parties

Quality decided today (standardized)

Quantity decided today (standardized)

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Futures terminologies

The price at which an asset trades in the cash market. This is the underlying value of Nifty on March 7, 2018 which is 10154.20.
The price of the futures contract in the futures market. The closing price of Nifty in futures trading is Rs. 10171.55. Thus Rs. 10171.55 is the future price of Nifty, on a closing basis.
It is a period over which a contract trades. On March 7, 2018, the maximum number of index futures contracts is of 3 months contract cycle- the near month (March 2018), the next month (April 2018) and the far month (May 2018).

Every futures contract expires on last Thursday of respective month or the day before if the last Thursday is a trading holiday (in this case since Thursday, March 29, 2018 is a trading holiday, the March contract expires on the day before i.e., on March 28, 2018).

And, a new contract (in this example – June 2018) is introduced on the trading day following the expiry day of the near month contract.
The day on which a derivative contract ceases to exist. It is last trading day of the contract. Generally, it is the last Thursday of the expiry month unless it is a trading holiday on that day.

If the last Thursday is a trading holiday, the contracts expire on the previous trading day. For the March 2018 contract, the expiry date is given as March 28, 2018 since March 29, 2018 (Thursday) is a trading holiday. On expiry date, all the contracts are compulsorily settled.

If a contract is to be continued, then it must be rolled to the near future contract. For a long position, this means selling the expiring contract and buying the next contract. Both the sides of a roll over should be executed at the same time.
It is minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 5 paisa. Bid price is the price buyer is willing to pay and ask price is the price seller is willing to sell.
Futures contracts are traded in lots and to arrive at the contract value we have to multiply the price with contract multiplier or lot size or contract size.

Let us understand various terms in the futures market with the help of quotes on Nifty futures from NSE:

1. Instrument type : Future Index
2. Underlying asset : Nifty 50
3. Expiry date : March 28, 2018
4. Open price (in Rs.) : 10200.00
5. High price (in Rs.) : 10254.00
6. Low price (in Rs.) : 10155.00
7. Closing price (in Rs.) : 10171.55
8. No of contracts traded : 1,98,900
9. Turnover (in Rs. Lakhs) : 15,21,894.99
10. Underlying value (in Rs.) : 10154.20

The difference between the spot price and the futures price is called basis. If the futures price is greater than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures price, basis for the asset is positive.

On March 7, 2018, spot price < future price thus basis for Nifty futures is negative i.e. (10154.20 - 10171.55 = - Rs 17.35).

Importantly, basis for one-month contract would be different from the basis for two or three month contracts. Therefore, definition of basis is incomplete until we define the basis vis-a-vis a futures contract i.e. basis for one month contract, two months contract etc.

It is also important to understand that the basis difference between say one month and two months futures contract should essentially be equal to the cost of carrying the underlying asset between first and second month.

Indeed, this is the fundamental of linking various futures and underlying cash market prices together.
Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the asset till delivery less the income earned on the asset during the holding period.

For equity derivatives, carrying cost is the interest paid to finance the purchase less (minus) dividend earned. For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A person wishes to buy the share, but does not have money.

In that case he would have to borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for one year and in that year he expects the company to give 200% dividend on its face value of Rs. 1 i.e. dividend of Rs. 2.

Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104. It is important to note that cost of carry will be different for different participants.
As exchange guarantees the settlement of all the trades, to protect itself against default by either counterparty, it charges various margins from brokers. Brokers in turn charge margins from their customers. Brief about margins is as follows:
The amount one needs to deposit in the margin account at the time of entering a futures contract is known as the initial margin. Let us take an example – On March 8, 2018 a person decided to enter into a futures contract.

He expects the market to go up so he takes a long Nifty Futures position for March expiry. On March 7, 2018, Nifty March month futures contract closes at 10171.55.

The contract value = Nifty futures price * lot size= 10171.55 * 75 = Rs 7,62,866.

Therefore, Rs 7,62,866 is the contract value of one Nifty Future contract expiring on March 28, 2018.

Assuming that the broker charges 10% of the contract value as initial margin, the person has to pay him Rs. 76,287 as initial margin. Both buyers and sellers of futures contract pay initial margin, as there is an obligation on both the parties to honour the contract.

The initial margin is dependent on price movement of the underlying asset. As high volatility assets carry more risk, exchange would charge higher initial margin on them
In futures market, while contracts have maturity of several months, profits and losses are settled on day-to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM margins) from the loss making participants and pays to the gainers on day-to-day basis.

Let us understand MTM with the help of the example. Suppose a person bought a futures contract on March 8, 2018 when the Nifty futures contract was trading at 10171.55.

He paid an initial margin of Rs. 76,287 as calculated above. At the end of that day, Nifty futures contract closes at 10242.95.

This means that he/she benefits due to the 71.4 points gain on Nifty futures contract. Thus, his/her net gain for the day is Rs 71.4 x 75 = Rs 5355.

This money will be credited to his account and next day his/her position will start from 10242.95 (for MTM computation purpose).
An open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset. It is important to understand that number of long futures as well as number of short futures is equal to the Open Interest.

This is because total number of long futures will always be equal to total number of short futures.

Only one side of contracts is considered while calculating/mentioning open interest. The level of open interest indicates depth in the market.

Volumes traded give us an idea about the market activity with regards to specific contract over a given period – volume over a day, over a week or month or over entire life of the contract.

Differences between Forwards and Futures

Forward contracts

It is not traded on the exchanges.
Terms of the contracts differ from trade to trade (tailor made contract) according to the need of the participants.
Exists, but at times gets reduced by a guarantor.
Low, as contracts are tailor made catering to the needs of the parties involved. Further, contracts are not easily accessible to other market participants.
Not Efficient, as markets are scattered.
Quality of information may be poor. Speed of information dissemination is week.
Currency markets are an example of forwards. Today currency futures and options have been introduced in India, but yet a market for currency forwards exists through banks.

Futures contracts

It is an exchange-traded contract.
Terms of the contracts are standardized.
Exists but the clearing agency associated with exchanges becomes the counter-party to all trades assuring guarantee on their settlement.
High, as contracts are standardised exchange-traded contracts.
Efficient, centralised trading platform helps all buyers and sellers to come together and discover the price through common order book.
Futures are traded nationwide. Every bit of decision related information is distributed very fast.
Commodities futures, Currency futures, Index futures and Individual stock futures in India.

Various risks faced by the participants in derivatives

Market Participants must understand that derivatives, being leveraged instruments, have risks like counterparty risk (default by counterparty), price risk (loss on position because of price move), liquidity risk (inability to exit from a position), legal or regulatory risk (enforceability of contracts), operational risk (fraud, inadequate documentation, improper execution, etc.) and may not be an appropriate avenue for someone of limited resources, trading experience and low risk tolerance.

A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters. Market participants, who trade in derivatives are advised to carefully read the Model Risk Disclosure Document, given by the broker to his clients at the time of signing agreement.

Model Risk Disclosure Document is issued by the members of Exchanges and contains important information on trading in Equities and F&O Segments of exchanges. All prospective participants should read this document before trading on Capital Market/Cash Segment or F&O segment of the Exchanges.

Pay off Charts for Futures contract

Pay off Charts

Pay off on a position is the likely profit/ loss that would accrue to a market participant with change in the price of the underlying asset at expiry. The pay off diagram is graphical representation showing the price of the underlying asset on the X-axis and profits/ losses on the Y-axis.

Pay off charts for futures

In case of futures contracts, long as well as short position has unlimited profit or loss potential. This results into linear pay offs for futures contracts. Futures pay offs are explained in detail below:

Pay off for buyer of futures: Long futures

Let us say a person goes long in a futures contract at Rs.100. This means that he has agreed to buy the underlying at Rs. 100 on expiry. Now, if on expiry, the price of the underlying is Rs. 150, then this person will buy at Rs. 100, as per the futures contract and will immediately be able to sell the underlying in the cash market at Rs.150, thereby making a profit of Rs. 50. Similarly, if the price of the underlying falls to Rs. 70 at expiry, he would have to buy at Rs. 100, as per the futures contract, and if he sells the same in the cash market, he would receive only Rs. 70, translating into a loss of Rs. 30. This potential profit/loss at expiry when expressed graphically, is known as a pay off chart. The X Axis has the market price of the underlying at expiry. It increases on the Right Hand Side (RHS). We do not draw the X Axis on the Left Hand Side (LHS), as prices cannot go below zero. The Y Axis shows profit & loss. In the upward direction, we have profits and in the downward direction, we show losses in the chart

Short Futures pay off

As one person goes long, some other person has to go short, otherwise a deal will not take place. The profits and losses for the short futures position will be exactly opposite of the long futures position. This is shown in the below table and chart: As can be seen, a short futures position makes profits when prices fall. If prices fall to 60 at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry and sell at 100, thereby making a profit of Rs. 40. This is shown in the above chart.
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