FINANCIAL DERIVATIVES

AND RISK MANAGEMENT

Introduction to derivatives

FINANCIAL DERIVATIVE
A financial instrument whose payoff(price) is based on
the price of an underlying asset, reference rate or an
index
Used by Mark Rubinstein for the first time in financial
context(1976)
Derivative is a generic term referring to forwards,
futures, options and swaps
A security derived from a debt instrument, share, loan,
whether secured or unsecured, risk instrument or
contract for differences or any other form of security; a
contract which derives its value from the prices, or index
of prices, of underlying securities(SCRA,1956)

EVOLUTION OF DERIVATIVES
Most of the derivative markets had evolved from
the basic commodity markets in the world
First organised futures market in India came up
in1875 Bombay Cotton Trade association Ltd.
Indian derivatives market commenced with the
forex derivatives in 1997
Currently the following contracts are allowed for
trading in Indian markets:

INDIAN DERIVATIVES MARKET

Interest rate
Forward
contracts
futures and forwards

HISTORY OF DERIVATIVE TRADING AT NSE

The derivatives trading on the NSE commenced on June 12, 2000

with futures trading on S&P CNX Nifty Index
Trading in index options and options on individual securities
commenced on June 4, 2001 and July 2, 2001.
Single stock futures were launched on November 9, 2001.
Now product base has increased to include trading in futures and
options on CNX IT Index, Bank Nifty Index, Nifty Midcap 50
Indices etc. Today, both in terms of volume and turnover, NSE is
the largest derivatives exchange in India.
The derivatives contracts have a maximum of 3-month expiration
cycles except for a long dated Nifty Options contract which has a
maturity of 5 years.
Three contracts are available for trading, with 1 month, 2 months
and 3 months to expiry. A new contract is introduced on the next
trading day following the expiry of the near month contract.

TYPES OF DERIVATIVES

TYPES OF DERIVATIVES
Forwards
Agreement between the buyer and the seller in which
the buyer has the right and obligation to buy a specified
asset on a specified date and at a specified price
Seller is also under an obligation to perform as per terms
of the contract
Underlying asset can be anything, Eg. stock, commodity,
bond
Futures
A kind of forwards
Represent obligations on the part of the buyer and seller
but the terms and conditions are of the contract are
specified by the exchange where they are actually traded

TYPES OF DERIVATIVES
Options
A form of forward contracts wherein the buyer will
have a right but not an obligation and on the expiry of
the contract he will decide whether or not to exercise
his right to buy or sell
SWAPS
financial structures that allow the counterparties to
exchange the obligations

EXCHANGE TRADED VS OTC TRADED DERIVATIVES

Derivatives that trade on an exchange are called

exchange traded derivatives,
Privately negotiated derivative contracts are called OTC
contracts.
OTC derivatives are negotiated deals between the buyer
and seller
There is no specific place where this market exists.
Forward contract is an example for OTC derivative
Practically all the terms of the contract are negotiable
between the counter parties such as quality of the asset,
quantity of the asset, place of delivery, price of the asset
and duration of the contract
Eg.On Jan 20,2004, A gold merchandiser enters into an
agreement to buy2.15 kg of gold of 99% purity at a price
of Rs.500 per gram at Baroda in 60 days time

FEATURES OF THE OTC DERIVATIVES

MARKETS
The management of counter-party (credit) risk is
decentralized and located within individual
institutions,
There are no formal centralized limits on individual
positions, leverage, or margining,
There are no formal rules for risk and burdensharing,
There are no formal rules or mechanisms for ensuring
market stability and integrity, and for safeguarding
the collective interests of market participants, and
The OTC contracts are generally not regulated by a
regulatory authority and the exchanges selfregulatory organization.

WHY DERIVATIVES
Derivatives help in discovery of future as well as current prices.
The derivatives market helps to transfer risks from those who have
them but do not like them to those who have an appetite for them.
With the introduction of derivatives, the underlying market
witnesses higher trading volumes. This is because of participation
by more players who would not otherwise participate for lack of an
arrangement to transfer risk.
Speculative trades shift to a more controlled environment in
derivatives market.
An important incidental benefit that flows from derivatives trading
is that it acts as a catalyst for new entrepreneurial activity. The
derivatives have a history of attracting many bright, creative, welleducated people with an entrepreneurial attitude.
In a nut shell, derivatives markets help increase savings and
investment in the long run.
Transfer of risk enables market participants to expand their
volume of activity.

DERIVATIVE TRADING IN INDIA

In India, derivatives are traded on:
Bombay stock exchange(BSE)
National stock exchange (NSE)
National commodity and derivatives Exchange
(NCDEX)
Multi Commodity Exchange(MCX)

TRADERS IN DERIVATIVE MARKET

TRADERS IN DERIVATIVE MARKET

Arbitrageurs

Set of traders who are on look out for risk-free profits, interested in
exploiting mispricing between spot market and the derivative market
Entails zero initial investment and zero risk

Speculators

Risk seeking traders who believes that thy have some specialized
knowledge about the market and can predict the direction of the markets
movement
If their forecast come true, they make profit, entails high risk

Hedgers

Risk averse traders. They want to reduce risk in business operations. For
reducing risk, they are even willing to pay a price
Eg. A cotton farmer may expect his crop to face a decrease in price when
it comes to the market. So he is entering into a futures contract to reduce
risk and sells it now even before the arrival of the crop for delivery

ECONOMIC BENEFITS OF
DERIVATIVES
Provide risk management and mitigation tools
Assist in managerial decision making by providing
some information on future prices that will help in
production decisions
Equip firms in the economy with more effective tools to
manage the exposure to interest rates, foreign
exchange rates and commodity prices
It helps in price discovery process of establishment of
benchmark market prices

EXCHANGE TRADED DERIVATIVES IN INDIA

Futures on indices
Options on indices
Futures on individual securities
Options on individual stocks
Interest rate futures

ST

future on a 91 day T Bill

LT future on a notional 10 year ZCB
LT future on a notional 10 year 6% Coupon Bond

Exchanges themselves do not trade in derivatives

but they only facilitate trading, as per the
eligibility criteria laid down by SEBI:

ELIGIBILITY CRITERIA LAID DOWN BY SEBI:

FOR EXCHANGE TRADED DERIVATIVES IN INDIA

The stocks should figure in top 500 stocks in terms of

average daily market capitalisation and average daily
traded value in the previous six months on a rolling
basis
For a stock to be eligible, the median quarter sigma
order size over the last six months should not be less
than Rs. 1 lakh
Quarter sigma order size order size(in value terms)
required to cause a change in the stock price equal to
one-quarter of the standard deviation
The market-wide position limit in the stock should not be
less than Rs.50 crores
Futures and options contracts on an index can be issued
only if 80% of the index constitutes are individually
eligible for derivative trading

MEDIAN QUARTER SIGMA RULE

Order size defined as the product of volume and
price(volume x price) required for a stock price to
change by one-fourth of its stand ard deviation
should be at least Rs. 1 lakh.
Aim is to ensure that derivatives will be
introduced only on those stocks that are very
liquid
Eg. If the SD () of a stock is 20%, the quarter
sigma will be 5%. If average price of the stock is
Rs.100, then quarter sigma price will be
computed as 100 x 5% = Rs.5

MEDIAN QUARTER SIGMA RULE

Order size that will move the stock price by quarter
sigma price is computed as:
Quarter Sigma Order size
Quarter Sigma Buy Price= Avg price - QSP
Quarter Sigma Sell Price= Avg price + QSP
Quarter Sigma Buy/Sell Order =
Quarter Sigma Buy or Sell Price x No. of shares

TYPES OF ORDERS
Limit order
Order for buying and selling at a limit price
Market order
Order to buy or sell at the best price in the market at the
time of submission of order
Stop loss
Order that becomes a limit order only when the market
trades at a specified price
Good till cancelled
Order which remains in the system until the trader
cancels it
Good till days/date
Order which remains till a specified number of days or till
a specified date

PARTICIPANTS IN THE DERIVATIVE

MARKET

PARTICIPANTS IN THE DERIVATIVE

MARKET
Trading member
One who trades in his own behalf and on behalf of
clients
Clearing member
One who undertakes to settle his own trades as well
as that of other non-clearing members
Self-clearing member
Those who clear and settle their own trades only

OTHER TERMS

Contract size
Unit of trading represents the value of the security
represented in the contract(SEBI stipulation
minimum contract size of derivatives should not be less
than Rs. 2 lakh)
Contract multiplier
Predetermined value used to arrive at the contract
size(fixed by the concerned exchanges, for sensex
futures Rs.50)
Lot size
Number of underlying securities in one contract
Tick size
Minimum price movement allowed(eg. Sensex futures
tick size is 0.05 points or Rs.2.5)

CLEARING HOUSE
A separate legal entity from the exchange
All concluded trades must be registered with the
clearing house, margins are deposited with it, it
administers settlement, takes responsibility in the
event of default
Clearing house assures financial integrity of traded
contracts by guaranteeing their settlement
Once deal is concluded, CH acts as a legal
counterparty to both buyers as well as sellers
NSCCL clearing house for NSE

MARGINS
Money indicating the capacity and willingness of the
trader to meet the contractual terms
This reduce the risk of the CH
If the margins are too high derivative trading will not
be attrative
If the margins are too low, the CH will be exposed to
very high risk
So setting up margins involves a trade off between
these two requirements
Initial margins is linked to the risk of the underlying
security.
Whenever an investor instructs a broker to trade in
derivatives, the investor has to deposit a margin
initial margin

MARGINS

Now CHs world wide use specialized margining

systems
SPAN Standard Portfolio Analysis of Risk
TIMS Theoretical Intermarket Margin System
Once the contract is initiated, the trader faces mark
to- market margins until the trader closes his position

MARKING-TO- MARKET
Recording the value of a contract at the days settlement price to
calculate profits and losses.
Eg. Suppose an investor contacts his broker on June 5 to buy 2 Dec
gold futures contracts on the NSE
Current future price is Rs.1400 per ounce, Contract size is 100, so
the investor contracted to buy 200 ounces
The broker will ask the investor to deposit margin in his account.
The amount to be deposited at the time of contract is called initial
margin suppose it is 2,000 per contract, i.e Rs.4,000
At the end of each trading day, the margin account is adjusted to
reflect the investors gain or loss referred to as marking -to
market the account
Suppose by the end of June5, the futures price dropped from
Rs.1400 to Rs.1397, the investor has a loss of Rs.600(Rs.3 x 200)
balance in the margin account is thus reduced by Rs.600 to Rs.3,400
Suppose by the end of June5, the futures price increased from
Rs.1400 to Rs.1403, the investor has a gain of Rs.600(Rs.3 x 200) so
balance in the margin account is thus increased by Rs. 600 to
Rs.4,600

MARKING-TO- MARKET - EXAMPLE

Day

Settlement price

Gain/2120loss

Opening
At close of day 0
At close of day 1
At close of day 2
At close of day 3
At close of day 4
At close of day 5
At close of day 6
At close of day 7
At close of day 8

2,100
2120
1970
1930
1950
1980
2010
2020
2125
2080

20
-150
-40
20
30
30
10
105
-35

VALUE AT RISK
VaR is a volatility based measure containing
information on losses during normal market
conditions and the probability in a single number
Used for the first time by J.P Morgan
VaR = TP
= critical value from standard normal
distribution
T = square root of the number of time
periods
= standard deviation
P=estimate of initial value of portfolio

FUNCTIONS OF DERIVATIVE
MARKET
Enable price discovery
Facilitate transfer of risk
Provide leveraging
Other benefits better portfolio management,
curb hoarding etc.