What are derivative instruments?
A derivative is an instrument whose
value is derived from the value of one or more underlying asset, which can be
commodities, precious metals, currency, bonds, stocks, indices, etc. Four most
common examples of derivative instruments are forwards, futures, options and
swaps.
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Why Derivatives?
There are several risks inherent in
financial transactions. Derivatives allow you to manage these risks more efficiently
by unbundling the risks and allowing either hedging or taking only one (or more
if desired) risk at a time
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What are futures?
As futures are similar to forward
contracts, it will be easier to understand futures if we understand what forward
contracts are.
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What are uses of Index Futures?
Index futures can be used for hedging,
speculating, arbitrage, cash flow management and asset allocation.
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What are forward contracts?
A: A forward contract is a contract
between two people who agree to buy/sell a specified quantity of a financial
instrument/commodity at a certain price at a certain date in future.
For example, Mr X and Mr Y. Mr X is
a wholesale sugar dealer and Mr Y is the prospective buyer. Mr Y agrees to buy
30 kg of sugar at Rs 15 per kg after three months. The price is arrived at on
the basis of prevailing market conditions and future perceptions about the price
of sugar.
If after three months, the market price
of sugar is Rs 20 per kg, then Mr Y is a gainer. and if the price of sugar is
Rs 10 per kg, then Mr X is a gainer.
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Does this mean one party has to lose?
A: No. Because by limiting my losses,
I am in better control of my business. Let us understand this from the perspective
of both Mr X and Mr Y.
Mr X will gain even if the price of
sugar is Rs 120 a kg because at the time of entering the contract with Mr Y,
Mr X did not know what exactly the price of sugar would be after three months.
So, by agreeing to sell sugar at Rs 100 a kg, Mr X is assured of a certain earning,
based on which he can now plan the financial needs of his business.
Similarly, Mr Y also knows that he
will have to shell out a fixed amount, based on which he too can take care of
the financial needs of his business. It will help Mr Y to control his cost.
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How are futures different from forwards?
A The basic difference is that while
forward contracts are customised, futures contracts are standardised.
A customised contract means that Mr
X and Mr Y can enter into it on the basis of mutual needs, and there is no one
else to determine the terms of their contract.
In futures, on the other hand, the
stock exchange offers certain fixed/standardised contracts for investors to
pick up and trade. Thus, unlike Mr X and Mr Y, who have the freedom to enter
into a contract for any length of time, in futures investors have to choose
from the series of contracts offered for various durations. For example, one
month, two months, three months.
In a forward market, both buyer and
seller deal with each other, while in futures market, both buyers and sellers
are faceless. Both deal with the exchange and exchange in turn assures performance
of the contract.
Default risk is very high in forward
contracts while in futures contracts the exchange takes ensures performance
of the contract.
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What is the scene on the domestic bourses?
A Futures' trading was launched on
the BSE on June 9, 2000, and on the NSE on June 12, 2000. Though volumes are
very low it is expected to take-off in the long term.
Q. How does one trade in futures and
how is it different from the normal market?
A. Trading in futures is similar to
trading in individual scrips. One has to contact a broker and deal through him.
Trading in derivatives is also screen based just as the cash market. But all
the members who trade in cash market cannot trade in the derivatives market.
It requires them to apply afresh for derivative trading. Currently more than
150 members of the BSE are trading in futures.
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Suppose I want to trade in futures, what should I do?
A: Before we get to that, it is important
to point out that so far, there is no futures contract available for individual
scrips and Sebi is unlikely to introduce it in the near future. However, options
on select individual scrips have been introduced on July 2 on the NSE.
To trade in futures, the person will
first have to approach a broker who is authorised to trade in derivatives. Then
the broker will tell him the different series that are available. In India,
both the BSE and NSE offer futures on the Sensex and Nifty respectively, and
these are popularly called as index futures.
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What are the different series which are available?
A At any point of time, there are three
series which are available in the futures market. For example, if we are in
July, we can trade in the July series, August series, or September series.
So, if you choose the July series,
say on July 2, you can buy or sell a future contract based on your forecast
of the value of the index on the expiry date of the contract, which is the last
Thursday of every month. The contract has a minimum size of 50 times the Sensex
and 200 times the Nifty. What this means is if the Sensex is considered to be
a tangible item, like any commodity, then by entering into a futures contract,
you intend to buy or sell 50 units of the Sensex or 200 units of Nifty.
Now, suppose you enter into the contract
on July 2 and the prevailing Sensex future is at 3350, but you feel that the
Sensex future on the expiry date will be 3500. Technically, your contract is
worth Rs 3350x50, but actually you will pay only a certain per cent of the contract
value, and this is called initial margin. Now, if the Sensex touches 3500 on
the expiry date, you will earn Rs 150x50 (that is the difference between 3350-3500),
but if the Sensex value on expiry date is 3200, you will make a loss of Rs 150x50
(that is the difference between 3200-3350).
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Who pays if you are a gainer and to whom do I pay if I lose?
A The stock exchange serves as the
clearing house and all claims are made to it. Let's go back to the earlier example.
Suppose you are the buyer at 3350 and the series expires at 3500, you are the
gainer, and you make a claim for Rs 150x50=Rs 7,500. The seller of the contract
at 3350 would have lost Rs 150 per unit, or Rs 7,500 in all. So, the exchange
will collect Rs 7,500 from the seller and pay it to you.
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Why should the exchange pay me or why should I pay the exchange?
A Since the index is not a tangible
commodity, no one can deliver the index on expiry of the futures contract. The
exchange acts as the medium to settle the deal.
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Can I buy an August contract in June?
A You can. After the expiry of the
June series, you can buy even a September contract, as at any point, an investor
can trade in three series.
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What are options?
A. As the word suggests option is a
contract that gives you an option, but not the obligation to buy or sell something.
Unlike futures, there is an option writer who initiates the contract. An option
writer is treated as the seller of the contract.
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How does one trade in options?
A Like in futures, an investor has
to register himself with a broker who is a member of the BSE or NSE derivatives
Segment. He can trade in three series at any point of time. But the difference
here is he has the option not to honour his commitment to buy or sell the index
or stock.
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What happens if he does not honour the commitment?
Nothing as the option buyer has the
right but not the obligation to buy or sell. His loss is limited to the amount
of premium paid upfront.
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What is option premium?
At the time of buying an option contract,
the buyer has to pay premium. The premium is the price for acquiring the right
to buy or sell the index. It is price paid by the option buyer to the option
seller for acquiring the added flexibility. Option premiums are always paid
upfront.
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What is exercise price?
In futures what is quoted or negotiated
is the exercise price. Exercise price is the price at which the parties are
willing to buy and sell. For example, a July future on Nifty can be quoted at
1100, which means a buyer of the contract promises to buy the Nifty at 1100.
In case of an option, however, he can
buy a right to buy the Nifty on the expiry day. He can talk to his broker and
tell him that he intends to buy an option on Nifty that can be exercised in
end July. The broker will tell him that there are various series available in
July itself. Each of the series expires on the same day, that is the last Thursday
of July. But the difference is that the strike price for different series is
different. For example, on June 26, 2001, there could be four call and four
put options series being traded on the NSE.
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What is a call and a put option?
A call option gives the buyer a right
to buy the underlying, that is the index or stock, at the specified price on
or before the expiry date.
A put option on the other hand gives
the right to sell at the specified price on or before expiry date.
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What are the different series available?
A. Different series on call options
give you a right to buy the Nifty at different prices. For example, you can
buy Nifty options at different strike prices of say 1060, 1080, 1100, 1140.
If you buy a Nifty option for July
at 1060, it means you are authorised to buy the Nifty at 1060 on the expiry
date.
If on July 27, the Nifty closes at
1080, just like futures, here also you stand to gain and you make a profit of
Rs 20x200. As the contract size is 200, one thus gets 20x200=Rs 4,000 on expiry
date.
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It seems that while entering into this type of contracts, people know that
they may or may not exercise the option. Why is it that they risk the premium
amount?
A. While buying an option nobody is
sure that he will finally exercise the option when it expires. This uncertainty
is the only reason behind the option buyer�s decision to buy.
When one enters into a futures contract
he is able to overcome the uncertainty. But in that case, when you enter a contract
to buy sugar at the rate of Rs 15 per kg, say after three months, assuming that
the market price will be much higher then, it may so happen that at the time
of expiry of the contract, you realise that the price of sugar in the market
actually declined and you are now compelled to take delivery at a price higher
than the market price.
But instead, if you buy an option you
get the liberty to buy the index only if it is profitable to you, which means
you will buy it only if the market price is higher than the price specified
in the contract. Similarly, you have the option not to sell the index if it
is below the price specified in the contract.
In short, the loss you will incur by
not fulfilling the contract is only the premium paid at the time of entering
into the contract. By paying the premium you are insured from the loss you may
have to bear in case of an adverse price movement.
But if the price moves favourably,
you can gain by buying or selling the index. Thus, for example, if you take
a call option on the Sensex at 3500, but on July 28 it actually ends at 3700,
you will gain because you will still be buying only at 3500. But if it ends
below 3500, you have the option not to honour the contract, and thus the only
loss you will incur is the premium paid at the time of entering into the contract.
Similarly, if you take a put option
at 3500, and the Sensex actually ends on July 28 below that level, you gain
by selling at a price higher than the current price. But if it ends above 3500,
you have the option not to sell and thus the only loss you will incur is the
premium paid.
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Who is an option writer and what is his role?
A. In any contract there are two parties.
In case of an option there is a buyer to the contract and also a seller. The
seller of the contract is called the options writer.
He receives premium through the clearing
house and is obliged to buy or sell the underlying if the buyer of the contract
so desires.
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Does that mean, buying a put option is same as writing the option?
A. No! An option writer can write a
call or a put option. Writing and selling an option are synonymous. When a writer
writes a call option he creates a short position and the buyer of that call
option creates a long position. On the other hand when an options writer writes
a put option he creates a long position, the buyer of this contract takes a
short position.
In the derivatives market a long position
is created when someone buys or writes a contract which gives him a right or
obligation to buy something, it is index in this case. A short position on the
other hand is created when someone buys or writes a contract, which gives him
a right or obligation to sell something - the index.
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How does stock-based option differ from the index option?
A. The only difference between index-based
and stock-based options is that the underlying asset is individual stock and
not the index.
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What do you mean by Closing out contracts?
A long position in futures can be closed
by selling futures, while a short position in futures can be closed by buying
futures on the exchange. Once position is closed out, only the net difference
needs to be settled in cash, without any delivery of underlying. Most contracts
are not held to expiry but closed out before that. If held until expiry, some
are settled for cash and others for physical delivery.
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Is the settlement mechanism different for Cash and Physical Delivery?
In case it is impossible, or impractical,
to effect physical delivery, open positions (open long positions always being
equal to open short positions) are closed out on the last day of trading at
a price determined by the spot "cash" market price of the underlying asset.
This price is called "Exchange Delivery Settlement Price" or EDSP.
In case of physical settlement short
side delivers to the specified location while long side takes delivery from
the specified location of the specified quantity / quality of underlying asset.
The long side pays the EDSP to clearing house/ corporation which is received
by the short side.
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Is there a theoretical way of pricing Index Future?
The theoretical way of pricing any
Future is to factor in the current price and holding costs or cost of carry.
The Futures Price = Spot Price + Cost
of Carry
Cost of carry is the sum of all costs
incurred if a similar position is taken in cash market and carried to maturity
of the futures contract less any revenue which may result in this period. The
costs typically include interest in case of financial futures (also insurance
and storage costs in case of commodity futures). The revenue may be dividends
in case of index futures.
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. These factors play a much more important
role in commodities, especially perishable commodities than in financial futures.
In general, the Futures price is greater
than the spot price. In special cases, when cost of carry is negative, the Futures
price may be lower than Spot prices.
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What is the concept of Basis?
The difference between Spot Price and
Futures price is known as basis. Although the spot price and Futures prices
generally move in line with each other, the basis is not constant. Generally
basis will decrease with time. And on expiry, the basis is zero and Futures
price equals spot price.
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What is Contango?
Under normal market conditions Futures
contracts are priced above the spot price. This is known as the Contango Market
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What is Backwardation?
It is possible for the Futures price
to prevail below the spot price. Such a situation is known as backwardation.
This may happen when the cost of carry is negative, or when the underlying asset
is in short supply in the cash market but there is an expectation of increased
supply in future � example agricultural products.
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What is margin money?
The aim of margin money is to minimize
the risk of default by either counter-party. The payment of margin ensures that
the risk is limited to the previous day�s price movement on each outstanding
position. However, even this exposure is offset by the initial margin holdings.
Margin money is like a security deposit
or insurance against a possible Future loss of value.
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Are there different types of Margin?
Yes, there can be different types of
margin like Initial Margin, Variation margin, Maintenance margin and Additional
margin.
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What is the objective of Initial margin?
The basic aim of Initial margin is
to cover the largest potential loss in one day. Both buyer and seller have to
deposit margins. The initial margin is deposited before the opening of the day
of the Futures transaction. Normally this margin is calculated on the basis
of variance observed in daily price of the underlying (say the index) over a
specified historical period (say immediately preceding 1 year). The margin is
kept in a way that it covers price movements more than 99% of the time. Usually
three sigma (standard deviation) is used for this measurement. This technique
is also called value at risk (or VAR).
Based on the volatility of market indices
in India, the initial margin is expected to be around 8-10%.
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What is Variation or Mark-to-Market Margin?
All daily losses must be met by depositing
of further collateral - known as variation margin, which is required by the
close of business, the following day. Any profits on the contract are credited
to the client�s variation margin account.
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What is the concept of Cross Margining?
This is a method of calculating margin
after taking into account combined positions in Futures, options, cash market
etc. Hence, the total margin requirement reduces due to cross-Hedges. This type
of margining is not allowed in India.
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What are long/ short positions?
In simple terms, long and short positions
indicate whether you have a net over-bought position (long) or over-sold position
(short).
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Who is a market maker?
A dealer is said to make a market when
he quotes both bid and offer prices at which he stands ready to buy and sell
the security. Thus, he is a person that brings buyers and sellers together.
He lends liquidity in the system by making trading feasible.
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What is marked-to-market?
This is an arrangement whereby the
profits or losses on the position are settled each day. This enables the exchange
to keep appropriate margin so that it is not so low that it increases chances
of defaults to an unacceptable level (by collecting MTM losses) and is not so
high that it increases the cost of transactions to an unreasonable level (by
giving MTM profits).
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What is the role of the clearing house/ Corporation?
The Clearing House / Corporation matches
the transactions, reconciles sales & purchases and does daily settlements.
It is also responsible for risk management
of its members and does inspection and surveillance, besides collection of margins,
capital etc. It also monitors the net-worth requirements of the members.
The other role of the Clearing House
/ Corporation is to ensure performance of every contract.
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What is Price Risk?
Price Risk is defined as the standard
deviation of returns generated by any asset. This indicates how much individual
outcomes deviate from the mean. For example, an asset with possible returns
of 5%, 10% and 15% is more risky than one with possible returns of �10%, 1%
and 25%. It simply mean higher the standard deviation more will be the risk.
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What are the different types of Price Risk?
Diversifiable risk or unsystematic
risk of a security arises from the security specific factors like strike in
factory, legal claims, non availability of raw material, etc. This component
of risk can be reduced by diversification.
Non-diversifiable risk or market risk
is an outcome of economy related events like diesel price hike, budget announcements,
etc that affect all the companies. As the name suggests, this risk cannot be
diversified away using diversification or adding stocks in portfolio.
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Who are Hedgers, Speculators and Arbitrageurs?
Hedgers wish to eliminate or reduce
the price risk to which they are already exposed. Speculators are those class
of investors who willingly take price risks to profit from price changes in
the underlying. Arbitrageurs profit from price differential existing in two
markets by simultaneously operating in two different markets. All class of investors
are required for a healthy functioning of the market.
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What are the general strategies for Speculating?
In general, the speculator takes a
view on the market and plays accordingly. If one is bullish on the market, one
can buy Futures, and vice versa for a bearish outlook.
There is another strategy of playing
the spreads, in which case the speculator trades the "basis". When a basis risk
is taken, the speculator primarily bets on either the cost of carry (interest
rate in case of index futures) going up (in which case he would pay the basis)
or going down (receive the basis).
Pay the basis implies going short on
a future with near month maturity while at the same time going long on a future
with longer term maturity.
Receiving the basis implies going long
on a future with near month maturity while at the same time going short on a
future with longer term maturity.
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What are European & American Style of options?
An American style option is the one
which can be exercised by the buyer on or before the expiration date, i.e. anytime
between the day of purchase of the option and the day of its expiry.
The European kind of option is the
one which can be exercised by the buyer on the expiration day only & not
anytime before that.
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