Introduction to Derivatives

ASHOK PATIL

15-Dec-13

NSE MARKET STATISTICS

Segments CM WDM Equity F&O Currency F&O Interest Rate Futures TOTAL

Total Turnover (Rs. Crore) 13-Jun 207,944 83,565 3,190,887 775,313.00 4,257,708 13-Jul 243,390 66,188 3,180,393 409,739.40 3,899,710

Average daily Percentage Change turnover over last month

Rs. crore 17 -20.8 -0.3 -47.2 -8.4 10,582 2,878 138,278 17,815 169,552

Market Capitalisation
Rs. crore 60,98,779 5,096,478 --5,096,478

ASHOK PATIL

15-Dec-13

Month/Yea r

No. of No. of co.s No of No. of co.s available co.s trading permitte for listed* days d* trading*

No. of Traded No. of securities Quantity trades (lakh) traded # (lakh)

Turnover (cr)

Average Demat Daily Average Securities Turnover Trade Size Traded (cr) (lakh)

Demat Turnover

Market Capitalisatio n (cr)*

Current Month

Jul-2013 Jun-2013 May-2013

1672 1,633 1,673

76 76 75

1590 1,589 1,589

23 20 23

1,684 1,743 1,670

1,285 1,124 1,245

1,32,750 1,15,633 1,28,785

2,43,390 2,07,944 2,44,392

10,582 10,397 10,626

18,946 18,500 19,625

1,32,750 1,15,633 1,28,785

2,43,390 2,07,944 2,44,392

60,98,779 62,48,442 65,18,227

Apr-2013

1,671

75

1,587

20

1,719

1,102

1,18,048

2,10,799

10,540

19,122

1,18,048

2,10,799

64,90,373

20122013
20112012 20102011 20092010

1,666

76

1,582

250

1,683

13605 16,59,160

27,08,279

10,833

19,907 16,59,160 27,08,279

62,39,035

1,646

73

1,563

249

1,807

14,377 16,16,978

28,10,893

11,289

19,551 16,16,978 28,10,893

60,96,518

1,574

61

1,484

255

1,607

15,507 18,24,515

35,77,412

14,048

23,009 18,24,515 35,77,412

67,02,616

1,470

37

1,359

244

1,968

16,816 2,215,530

4,138,024

16,959

24,608 2,215,530 4,138,024

6,009,173

ASHOK PATIL

15-Dec-13

Index Futures

Stock Futures

Index Options

Stock Options

Total Average Daily Turnover ( cr.)

Year

No. of contracts

Turnover ( cr.)

No. of contracts

Turnover ( cr.)

No. of contracts

Notional Turnover ( cr.)

No. of contracts

Notional Turnover ( cr.)

No. of contracts

Turnover ( cr.)

2013-14

43107326 1236735.51 68812096 1899443.84 415114194 12067781.37 36098358 1038942.09 563131974 16242902.82

156181.76

2012-13

96100385 2527130.76 147711691 4223872.02 820877149 22781574.14 66778193 2000427.29

113146741 31533003.96 8

126638.57

2011-12

146188740 3577998.41 158344617 4074670.73 864017736 22720031.64 36494371

977031.13

120504546 31349731.74 4

125902.54

2010-11

165023653 4356754.53 186041459 5495756.70 650638557 18365365.76 32508393 1030344.21

103421206 29248221.09 2

115150.48

2009-10

178306889 3934388.67 145591240 5195246.64 341379523

8027964.20 14016270

506065.18 679293922 17663664.57

72392.07

ASHOK PATIL

15-Dec-13

As on Aug 28, 2013 10:23:11 IST Product Index Futures Stock Futures No. of contracts 3,12,108 3,85,511 Traded Value (Rs crores) 7,804.90 8,941.15

Index Options
Stock Options F&O Total

27,90,542
1,03,717 35,91,878

73,076.98
2,555.33 92,378.36

ASHOK PATIL

15-Dec-13

Trading Value of Different market segments (NSE)

Segment/Year

2006-07
1,945,287 7,356,242 219,106

2007-08
3,551,038 13,090,478 282,317 ---

2008-09
2,752,023 11,010,482 335,952 162,272 --

2009-10
4,138,024 17,663,665 563,816 1,782,608 2,975

2010-11
3,577,412 29,248,221 559,447 3,449,788 62

(` Crores) 2011-12
2,810,893 31,349,732 633,179 4,674,990 3,959

Capital Market Equity Futures & Options Wholesale Debt Market

-Currency F&O * Interest Rate Futures -**

Total

9,520,635

16,923,833

14,260,729

24,151,088

36,834,929

39,472,753

*Trading in Currency Futures commenced on August 28, 2008 ** Trading in Interest Rate Futures commenced on August 31,2009

ASHOK PATIL

15-Dec-13

Index Futures

Stock Futures

Index Options Notional Turnover ( cr.)

Stock Options Notional Turnover ( cr.)

Total Average Daily Turnover ( cr.)

Year

No. of contracts

Turnover ( cr.)

No. of contracts

Turnover ( cr.)

No. of contracts

No. of contracts

No. of contracts

Turnover ( cr.)

2012-13

49839522

1212552.45

61634361 1603703.45

359897356

9330320.79

22662656

620738.49

494033895 12767315.01

116066.50

2011-12

146188740

3577998.41

158344617 4074670.73

864017736

22720031.64

36494371

977031.13 1205045464 31349731.74

125902.54

2010-11

165023653

4356754.53

186041459 5495756.70

650638557

18365365.76

32508393

1030344.21 1034212062 29248221.09

115150.48

2009-10

178306889

3934388.67

145591240 5195246.64

341379523

8027964.20

14016270

506065.18

679293922 17663664.57

72392.07

2008-09

210428103

3570111.40

221577980 3479642.12

212088444

3731501.84

13295970

229226.81

657390497 11010482.20

45310.63

2007-08

156598579

3820667.27

203587952 7548563.23

55366038

1362110.88

9460631

359136.55

425013200 13090477.75

52153.30

2006-07 2005-06 2004-05 2003-04 2002-03 2001-02 2000-01

81487424 58537886 21635449 17191668 2126763 1025588 90580

2539574 1513755 772147 554446 43952 21483 2365

104955401 80905493 47043066 32368842 10676843 1957856 -

3830967 2791697 1484056 1305939 286533 51515 -

25157438 12935116 3293558 1732414 442241 175900 -

791906 338469 121943 52816 9246 3765 -

5283310 5240776 5045112 5583071 3523062 1037529 -

193795 180253 168836 217207 100131 25163 -

216883573 157619271 77017185 56886776 16768909 4196873 90580

7356242 4824174 2546982 2130610 439862 101926 2365

29543 19220 10107 8388 1752 410 11

ASHOK PATIL

15-Dec-13

Currency Futures Year Turnover ( cr.)

Currency Options

Total No. of contracts Turnover ( cr.) Average Daily Turnover ( cr.)

No. of contracts

No. of contracts

Notional Turnover ( cr.)

2012-2013

26,13,26,113 14,46,817.83

9,20,63,927

5,09,524.14 35,33,90,040 19,56,341.97

18,114.28

2011-2012

70,13,71,974 33,78,488.92

27,19,72,158

12,96,500.98 97,33,44,132 46,74,989.91

19,479.12

2010-2011

71,21,81,928 32,79,002.13

3,74,20,147

1,70,785.59 74,96,02,075 34,49,787.72

13,854.57

2009-2010

37,86,06,983 17,82,608.04

- 37,86,06,983 17,82,608.04

7,427.53

2008-2009

3,26,72,768

1,62,272.43

- 3,26,72,768

1,62,272.43

1,167.43

ASHOK PATIL

15-Dec-13

ASHOK PATIL

15-Dec-13

10

A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset;

Four most common examples of derivative instruments are

forwards, futures, options and swaps

the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc.

ASHOK PATIL

15-Dec-13

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The Securities Contracts (Regulation) Act, 1956 defines derivative to include

Derivative has following features

A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or any other form of security A contract which derives its value from the prices, or index of prices, of underlying securities. It has one or more underlying assets Requires negligible initial investment compared to other types of financial contracts. Should provide for net settlement i.e. offsetting of initial contract position

ASHOK PATIL

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A derivative is
a financial instrument with promised payoffs derived from the value of one or several contractually specified underlyings.

Derivatives are like jets. They make it possible to reach a destination faster, but untrained or poorly trained users can crash.

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A derivative instrument is one for which the ultimate payoff to the investor depends directly on the value of another security or commodity.

Two basic types of derivatives

Forward and futures contracts

Options contract

E.g. A forward contract to sell a specific bond for a fixed price at a future date will see its value to the investor rise or fall with decreases or increases in the market price of the underlying bond.

E.g. A call option gives its owner the right to purchase the underlying security, such as a stock or a bond, at a fixed price within a certain amount of time.

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Derivatives are used

to modify the risk and expected return characteristics of existing investment portfolios, i.e. options and futures allow investors to hedge the risk of a collection of stocks

Derivatives also create

the possibility of arbitrage if two otherwise identical series of cash flows do not carry the same current price.

ASHOK PATIL

15-Dec-13

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ASHOK PATIL

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A forward contract is a legally enforceable agreement for delivery of goods or the underlying asset on a specific date in future at a price agreed on the date of contract.

Under Forward Contracts (Regulation) Act, 1952, all the contracts for delivery of goods, which are settled by payment of money difference or where delivery and payment is made after a period of 11 days, are forward contracts.

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A forward contract gives its holder both the right and the full obligation to conduct a transaction involving another security or commodity the underlying asset at a predetermined future date and at a predetermined price.

The future date on the which the transaction is to be consummated is called the contracts maturity (or expiration) date.

The predetermined price at which the trade takes place is the forward contract price.

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The terms that must be considered in forming a forward contract are the same as those that would be required for the spot market transaction but with two exceptions:

The settlement date agreed is set in the future The contract price usually different from the prevailing spot price (S0)

Even though the timing of the trades settlement has shifted, buy low, sell high is still the way to make a profit in the forward market

ASHOK PATIL

15-Dec-13

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Futures Contract is specie of forward contract. Futures are exchange-traded contracts to sell or buy standardized financial instruments or physical commodities for delivery on a specified future date at an agreed price. Futures contracts are used generally for protecting against rich of adverse price fluctuation (hedging).

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Forward contracts are negotiated in the over-the-counter market. means that forward contracts are agreements between two private parties.

Therefore, the terms of the contract are completely flexible, and it may not require collateral. This lack of collateral means that forward contracts involve credit (or default) risk, which is one reason why banks are often market makers in these instruments Forward contracts are illiquid (a by-product of flexibility). To avoid this problem of liquidity, future contracts come into picture by standardizing the terms of the agreement so that it can be traded on exchange.

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The futures price is analogous to the forward contract price; however, the futures exchange will require both counterparties to post collateral, or margin, to protect itself against the possibility of default.

These margin accounts are held by the exchanges clearinghouse and are marked to market.
Marked to market means that the margin accounts are adjusted for contract price movements on daily basis to ensure that both end users always maintain sufficient collateral to guarantee their eventual participation.

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Agreement to:

buy 100 oz. of gold @ US$400/oz. in December (COMEX) sell 62,500 @ 1.5000 US$/ in March (CME) sell 1,000 bbl. of oil @ US$20/bbl. in April (NYMEX)
ASHOK PATIL 15-Dec-13 1.2 3

 The

party that has agreed to buy has a long position The party that has agreed to sell has a short position

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January: an investor enters into a long futures contract on COMEX to buy 100 oz of gold @ $300 in April

April: the price of gold $315 per oz

What is the investors profit/loss?

ASHOK PATIL

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call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

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An American options can be exercised at any time during its life A European option can be exercised only at maturity (end)

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Strike Price 50

July Oct Call Call 16.87 18.87

July Put 2.69

Oct Put 4.62

65
80

7.00 10.87
2.00

8.25 10.62

5.00 17.50 19.50

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A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

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ASHOK PATIL

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 Hedgers
Speculators Arbitrageurs

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Hedgers
Those who desire to off-load their risk exposure on a position A hedge is a financial position put on to reduce the impact of risk one is exposed to Therefore, hedging means taking a financial position to reduce the impact of risk

Speculators
Those willing to absorb risk of hedgers for a cost

Arbitragers
Those who wish to have riskless gain in transaction

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An Indian company is required to pay 10 million for imports from Britain in 3 months and decides to hedge using a long position in a forward contract An investor owns 1,000 ABC shares currently worth 73 per share. A twomonth put with a strike price of 63 costs 2.50. The investor decides to hedge by buying 10 contracts (Lot size 100)

ASHOK PATIL

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An investor with 4,000 to invest feels that ABCs stock price will increase over the next 2 months. The current stock price is 40 and the price of a 2-month call option with a strike of 45 is 2 What are the alternative strategies?

ASHOK PATIL

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A stock price is quoted as 100 pounds in London and $172 in New York. The current exchange rate is $1.7500/pound. What is the arbitrage opportunity?

ASHOK PATIL

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Suppose that:
The spot price of gold is US$390 The quoted 1-year futures price of gold is US$425 The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?

ASHOK PATIL

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Suppose that:

Is there an arbitrage opportunity?

The spot price of gold is US$390 The quoted 1-year futures price of gold is US$390 The 1-year US$ interest rate is 5% per annum

ASHOK PATIL

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If the spot price of gold is S & the futures price is for a contract deliverable in T years is F, then F = S (1+r )T where r is the 1-year (domestic currency) risk-free rate of interest. In our examples, S=390, T=1, and r=0.05 so that F = 390(1+0.05) = 409.50

ASHOK PATIL

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Suppose that:

Is there an arbitrage opportunity?

The spot price of oil is US$19 The quoted 1-year futures price of oil is US$25 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum

ASHOK PATIL

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Suppose that:

Is there an arbitrage opportunity?

The spot price of oil is US$19 The quoted 1-year futures price of oil is US$16 The 1-year US$ interest rate is 5% per annum The storage costs of oil are 2% per annum

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Risk preference Short selling Repurchase agreement Return and risk Market efficiency and theoretical fair value

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Arbitrage and law of one price The storage mechanism: Spreading consumption across time Delivery and settlement

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Risk management Discovery of prices

Operational advantages

Reflect the perception of participants about the future Lower the transaction costs Liquidity and volume trading

Transfer of risk

Allows investors to sell short From hedgers to speculators

Underlying market witnesses higher trading volumes

Market efficiency

The ease and low cost of transacting in derivative markets facilitate the arbitrage trading and rapid price adjustments

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15-Dec-13

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