Simplifying how derivative products operate in the stock market (Extended Version)

By Prof. Simply Simple

TM

Hopefully the last lesson on derivatives in the real world helped you get a good idea about its concept. In this lesson, I will explain to you how a derivative deal is practically done in the market place.

In our previous lesson we explained how in a market comprising of several buyers and sellers, one need not know who the counter-party is.

As we saw in our earlier lesson, there are several farmers in the market, perhaps a few thousands!

And several thousand bread manufacturers!!

And a market place where there is free flow of information!!!

So that the expected future stock price (price of wheat for the sake of comparison with our previous examples) is known to every farmer and bread manufacturer.

Any farmer trying to extract a higher price will not be able to do so because for the bread manufacturer there are several other farmers to buy from and vice versa. This is what we call Price Discovery.

Now in the stock market we do not have farmers and bread manufacturers, but instead have investors who are both buyers and sellers of stocks.

Now lets say there is a stock A listed on the stock exchange and its futures is quoted at Rs. 120.
Also, lets assume there are participants in the market to buy and sell the futures to each other based on their contrarian view about the stock. And lets say the expiry date for settlement of the futures contract is after 5 days.

Now, for the sake of understanding, suppose you were to buy a futures of stock A for Rs 120. In this context, it is important for you to understand that in a derivative product what you actually do is take a view on future price movements and at the end of the settlement period, you reconcile based on whether your view was right or wrong.

Since at no point in time the investor has to take delivery of the stock, he does not have to pay the entire price of the stock at the time of the deal. All he has to pay hence is the margin money which is a fraction of the price, say, 15% of the price which is Rs 18 in the above example.

Now to understand this better, lets look at how the prices move in these 5 days.

Day 1 Closing Price on day One 122

Your buying price day One 120

Your profit Rs 2 So at the end of the day your account with your broker would get credited by Rs 2.

Debit Day 1

Credit Rs. 2

Day 2

Closing Price on day two 125 Your profit as compared to the previous day is Rs 3 So at the end of day 2, your account with your broker would get credited by Rs 3.

Debit Day 1 Day 2

Credit Rs. 2 Rs 3

Day 3 Closing Price on day Three 124 Your loss as compared to the previous day is Rs.1 So at the end of day 3, your account with your broker would get debited by Rs 1.

Debit Day 1 Day 2 Day 3 Rs.1

Credit Rs. 2 Rs 3

Day 4

Closing Price on day Four 123 Your loss as compared to the previous day is Rs.1 So at the end of day 4, your account with your broker would get debited by Rs 1.

Debit
Day 1 Day 2 Day 3 Day 4 Rs.1 Rs. 1

Credit
Rs. 2 Rs 3

Day 5 Settlement Date

Closing Price on day Five 125

Your profit as compared to the previous day is Rs.2 So at the end of day 5, your account with your

broker would get credited by Rs 2.

Debit

Credit

Day 1 Day 2 Day 3

Day 4 Day 5

Rs. 2 Rs 3 Rs.1
Rs. 1 Rs 2

Day 5 Settlement Date Thus the effect of the 5 days leading to the settlement would be like

this

Debit Day 1 Day 2 Day 3 Day 4 Day 5 Total Rs 2 Rs.1 Rs. 1

Credit Rs. 2 Rs 3

Rs 2 Rs 7

So in this case the investor gained Rs 5 on settlement date.

However since your investment was only Rs. 18 (15% margin money), you need to calculate Rs. 5 as a percentage of Rs. 18. Thus, the returns earned would be equal to 5/18 x 100 = 27% (approx.)

Please do let me know if I have managed to clear this concept for you. Your feedback is very important as it helps me plan my future lessons.

Hence please give your feedback at professor@tataamc.com