Name -Mihir Asher Roll no- 1 Derivatives trading. Sub- Essentials of management. Prof.-Mr.Ranjit Krishnan.

Contents1-Introduction 2-Summary 3-Appendix 4-expert opinion 5-bibliography

DERIVATIVES
INTRODUCTION Derivatives, as the name suggests, are financial instruments that derive their value from an underlying security or asset. The underlying could be equity shares or an index, a commodity, a currency or the exchange rate, bonds, etc. There are various derivative products, which derive their value from equity shares or an index, a commodity, a currency or the exchange rate, bonds, etc. These derivative products vary according to their structure and terms and conditions. The most popular derivative products are Forwards, Futures, Options, Warrants and Swaps. Some of these are short term in nature while others are long term. For example stock and index options that can be traded on stock exchanges are short term in nature, while options like warrants and rights have a longer term. Futures A futures contract or a future is a legally binding agreement between two parties that one will buy from the other, a specific quantity of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.

Types of futures

From the point of view of settlement, there are 2 types of futures contracts those that provide for physical delivery (in the case of commodities) and those, which are settled in cash. The delivery or settlement is a pre-decided feature of the contract. The month and date during which delivery or settlement is to occur is specified.

Forward Contracts A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties assumes a long position and agrees to buy an underlying asset on a certain specified date for a specified price. The other assumes a short position and agrees to sell the asset on the same date for the same price. The forward contracts are normally traded outside the exchange. However a Forward contract is different from futures contract following are the differences Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.

Futures are highly standardized, whereas each forward is unique

The price at which the contract is finally settled is different:

Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end) Forwards are settled by the delivery of the commodity at the specified contract price.

The credit risk of futures is much lower than that of forwards:

Traders are not subject to credit risk because the clearinghouse always takes the other side of the trade. The day's profit or loss on a futures position is marked-to-market in the trader's account. If the mark to market results in a balance that is less than the margin requirement, then the trader is issued a margin call. The risk of a forward contract is that the supplier will be unable to deliver the grade and quantity of the commodity or the buyer may be unable to pay for it on the delivery day.

In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange. In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and a daily mark to market of the traders' accounts.

Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers

that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. Pricing of futures contracts

The theoretical way of pricing any future is to factor in the current price and holding costs (called the cost of carry) i.e. Futures Price = Spot Price + Cost of Carry where: The spot price = the price at which the underlying asset is currently trading in the cash market; and, The cost of carry = the sum of all costs incurred if you take a similar position in the cash market and carry it to the maturity of the futures contract, less any revenue which may accrue during this period. The costs typically include interest, in case of financial futures, or interest, insurance and storage costs in case of commodity futures. The revenue may be dividends, in case of stock futures

Basis Basis = Futures price Spot price The difference between the price of the underlying asset in the cash market and the futures price is called the basis. As a futures contract reaches its expiry date, the basis tends to become less till it becomes zero at the time of

settlement. This is because the futures contract is settled at the closing market price of the underlying asset. In general, since the futures price is greater than the spot price, the basis is positive. However, at times, the futures price may be lower than the spot price. This may happen when expectations are bearish in the near future or the cost of carry is negative etc.

Future market participants Operators in the futures markets can be broadly categorized in the following 3 kinds: 1. Hedgers Hedgers are the players who protect their long / short positions in their regular business or trading ventures by entering the futures markets. Lets say you own 100 shares of ABC Ltd. If you fear that the price of these shares will fall in the near future, you could protect yourself financially, by selling ABC Ltd. futures in the market. Here's how you remain insulated from any fall in price. If the cash market price of ABC Ltd. at present is Rs 130 per share, you should sell futures comprising of the same number of shares that you hold, i.e. 100 shares, at a futures price that is as close to the prevailing current price. For simplicity sake, let's say you manage to sell futures at Rs 130 per share.

Three months later, if the price of ABC Ltd. has fallen to Rs 110 you would have made a loss of Rs 2,000 (Rs 20 x 100 shares) in your shares. However, your futures contract will be settled at Rs 110 per share, giving you a gain of Rs 2,000 (Futures sale price of Rs 130 - settlement price of Rs 110 x 100 shares). Thus, your net value of holding is protected. Similarly, if the price of ABC Ltd. in the cash market rises, the value of your net holdings will still remain unchanged, since the appreciation in your shares will be nullified by the loss that you make by settling your futures at a higher price than your selling price. 2. Speculators Speculators accept risk in pursuit of profit. This is a highly specialized business and speculators success is dependent on their ability to forecast the future prices of the underlying assets accurately. As opposed to hedgers, they take naked positions in the futures market i.e. they go long or short in various futures contracts available in the market (without owning the underlying asset). Speculators perform a very important function by acting as counter parties to hedgers. It can hence be said that derivatives facilitate the transfer of risk from hedgers to speculators. 3. Arbitrageurs Arbitrageurs lock in their non-speculative profits by operating in various markets simultaneously (long in one market and short in another market). In the process, they remove mis-pricing, if any, in either the cash or derivatives markets and align the prices through operating in both the markets.

Speculators and arbitrageurs give enormous liquidity to the products traded on the exchanges. This liquidity, in turn, results in better price discovery, lower transaction costs and less manipulation of the market.

Options An option contract is an agreement between a buyer and seller, wherein the seller gives the buyer the right but not the obligation to buy (in this case it is called a call option) or sell (in this case it is called a put option) an buy a certain date for a certain price The option holder may or may not exercise his option to buy or sell the asset but the option seller has to comply with the wishes of the option holder, if he decides to exercise his option. Although it is called an option contract, in reality no physical agreement is entered into and signed by the buyer and the seller. Transactions are conducted through the stock exchange and settlement is taken care of by the clearing house and the stock exchange

Option Premium

The buyer of the option pays a price called option premium to the writer for the right to buy/sell the underlying asset. This relatively small amount per

option is market-determined and depends upon a number of factors, including demand and supply for the option.

American and European Style Options

Options can be categorized based on the time when they can be exercised. Based on this categorization, there are 2 kinds of options: 1. American style options 2. European style options American style options can be exercised by the owner, any time on or before the expiration date. The stock options traded on the domestic stock exchanges in India are American style options. In case of European style options, the owner can exercise his right only on the expiration date and not before that. Index options traded on the domestic stock exchanges in India are European style options. Uses of Options 1 A person can take a long position in underlying and at the same time he can buy Put Option also this is called protective Put strategy.

2 A person can take long position in underlying plus short position in call option. This is called writing a covered call because the long stock protects the investor from possibility of sharp decline in underlying price. 3 A person can take short position in stock with a long position in call option this protect him when there is sharp increase in the price of underlying. Summary A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities. Derivatives are basically of 3 types: Forwards and Futures Options Swaps A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole Arbitraguer-

 An arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits. When markets are imperfect, buying in one market and simultaneously selling in other market gives risk less profit. Arbitrageurs are always in the look out for such imperfections. Margins The margining system is based on the JR Verma Committee recommendations. The actual margining happens on a daily basis while online position monitoring is done on an intra-day basis.

The daily settlement process called "mark-to-market" provides for collection of losses that have already occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding positions. The mark-to-market settlement is done in cash.

Settlements All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the position will be carried to the next day at the settlement

AppedixFutures- Agreement to buy or sell in future at a certain price. OptionsAn option contract is an agreement between a buyer and seller, wherein the seller gives the buyer the right but not the obligation to buy (in this case it is called a call option) or sell (in this case it is called a put option) an buy a certain date for a certain price. Hedging-Hedging involves protecting an existing asset position from future adverse price movements ArbitrageurAn arbitrageur is basically risk averse. He enters into those contracts were he can earn risk less profits.

Experts opinion

Mr.Alroy lobo (kotak asset management services) The current siatuation is pretty stable in the derivatives market, though it has not yet gained much prominence than the BSE and the NSE. Though the ncdex is in constant endeavour to bring out new changes in the market in relation to options and futures.It has opened various courses for training students in derivatives. It conducts courses in derivatives in bandra kurla complex. The current average transaction done on daily basis is 65000 crore.

BibliographyThe times of India The economic times WebliographyMoneycontrol.com Nseindia.com