EQUITY DERIVATIVES The securities market is divided into two interdependent segments: The primary market provides the

channel for creation of funds through issuance of new securities by companies, governments, or public institutions. In the case of new stock issue, the sale is known as Initial Public Offering (IPO). The secondary market is the financial market where previously issued securities and financial instruments such as stocks, bonds, options, and futures are traded Derivative Markets: The emergence of the market for derivative products such as futures and forwards can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of price fluctuations in various asset classes By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices This instrument is used by all sections of businesses, such as corporates, SMEs, banks, financial institutions, retail investors, etc Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity linked derivatives remained the sole form of such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets. According to the International Swaps and Derivatives Association, more than 90 percent of the global 500 corporations use derivatives for hedging risks in interest rates, foreign exchange, and equities Derivative contracts, commonly known as Derivatives are financial instruments which derive its value from an underlying asset or assets such as commodities, equities, equity indices etc. There are a variety of derivative products like swap, forward, futures, options etc. The term `Derivative' indicates that it has no independent value, i.e. its value is entirely `derived' from the value of the underlying asset The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes

a financial derivative is a financial instrument, whose value is linked in some way to the value of another instrument, underlying the transaction. The underlying instrument could be securities, currencies or indices. For example an option on a share of stock depends on the value of the underlying share. Broad categories of participants Hedgers, speculators, and arbitragerstrade in the derivatives market.

Hedgers face risk associated with the price of an asset. They belong to the business community dealing with the underlying asset to a future instrument on a regular basis. They use futures or options markets to reduce or eliminate this risk. Speculators have a particular mindset with regard to an asset and bet on future movements in the assets price. Futures and options contracts can give them an extra leverage due to margining system. Arbitragers are in business to take advantage of a discrepancy between prices in two different markets. For example, when they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

Exchange-Traded Vs. OTC Contracts: Exchange-traded contracts are standardized (futures). It is easy to buy and sell contracts (to reverse positions) and no negotiation is required. The OTC market is largely a direct market between two parties who know and trust each other. Most common example for OTC is the forward contract. Forward Contracts are directly negotiated, tailor-made for the needs of the parties, and are often not easily reversed. Reasons for using Derivatives: Risk Management ( Hedging ) Trading Efficiency (Low cost & high liquidity compared with underlying) Obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives) Arbitrage Speculation Leverage (a small movement in the underlying value can cause a large difference in the value of the derivative) (you can take a larger exposure with a lower investment requirement. )

Price Discovery ( trader of rice , suppose you are a jeweler , If you are an importer and you need dollars to pay for your imports in the next month ) Asset Class

Demerits: --------------------Other types of derivatives: Warrants: Longer-dated options are called warrants and are generally traded over-thecounter. LEAPS: LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years. Baskets: Basket options are options on portfolios of underlying assets. Equity index options are a form of basket options. Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. ----------------------Swap: Swaps are private agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. Interest rate swaps account for the majority of banks swap activity and the fixed-for-floating rate swap is the most common interest rate swap. In such a swap, one party agrees to make fixed-rate interest payments in return for floating-rate interest payments from the counterparty, with the interest rate payment calculations based on a hypothetical amount of principal called the notional amount. Notional amount typically does not change hands and it is simply used to calculate payments

Currency swaps: These entail swapping both principal and interest between the Parties. Currency swaps involve exchange of currencies at specified exchange rates and to make a series of interest payments for the currency that is received at specified intervals Swaps are not traded on organized exchanges and have an informal market among the dealers. swaps market affords privacy that may not be there in exchange trading Limitations of a swap first, a party has to find a counter party willing to take the opposite side of the transaction, second, a swap agreement, being between two counter parties cannot be altered or terminated early without the agreement of both the parties, third, parties to the swap must be certain of the creditworthiness of the counter party as the risk of counter party default is always there ---------------------------Forwards: A forward contract is an agreement between parties to buy/sell a specified quantity of an asset at a certain future date for a certain price. (Different from a spot market contract, which involves immediate payment and immediate transfer of asset. ) A forward is thus an agreement or contract between two parties in which one party, the buyer, enters into an agreement with the other party, the seller that he would buy from the seller an underlying asset on the expiry date at the predetermined (forward) price. Essential features of a forward contract are: Contract between two parties Custom designed Price decided today Contract size decided today (can be based on convenience of the parties) Quality decided today (can be based on convenience of the parties) Settlement date or Expiration date will take place sometime in future (can be based on convenience of the parties) No margins are generally payable by any of the parties to the other Traded over the counter and are not dealt with on an exchange Afford privacy that is not there in the exchange trading Predominantly used in commodities and Foreign exchange market Physical settlement and cash settlement.

Demerits: Lack of centralized trading Illiquidity Counter party Risk and Exposure. Futures Futures are similar to forwards in the sense that the price is decided today and the delivery will take place in future. A futures contract is a standardized forward contract executed at an exchange, Essential features of a Futures contract are: Contract between two parties through an organised exchange Exchange is the legal counterparty to both parties (Clearing Corporation) Standardized contract terms viz. the underlying asset, the time of maturity and the manner of maturity etc. Clearinghouse to ensure smooth functioning of the market (the Clearing Corporation holds an amount as a security from both the parties. This amount is called the Margin money and can be in the form of cash or other financial assets ) Margin requirements (counterparty risk is minimum ) and daily settlement (hence more liquid ) to act as further safeguard (Margins are payable by both the parties to the exchange) Futures contracts are marked to market each day at their end-of-day settlement prices, and the resulting daily gains and losses are passed through to the gaining or losing accounts. Existence of a regulatory authority. Price decided today Quantity decided today (quantities have to be in standard denominations specified by the exchange) Quality decided today (quality should be as per the specifications decided by the exchange) Tick size (i.e. the minimum amount by which the price quoted can change) is decided by the exchange Delivery will take place sometime in future (expiry date is specified by the exchange) In some cases, the price limits (or circuit filters) can be decided by the exchange Disadvantages Does not provide a perfect hedge as amount and maturity of contracts rarely coincides with standardized amounts and maturities of contracts traded on the exchange Types of Futures Few types of financial futures are:

Equity Shares Equity Indices Debt Market Securities Interest Rates Foreign Exchange (Currencies) Commodities

Contango and backwardation:

Common Terminologies Spot price : The price at which an asset trades in the spot market. Future price : The price at which the futures contract trades in the futures market. Contract cycle: The period over which contract trades. Expiry date: It is the date specified in the futures contract. This is last day on which the contract will be traded, at the end of which it will cease to exist. In India, futures contracts expire on the last Thursday of every month. Contract size: The amount of asset that has to be delivered under one contract. Basis: In the context of financial futures, basis can be defined as futures price minus the spot price. Cost of carry : This is the cost of maintaining or carrying a forward position over time.

Initial margin: That the amount must be deposited in the margin account at the time a futures contract is first entered into is initial margin. Mark-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor`s gain or loss depending upon the futures closing price. This is called mark to market. Cash Settlement: Cash settlement means that one of the parties will pay the other party the difference in cash. (Delivery Based Settlement). Cash settlement allows parties to trade in Futures, even when they are not interested in delivery of the underlying. Impact Cost: Impact cost is the cost you end up paying because of movement in the market price resulting from your order. Distinction between Futures & Forwards (book no 5 and 6) Forwards Privately negotiated contracts Not standardized Settlement dates can be set by the parties High counter party risk Options: Futures Traded on an exchange Standardized contracts Fixed settlement dates as declared by the exchange Almost no counter party risk