Derivatives 110918074157 Phpapp01

8/3/2019 Derivatives 110918074157 Phpapp01

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Financial EngineeringFinancial EngineeringBy CA. Pradeep Kumar GuptaBy CA. Pradeep Kumar Gupta

(CA., CS., B.com)(CA., CS., B.com)


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Financial MarketFinancial Market

Capital Market (SEBI)Capital Market (SEBI)

Money Market (RBI)Money Market (RBI)


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Capital MarketCapital Market

Primary Market (IPO)Primary Market (IPO)

Secondary Market (FPO)Secondary Market (FPO)


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Secondary MarketSecondary Market

Cash MarketCash Market

Derivative MarketDerivative Market


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Stock Exchanges of IndiaStock Exchanges of India

(under SEBI)(under SEBI)

BSE (Bombay Stock Exchange)BSE (Bombay Stock Exchange)

NSE (National Stock Exchange)NSE (National Stock Exchange)


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Commodity Exchange of IndiaCommodity Exchange of India

( under Forward Market Commission)( under Forward Market Commission)

NCDEX (National Commodity & DerivativesNCDEX (National Commodity & Derivatives

Exchange) (Agriculture Products)Exchange) (Agriculture Products)

(Index-Dhanya)(Index-Dhanya)

MCX (Multi Commodity Exchange)MCX (Multi Commodity Exchange)

(Metals)(Metals)

0nly future trading is permitted in Indian0nly future trading is permitted in Indiancommodity exchanges.commodity exchanges.

(Index Comdex)(Index Comdex)


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What is derivativesWhat is derivatives

The word derivatives originates fromThe word derivatives originates from

mathematics and refers to a variable,mathematics and refers to a variable,

which has been derived from anotherwhich has been derived from another

variable. Derivatives are so called becausevariable. Derivatives are so called becausethey have no value of an underlyingthey have no value of an underlying

assets. The underlying assets can beassets. The underlying assets can be

equity, commodity, or any other assets.equity, commodity, or any other assets.


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Types of DerivativesTypes of Derivatives

ForwardForward

FutureFuture

OptionOption


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Forward ContractForward Contract

Forward contract is a agreement to buy orForward contract is a agreement to buy or

sell an assets at a certain future time for asell an assets at a certain future time for a

certain price.certain price.


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Parties of Forward ContractParties of Forward Contract

Buyer-One of the parties to a forwardBuyer-One of the parties to a forward

Contract assumes a Buying Position (LongContract assumes a Buying Position (Long

Position) and agrees to buy the underlyingPosition) and agrees to buy the underlying

assets on a certain specified future dateassets on a certain specified future datefor a certain specified price.for a certain specified price.


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Seller-Other parties to contract i.e.theSeller-Other parties to contract i.e.the

seller assumes a short position and agreesseller assumes a short position and agrees

to sale the assets on the same date forto sale the assets on the same date for

the same price.the same price.

Example-on a 01/08/2011 ABC Ltd. entersExample-on a 01/08/2011 ABC Ltd. enters

into a forward contract with PQR.Ltd forinto a forward contract with PQR.Ltd for

buying USD 1 crore at Rs.45 per USD onbuying USD 1 crore at Rs.45 per USD on30/09/2011.30/09/2011.


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Features of the forward contractFeatures of the forward contract

Quantity of the Commodity to be deliveredQuantity of the Commodity to be delivered

Quality of the commodity to be deliveredQuality of the commodity to be delivered

Price which the buyer would payPrice which the buyer would pay Counter parties risk involvedCounter parties risk involved

Over the counter agreementOver the counter agreement


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Future ContractFuture Contract

Future contract is standardized ForwardFuture contract is standardized Forward

contract .In future trading there is usuallycontract .In future trading there is usually

a contract which is essentially ana contract which is essentially an

agreement between two parties to buy oragreement between two parties to buy orsell an underlying assets at a certain timesell an underlying assets at a certain time

in the future at a certain price.in the future at a certain price.


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Feature of future contractFeature of future contract

A future contract usually has aA future contract usually has a

standardized date and month of deliverystandardized date and month of delivery

quantity and price.quantity and price.

Future trading are traded on exchange.Future trading are traded on exchange.

Three series of future contract are alwaysThree series of future contract are always

available and have one-month, twoavailable and have one-month, two

month, and three month expiry cycles.month, and three month expiry cycles.


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Comparison of forward and futures contractComparison of forward and futures contract

Forwardorward FutureuturePrivate Contract between two partiesrivate Contract between two parties Traded on an exchangeraded on an exchangeNot standardizedot standardized Standardized Contracttandardized ContractUsually one specified delivery datesually one specified delivery date Range of delivery datesange of delivery datesSettled at the end of contractettled at the end of contract Settled dailyettled dailyDelivery or final cash settlement usuallyelivery or final cash settlement usuallytakes placeakes place Contract is usually closed out priorontract is usually closed out priorto maturityo maturitySome credit riskome credit risk Virtually no credit riskirtually no credit risk


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Index FutureIndex Future

Index future are the future contract whichIndex future are the future contract which

underlying assets is a market index. For aunderlying assets is a market index. For a

example future contract on Senesx andexample future contract on Senesx and

Nifty are called index future.Nifty are called index future.


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OptionOption

Option is a derivatives instrument thatOption is a derivatives instrument that

gives the holder a right, without anygives the holder a right, without any

obligation to perform.obligation to perform.

Option are basically contracts which giveOption are basically contracts which give

to the buyer a facility which is similar toto the buyer a facility which is similar to

buy or sell certain asset (underlying) butbuy or sell certain asset (underlying) but

the buyer of an option has limited risk &the buyer of an option has limited risk &unlimited profit.unlimited profit.


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Types of optionTypes of option

(Based on Nature of Activity)(Based on Nature of Activity)

Call OptionCall Option

Put OptionPut Option


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Call OptionCall Option

A call option gives the buyer the right to buy inA call option gives the buyer the right to buy inthe underlying assets at the strike price specifiedthe underlying assets at the strike price specifiedin the option.in the option.

The profit /loss that the buyer makes on theThe profit /loss that the buyer makes on theoption depend upon the spot price of theoption depend upon the spot price of theunderlying. If upon expiration the spot priceunderlying. If upon expiration the spot priceexceeds the strike price he makes a profit.if theexceeds the strike price he makes a profit.if thespot price of the underlying assets is less thanspot price of the underlying assets is less thanthe strike price the premium of that option willthe strike price the premium of that option willbecome zero & maximum loss in this case is thebecome zero & maximum loss in this case is thepremium he paid for buying the option.premium he paid for buying the option.


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Put OptionPut Option

A put option gives the buyer the right to sell inA put option gives the buyer the right to sell inthe underlying assets at the strike price specifiedthe underlying assets at the strike price specifiedin the option.in the option.

The profit /loss that the buyer makes on theThe profit /loss that the buyer makes on theoption depend upon the spot price of theoption depend upon the spot price of theunderlying. If upon expiration the spot priceunderlying. If upon expiration the spot pricebelow the strike price he makes a profit. if thebelow the strike price he makes a profit. if thespot price of the underlying assets is exceedsspot price of the underlying assets is exceedsthan the strike price the premium of that optionthan the strike price the premium of that optionwill become zero & maximum loss in this case iswill become zero & maximum loss in this case isthe premium he paid for buying the option.the premium he paid for buying the option.


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Comparison between Call Option & Put OptionComparison between Call Option & Put Option

Call Optionall Option Put Optionut OptionOption which gives the holder right toption which gives the holder right toBUY an assets but not an obligationUY an assets but not an obligationto buy.o buy.

Option which gives the holder rightption which gives the holder rightto SELL an assets but not ano SELL an assets but not anobligation to SELL.bligation to SELL.Call option will be exercise only whenall option will be exercise only whenthe exercise price is lower than thehe exercise price is lower than themarket price.arket price.

Put option will be exercise onlyut option will be exercise onlywhen the exercise price is Higherhen the exercise price is Higherthan the market price.han the market price.Seller/writer is under obligation to selleller/writer is under obligation to sellthe underlying assets if the buyerhe underlying assets if the buyerexercise his option to buy the sharesxercise his option to buy the shares

.

Seller/writer is under obligation toeller/writer is under obligation tosell the underlying assets if theell the underlying assets if thebuyer exercise his option to selluyer exercise his option to sellthe shares .he shares .


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Types of the OptionTypes of the Option

((Based on the Exercising the Option)Based on the Exercising the Option)

American OptionAmerican Option

European OptionEuropean Option


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American OptionAmerican Option

Option under which holder can exerciseOption under which holder can exercise

his right at any time before expiry date.his right at any time before expiry date.


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European OptionEuropean Option

Option under which holder can exerciseOption under which holder can exercise

his right only on the expiry date.his right only on the expiry date.


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Types of Players/TraderTypes of Players/Trader

HedgersHedgers

SpeculatorsSpeculators

ArbitrageursArbitrageurs


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Example of hedging using forwardExample of hedging using forward

contractcontract

Payment $100000Payment $100000

Received $100000Received $100000


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SpeculatorsSpeculators

Whereas hedgers want to avoid exposureWhereas hedgers want to avoid exposure

to adverse moment in the price of anto adverse moment in the price of an

assets, speculators wish to take a positionassets, speculators wish to take a position

in the market.in the market. Either they are betting that the price ofEither they are betting that the price of

the assets will go up or they are bettingthe assets will go up or they are betting

that it will go down.that it will go down. Example:-future and option bothExample:-future and option both


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ArbitrageursArbitrageurs

Arbitrageurs are a careful lot who keepArbitrageurs are a careful lot who keepconstant vigil on the market, acrossconstant vigil on the market, acrossproducts and locations to identifyproducts and locations to identify

temporary imperfection and convert suchtemporary imperfection and convert suchopportunities into risk less profit. In theopportunities into risk less profit. In thepure form of arbitraging, the operator:pure form of arbitraging, the operator:

1-has no investment; and1-has no investment; and

2-simultaneously buys and sells in different2-simultaneously buys and sells in differentmarkets and /or different period whichmarkets and /or different period whichensure risk less profit to him. (example $ensure risk less profit to him. (example $

in diff. mkt)in diff. mkt)


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Types of OrderTypes of Order

Market Order-Buy or sell the rate prevailing inMarket Order-Buy or sell the rate prevailing in

the market at the time of placing the order.the market at the time of placing the order.

Limit Order-Buy/Sell order at specified time limitLimit Order-Buy/Sell order at specified time limit

irrespective of the rate prevailing in the marketirrespective of the rate prevailing in the marketat the time of placing order.at the time of placing order.

Stop loss order-Order where the trader wants toStop loss order-Order where the trader wants to

restrict his loss by specifying the limit for closingrestrict his loss by specifying the limit for closing

his deal.his deal.


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Market-if-Touched order: These areMarket-if-Touched order: These aresimilar to stop loss order.This will becomesimilar to stop loss order.This will becomemarket order if certain price is reached.market order if certain price is reached.

Example:sell when Wipro Future reachesExample:sell when Wipro Future reachesRs.2500.Rs.2500. Spread order-when customer order to buySpread order-when customer order to buy

future in one delivery month and sell infuture in one delivery month and sell inanother delivery month, they are termedanother delivery month, they are termedas spread order.as spread order.


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Scale Order-when customer wishes toScale Order-when customer wishes to

make a gradual entry or exit from themake a gradual entry or exit from the

market rather than execute the trade atmarket rather than execute the trade at

just one price.just one price.


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Strike Price/Exercise Price: It is the priceStrike Price/Exercise Price: It is the price

at which the contract is entered into.at which the contract is entered into.

There can be several strike prices at whichThere can be several strike prices at which

one can enter into in contract in theone can enter into in contract in theoption market.option market.

Spot price: The spot price of theSpot price: The spot price of the

underlying asset in the cash market..underlying asset in the cash market..


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Types of MarginTypes of Margin

Initial MarginInitial Margin

Mark to Market MarginMark to Market Margin

Maintenance MarginMaintenance MarginAdditional MarginAdditional Margin

Cross MarginCross Margin


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Initial MarginInitial Margin

Whenever a client (both buyer & seller)Whenever a client (both buyer & seller)

books future contract he is required tobooks future contract he is required to

deposit a certain % of contract price(Ex-deposit a certain % of contract price(Ex-

20%) as margin money which is called20%) as margin money which is calledinitial margin.initial margin.


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Variation/Mark to market marginVariation/Mark to market margin

It is paid to/received from the client dailyIt is paid to/received from the client daily

and is calculated on the basis of dailyand is calculated on the basis of daily

settlement price.settlement price.


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Maintenance MarginMaintenance Margin

Some exchange in the world work on theSome exchange in the world work on the

system of maintenance margin, which issystem of maintenance margin, which is

set at a level slightly less than initialset at a level slightly less than initial

margin. The margin is required to bemargin. The margin is required to bereplenished to the level of initial margin,replenished to the level of initial margin,

only if the margin level drops below theonly if the margin level drops below the

margin limit.margin limit.


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For example if the initial margin is fixed atFor example if the initial margin is fixed at

100 and maintenance margin is 80 then100 and maintenance margin is 80 then

the broker is permitted to trade till suchthe broker is permitted to trade till such

time limit that the balance in this initialtime limit that the balance in this initialmargin account 80 or more. If it dropsmargin account 80 or more. If it drops

below 80 say it drops to 70 then a marginbelow 80 say it drops to 70 then a margin

of 30(and not 10) is to be paid toof 30(and not 10) is to be paid toreplenish the levels of initial margin.replenish the levels of initial margin.


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Additional MarginAdditional Margin

In case of sudden higher than expectedIn case of sudden higher than expected

volatility ,additional margin may be calledvolatility ,additional margin may be called

by the exchange. This is generallyby the exchange. This is generally

imposed when the exchange fears thatimposed when the exchange fears thatthe market have become too volatile andthe market have become too volatile and

may result in some crises, like paymentmay result in some crises, like payment

crisis.crisis.


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Cross MarginCross Margin

This is a method of calculating marginThis is a method of calculating margin

money account balance and this takes intomoney account balance and this takes into

account combined position in future,account combined position in future,

Option, Cash market etc. Hence the totalOption, Cash market etc. Hence the totalmargin requirement reduces due to crossmargin requirement reduces due to cross

hedges.hedges. It is also not use in India.It is also not use in India.


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Comparison of Stock Market and commodity marketComparison of Stock Market and commodity market

Stock Markettock Market Commodity Marketommodity Market

Future trading Settlement at Every Last MonthFuture trading Settlement at Every Last Month

of Thursdayof ThursdayDifferent dates (As.Metal 5Different dates (As.Metal 5thth of the nextof the next

month, Agriculture Product 20month, Agriculture Product 20thth of theof the

month, Electricity 15month, Electricity 15thth of the month)of the month)

Time 9.30 to 3.30Time 9.30 to 3.30 10am to 11.55pm10am to 11.55pm

Monday to FridayMonday to Friday Monday to SaturdayMonday to Saturday

Future trading available only upto 3 monthsFuture trading available only upto 3 months Future trading available only upto 10-12Future trading available only upto 10-12

monthsmonths

Delivery not possibleDelivery not possible Delivery also possible.Delivery also possible.

Top cities-Ahemdabad,Mumbai,Delhi.Top cities-Ahemdabad,Mumbai,Delhi. Top cities-Ahemdabad, Rajkoat,IndoreTop cities-Ahemdabad, Rajkoat,Indore

Controlled by SEBIControlled by SEBI Controlled by FMC (forward MarketControlled by FMC (forward Market

Commission)Commission)

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Derivatives 110918074157 Phpapp01