Derivatives market
- 1. Derivatives Market Financial Markets Tejaswi Kare 19MBMA32 Sandeep Ammula 19MBMA33
- 2. Derivative Meaning:- a contract whose value is derived from the value of another asset, known as the underlying- a share, an index, an interest rate, a commodity, or a currency. is defined under the Securities Contracts (Regulation) Act, 1956 as ● 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 prices or index of prices of underlying securities. Ex. 1 Consider Insurance which provides protection against specific risks such as fire, floods, theft, accident, & health. This is done by paying premiums(calculated based on life of the asset) to the concerned insurance company. Result is, financial burden has been mitigated & diversified for each of the risks. Ex. 2 Consider the advance paid (premium) for booking a flat in an apartment to be constructed . Scenario 1- low demand saw slump in flat prices, the buyer made the decision to sell that flat for discount. The person who sold the flat transferred the risk whereas the person who purchased it took the risk hoping that flat prices will find appreciation. Scenario 2- high demand for flats saw rocketing in flat prices, the buyer made the decision to sell the flat for the appreciation it received. The seller sold it due to exorbitant price assuming it might fall in future whereas the person who purchased it assumed the price will be still move upside.
- 3. Significance:- it offers a mechanism for hedging risks. Need:- facilitates in shifting risks or to diversify the risks from those ‘who have it but may not want it’ to ‘those who have appetite and are willing to take it.’ 3 broad types of risks- ● Market (Systematic Risk)- Market sentiments may push prices in upward direction or pull down the prices from time to time. ● Interest Rate- prices of fixed income securities may heavily fluctuate due to the sensitive nature towards changes in interest rates. ● Exchange Rate- Imports/Exports or Foreign loans/Investments involves currency exchange. When derivatives are employed wisely, they make the world simpler because they give their buyers an ability to manage and transfer risk -Carol Loomis
- 5. Derivatives offered, that are traded on exchanges:- Currency pairs Minor/Exotic- USD/INR, GBP/INR, JPY/INR, EUR/INR Major- USD/JPY, GBP/USD, EUR/USD Interest Rates 07.68 GS 2023, 05.79 GS 2030, 05.85 GS 2030, 07.95 GS 2032, 06.19 GS 2034, 06.68 GS 2031, 07.17 GS 2028, 07.26 GS 2029, 07.27 GS 2026, 07.57 GS 2033, 06.45 GS 2029. Non-Agri commodities Precious-Metals- Gold- also in Mini, Guinea; Silver- also in Mini & Micro; Diamond. Base-Metals- Aluminium, Lead, Nickel, Copper, & Zinc; Steel Long. Energy- Brent Crude Oil, Natural Gas. Agri Commodities Cereals & Pulses- Wheat, Barley, Paddy(Basmati), Maize, Moong, Chana & Bajra. Spices- Black Pepper, Cardamom, Turmeric, Jeera, Coriander. Oil Seeds- Castor, Soybean, Mustard, Cotton. Fibre- Cotton, Raw Jute. Plantation- Rubber.
- 6. Derivatives BSE NSE Index futures June 9, 2000 June 12, 2000 Index options June 1, 2001 June 4, 2001 Options on individual securities July 9, 2001 July 2, 2001 Futures on individual securities November 9, 2002 November 9, 2001 No. of individual securities 140 156 Currency/FX futures October 1, 2008 August 29,2008 Currency/FX options NA October 10, 2010 Cross-Currency futures NA February 27, 2018 FINNIFTY is the latest index offered to trade in futures and options based on its underlying index FINNIFTY.
- 7. EXCHANGE Commenced Regulator MCX 2003 SEBI Metals- Precious, Base; Energy- Crude Oil, Natural Gas; Agri-Commodities- Spices, Plantation, Oil Seeds, Fibre. NCDEX 2015 SEBI Cereals & Pulses, Fibre, Spices, Oil Seeds, Soft Gaur, Gaur Complex; Steel Long ICEX 2015 SEBI Spices, Oil Seeds, Plantation, Fibre, Cereals; Metals- Diamond, Steel Long INDIAINX 2017 SEBI Equity, Currency; Metals- Precious, Base; Energy- Brent Crude Oil MSE 2012 SEBI, RBI Equity, Currency Futures Industry Association World Federation of Exchanges Associate members: Indian Commodity Exchange Ltd. Multi-Commodity Exchange Ltd. National Stock Exchange of India National Commodity & Derivatives Exchange Ltd. Member National Stock Exchange of India Affiliate Indian Commodity Exchange Ltd. Do we have to regulate derivatives? Yes, we do. Cause when I did this in my investments, frankly, no one knew who could pay who. But derivatives has important palace in our economy. - Jeff Greene https://www.sebi.gov.in/stock-exchanges.html From 2015 SEBI has been the regulator for Commodity markets after the Forwards Markets Commission was merged with it.
- 8. NSE has been ranked 1st consecutively for 2nd time (Derivatives contracts) in terms of No. of Volumes
- 10. Growth fuelled by ● The increased volatility in global financial markets. (Financial crisis- recession, Depression) ● The technological changes enabled low-cost communications (OTE) and computing power (BSE - median trade speed 6 μ sec) ● Choice of strategies and instruments provide optimal combination of risk and returns. ● Government more of facilitator by moving towards market-oriented policies and the deregulation in financial markets that has increased the risk at the individual level. Government's plan to consolidate the provisions of SEBI Act, 1992, Depositories Act, 1996, Securities Contract (Regulation) Act, 1956 and Government Securities Act, 2007 into single securities market code. ● Increased integration of domestic financial markets with international markets. Establishment of India INX
- 11. Economic Benefits ● Reduce Risk - hedging ● Enhance liquidity of the underlying asset - participation of large number of players. ● Lower transaction costs - than the underlying asset ● Enhance price discovery process - reflect the perception of market participants that in-turn leads to the perceived future price of the underlying- breaking of Circuit Limits ● Portfolio Management - choice of hedging with a unique risk/return to meet the requirements of the market participants ● Provide signals of market movements - to cash markets as to where the markets heading ● Facilitate financial markets integration - Global Securities Market, India’s first international primary market platform connecting global investors with Indian and foreign issuers.
- 12. Derivative Features ● Highly leveraged market ● Dependent on market view for booking gains/losses ● Have definite lifespan i.e., fixed expiration date ● Investor can take both the long and short positions on the same asset at the same time ● Higher degree of risk than stocks ● Flexibility, investors can capitalize on bearish view ● Margin-based trading makes it more attractive Derivatives are financial weapons of mass destruction - Warren Buffet Exchange-traded Derivatives L.C. Gupta committee recommended only exchange traded derivatives and no reference was made to the OTC derivatives. Note: Recently RBI made draft on OTC related products for responsibility and accountability of organisations involved and adequate & effective measures towards the regulatory compliance and also measures to observe from internal as well as external audit. https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=3933
- 13. The National Securities Clearing Corporation Limited (NSCCL) undertakes clearing & settlement of all deals executed on the NSE’s (F&O) segment. https://www.sebi.gov.in/clearing-corporations.html
- 15. Share of average daily trading volume of derivatives in India
- 16. Participants Domestic Institutional Investors Foreign Institutional Investors Corporates Proprietary Traders Individual Investors - Individual Domestic investors, NRI’s, Sole proprietorship firms and HUF’s Partnership Firms,/LLP’s, Trust/Society, Alternative Invest Fund, Depository Receipts, PMS Clients, Statutory Bodies, FDI, OCB, QFI’s, VC Funds & NBFC’s Note: Mutual Funds whose existing schemes have not envisaged investments in derivatives market are subject to following conditions: I. The extent and the manner of the proposed participation in derivatives shall be disclosed to the unit holders II. The risks associated with such participation shall be disclosed and explained by suitable numerical examples III. Prior to commencing participation in derivatives, the scheme shall comply with the provisions of Regulation 18 (15A) of SEBI (Mutual Funds) Regulations, 1996 and all unit holders shall be given at least 30 days to exercise option to exit at prevailing NAV with charging of exit load.
- 17. Few prescribed eligibility criteria for introduction of derivatives on stocks and indices given by SEBI A. A stock to be part of Top 500 stocks in terms of average daily market market capitalization and average daily traded value in the previous six months on a rolling basis B. The stock’s median quarter sigma order size over the last six months shall be not less than ₹25 Lakhs and C. The market wide position limit (MWPL) in the stock shall not be less than ₹500 cr. on a rolling basis. For equity derivatives https://www.nseindia.com/products-services/equity-derivatives- selection-criteria Selection Criteria to be traded as derivatives
- 20. Traders Hedger Reduce the asset risk by entering a position in derivatives Offset the risk Speculator Buy or Sell the derivative without actually owning it High risk Appetite Arbitrageur Buy the asset and sell the futures simultaneously Exploit the imperfections in the market ❖ Enable the smooth functioning of the market ❖ Provide liquidity and depth to the market ❖ Enable price discovery Note: Basis: The difference between cash price and the futures prices of a particular good Contango: Futures contracts are priced above the expected spot price Backwardation: Futures contracts price prevail below the expected future spot price.
- 21. Instruments ● Forwards ● Futures ● Option ● Warrants ● Swaps ● Swaptions
- 22. Forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. For Example: If A has to buy a share 6 months from now. and B has to sell a share worth Rs.100. So they both agree to enter in a forward contract of Rs. 104. A is at “Long Position” and B is at “Short Position” Suppose after 6 months the price of share is Rs.110. so, A overall gained Rs. 4 but lost Rs. 6 while B made an overall profit of Rs. 6. Why Forwards contracts ● They are customized contracts unlike futures ● Tailor-made and more suited for certain purpose ● Useful when Futures do not exist for commodities and financial being considered ● Useful in cases futures standard may be different from the actual
- 23. is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price ) with delivery occurring at a specified future date, the delivery date . Since such contract is traded through exchange, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin Future contracts Characteristics of Futures contracts ● Futures are highly standardised contracts that provide for performance of contracts through either deferred delivery of asset or final cash settlement. ● These contracts trade on organized futures exchanges with a clearing association that acts as a middleman between the contracting parties. ● Contract seller is called ‘short’ and buyer ‘long’. Both parties pay margin to the clearing association. This is used as performance bond by contracting parties Margins paid are generally marked to market price everyday; ● Each Futures contract has an associated month that represents the month of contract delivery or final settlement. These contracts are identified with their delivery months like ITC MAY FUT. ● Every futures contract represents a specific quantity. It is not negotiated by the parties to the contract
- 26. Swap contracts The derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. Types of Swaps ❖ Currency swaps ❖ Commodity swaps ❖ Equity Swaps
- 27. Options contract An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. Features of Options ● A fixed maturity date on which they expire (Expiry date). ● The price at which the option is exercised is called the exercise price or strike price. ● The person who writes the option and is the seller is referred as the “option writer”, and ● who holds the option and is the buyer is called “option holder”. ● The premium is the price paid for the option by the buyer to the seller. ● A clearing house is interposed between the writer and the buyer which guarantees performance of the contract.
- 28. Terminologies Call Option: Right but not the obligation to buy Put Option: Right but not the obligation to sell Option Price: The amount per share that an option buyer pays to the seller Expiration Date: The day on which an option is no longer valid Strike Price: The reference price at which the underlying may be traded Long Position: Buyer of an option assumes long position Short Position: Seller of an option assumes short position. Factors affecting Value of Option I. Price movement of the Underlying II. Time till expiry III. Volatility in Stock prices (IV)
- 29. Options Call Put In- the-money Spot Price of Underlying Asset > Strike Price (S>X) Spot Price of Underlying Asset < Strike Price (S<X) At-the-money Spot Price of Underlying Asset = Strike Price (S=X) Spot Price of Underlying Asset = Strike Price (S=X) Out-of-the-money Spot Price of Underlying Asset < Strike Price (S<X) Spot Price of Underlying Asset > Strike Price (S>X)
- 30. Option trading strategies Option spreads Taking positions in two or more options of the same type. Example. Buying a call and selling another call either with different strikes or different expiration. Buy 10700 CE AUG 2020 Sell 10800 CE AUG 2020 Why? Reduce the risk And also limits the profit Types of spreads
- 31. Vertical spreads Same expiry but different strike prices. 1. Bull spread It's created by buying a low strike price and selling a high strike price option. Designed to profit if the price goes up. Example. Spot price 10730 Buy nifty 10750CE - 67 Sell nifty 10850CE -28 = -39
- 32. 2. Bear spread Created by buying a high strike option and selling a low strike option. Designed to profit if the market goes down. Example: spot price 11455 Buy nifty 11500 CE SEP 2020 @112 Sell nifty 11300CE SEP 2020 @ 241 = 129
- 33. Diagonal spread It's combination of both vertical and horizontal. Both expiration and strike prices are different. A Diagonal bull spread is adopted when investor is bearish in short term and bullish in long term A Diagonal bear spread is adopted when investor thinks market will be flat or slight rally but will fall in long term Horizontal spread Same strike price but different expiration dates. It's used by the investors who thinks the market will be weak in short term and bullish in the long term. Can be created by selling a short maturity call option with certain strike price and buying a longer maturity call option with the same strike price.
- 35. Thank You Q & A Time