Derivatives daksha pathak

Derivatives daksha pathak

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  DERIVATIVES INTRODUCTION MS. DAKSHAPATHAK Assistant Professor Department of Financial studies IIS (Deemed to be) University , JAIPUR
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  INTRODUCTION • The term“derivatives” is used to refer to financial instruments which derive their value from some underlying assets. • The underlying assets could be equities (shares), debt (bonds, T-bills, and notes), currencies, and even indices of these various assets, such as the Nifty 50 Index. • Derivatives contracts are bought and sold by a large number of individuals, institutions and other’s for a variety of purposes. • When the price of the underlying changes, the value of the derivative also changes. • A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Example : The value of a gold futures contract is derived from the value of the underlying asset i.e. Gold.
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  DEFINITION • According toSecurities Contracts (Regulation) Act, 1956 {SC(R)ACT derivatives is: • 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. • Derivatives are securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act.
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  FUNCTIONS OF DERIVATIVESMARKET • Risk management- Stop loss • Transfer of risk • Price discovery • Transitional efficiency - low transaction cost compare to rest like, brokerage, commission, regulatory costs and margin requirements • Financial Engineering- as it is new field creating calls, puts, futures and other derivatives
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  ADVANTAGES OF DERIVATIVES •Since all transactions related to derivatives take place in future it provides individuals with better opportunities because an individual who want to short some stock for long time can do it only in futures or options hence the biggest benefit of this is that it gives numerous options to an investor or trader to execute all sorts of strategies. • In derivatives market people can transact huge transactions with small amounts and therefore it gives the benefit of leverage and hence even people who have less amount of money can enter into this market. • Intraday traders get the benefit of liquidity as these contracts are very liquid and also the costs such as basis expense, brokerage are less as compared to cash market. • It is a great risk management tool and if applied judiciously it can produce good results and benefit its user.
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  DISADVANTAGES OF DERIVATIVES •Leverage is a double edged sword and therefore if you do not get it right chances are you wound end up losing huge amount of money because these contracts have specific maturities and on that date they get expired unlike cash market where you can hold on to stocks for long period of time. • Since its inception many critics have been blaming derivatives for huge fall which keeps happening frequently after the introduction of derivatives and many people say that it increases unnecessary speculation in the market which is not good for the small retail investors who are the backbone of stock market. • It is quite complex and various strategies of derivatives can be implemented only by an expert and therefore for a layman it is difficult to use this and therefore it limits its usefulness
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  MARKET PLAYERS/PARTICIPANTS/TRADERS IN DERIVATIVE MARKET
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  HEDGERS • Hedge isthe position taken in derivative exchange/markets for the purpose of reducing risk. A person who takes such position is called hedger. • A hedger uses the derivatives market to reduce risk caused by movement in prices of shares/securities, commodities, exchange rates, interest rate, indices, etc. • The position taken by hedger is opposite to the risk he is exposed. • Taking an opposite position to the risk exposure is called hedging strategy
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  SPECULATORS • A speculatormay be defined as a investor who is willing to take a risk by taking derivatives position with the expectation to earn profits. • The speculator forecasts the future economic conditions and decides which position (long or short) to be taken will yield a profit if his forecast is correct
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  ARBITRAGEUR • An arbitrageuris an intelligent trader who attempts to make profits in a derivatives market by simultaneously entering into two transaction at a time in two different markets and takes advantage of the difference in pricing. • The arbitrage opportunities available in two markets usually do not last long because of heavy transaction by arbitrageur when such opportunity arises.
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  TYPES OF DERIVATIVEMARKETS • Exchange Traded Derivatives: Derivatives which are traded on an exchange are called exchange traded derivatives. Trades on an exchange generally take place with anonymity i.e. buyer and seller do not know each other. Generally go through the clearing corporation. E.g. S&PCNX nifty futures, OPTINDX nifty. • OTC Derivatives: A derivative contract which is privately negotiated is called the OTC derivative. OTC trades have no anonymity and they generally do not go through a clearing corporation. E.g. foreign exchange transaction between banks and its cliants.
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  What is aForward? • A forward is a contract in which one party commits to buy and the other party commits to sell a specified quantity of an agreed upon asset for a pre-determined price at a specific date in the future. • It is a customized contract, in the sense that the terms of the contract are agreed upon by the individual parties. • Hence, it is traded OTC. Risks in Forward Contracts • Credit Risk – Does the other party have the means to pay? • Operational Risk – Will the other party make delivery? Will the other party accept delivery? • Liquidity Risk – Incase either party wants to opt out of the contract, how to find another counter party? Terminology • Long position - Buyer • Short position - seller • Spot price – Price of the asset in the spot market.(market price) • Delivery/forward price – Price of the asset at the delivery date
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  What are Futures? •A future is a standardized forward contract. • It is traded on an organized exchange. • Standardizations- - quantity of underlying - quality of underlying(not required in financial futures) - delivery dates and procedure - price quotes • Types of Futures Contracts • Stock Futures Trading (dealing with shares) • Commodity Futures Trading (dealing with gold futures, crude oil futures) • Index Futures Trading (dealing with stock market indices)
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  Terminology • Contract size– The amount of the asset that has to be delivered under one contract. All futures are sold in multiples of lots which is decided by the exchange board. Eg. If the lot size of Tata steel is 500 shares, then one futures contract is necessarily 500 shares. • Contract cycle – The period for which a contract trades. The futures on the NSE have one (near) month, two (next) months, three (far) months expiry cycles. • Expiry date – usually last Thursday of every month or previous day if Thursday is public holiday. • Strike price – The agreed price of the deal is called the strike price. • Cost of carry – Difference between strike price and current price.
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  Margins • A marginis an amount of a money that must be deposited with the clearing house by both buyers and sellers in a margin account in order to open a futures contract. • It ensures performance of the terms of the contract. • Its aim is to minimise the risk of default by either counterparty. • Initial Margin - Deposit that a trader must make before trading any futures. Usually, 10% of the contract size. • Maintenance Margin - When margin reaches a minimum maintenance level, the trader is required to bring the margin back to its initial level. The maintenance margin is generally about 75% of the initial margin Marking to Market • This is the practice of periodically adjusting the margin account by adding or subtracting funds based on changes in market value to reflect the investor’s gain or loss. • This leads to changes in margin amounts daily. • This ensures that there are no defaults by the parties.
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  Options • Contracts thatgive the holder the option to buy/sell specified quantity of the underlying assets at a particular price on or before a specified time period. The word “option” means that the holder has the right but not the obligation to buy/sell underlying assets. Types of Options • Options are of two types – call and put. • Call option give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a particular date by paying a premium. • Puts give the buyer the right, but not obligation to sell a given quantity of the underlying asset at a given price on or before a particular date by paying a premium. Types of Options • The other two types are – European style options and American style options. • European style options can be exercised only on the maturity date of the option, also known as the expiry date. • American style options can be exercised at any time before and on the expiry date
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  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.
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  Options Terminology • Underlying:Specific security or asset. • Option premium: Price paid. • Strike price: Pre-decided price. • Expiration date: Date on which option expires. • Exercise date: Option is exercised. • Open interest: Total numbers of option contracts that have not yet been expired. • Option holder: One who buys option. • Option writer: One who sells option. • Option class: All listed options of a type on a particular instrument. Option series: A series that consists of all the options of a given class with the same expiry date and strike price. • Put-call ratio: The ratio of puts to the calls traded in the market.
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  SWAPS • In aswap, two counter parties agree to enter into a contractual agreement wherein they agree to exchange cash flows at periodic intervals. • Most swaps are traded “Over The Counter”. • Some are also traded on futures exchange market. Types of Swaps • There are 2 main types of swaps: • Plain vanilla fixed for floating swaps or simply interest rate swaps. • Fixed for fixed currency swaps or simply currency swaps
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  Interest Rate Swap •A company agrees to pay a pre-determined fixed interest rate on a notional principal for a fixed number of years. • In return, it receives interest at a floating rate on the same notional principal for the same period of time. • The principal is not exchanged. Hence, it is called a notional amount. Floating Interest Rate • LIBOR – London Interbank Offered Rate • It is the average interest rate estimated by leading banks in London. • It is the primary benchmark for short term interest rates around the world. • Similarly, we have MIBOR i.e. Mumbai Interbank Offered Rate. • It is calculated by the NSE as a weighted average of lending rates of a group of banks.
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  Currency Swap • Itis a swap that includes exchange of principal and interest rates in one currency for the same in another currency. • It is considered to be a foreign exchange transaction. • It is not required by law to be shown in the balance sheets. • The principal may be exchanged either at the beginning or at the end of the tenure. • However, if it is exchanged at the end of the life of the swap, the principal value may be very different. • It is generally used to hedge against exchange rate fluctuations.
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  The other kindof derivatives, which are not, much popular are as follows : • BASKETS - Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets. • LEAPS – Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.(created by investor who writes an option and keep the premium as income) • WARRANTS - Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.(directly issued by the company) • 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.