The Derivatives Market Sessions 13 and 14

Objectives
To understand:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Meaning of Derivatives Economic benefits of Derivatives History of Derivatives Trading Need for financial derivatives Types of financial derivatives Distinctive features of derivatives market Exchange traded v/s OTC derivatives market Traders in derivatives market Forwards and Futures Options Derivatives trading in India

Derivative Defined
Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index or reference rate) in a contractual manner The underlying asset can be equity, forex, commodity or any other asset

Types of Financial Derivatives

Forwards Futures Options Warrants Swaps Swaptions

Products
Futures and Forwards
an agreement between two entities, where settlement takes place on a specified date in the future as todays pre-agreed price

Options
Call - gives 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 given future date Put gives the buyer the right but not the obligation to sell the a given quantity of the underlying asset at a given price on or before a given date

Forward contracts : Features

Bilateral Custom designed settled by delivery help in hedging foreign exchange rate fluctuation risks. non tradable can be reversed only with the same counter party possibility of default

Futures Contracts : Features

exchange traded forward contracts standardised specification Transparent Liquid marked to market daily Flexible can be reversed with any member no credit risk regulated

Forward Contracts vs Futures Contracts

FORWARDS FUTURES

Private contract between 2 parties

Non-standard contract Usually 1 specified delivery date

Exchange traded
Standard contract Range of delivery dates

Delivery or final cash settlement usually occurs

Some credit risk

Contract usually closed out prior to maturity

Virtually no credit risk

Traders in Derivatives market

- Hedger- enters the market to reduce risk

- Speculator enters the market to make profit

- Arbitrageur enters the market to make profit from relative mispricing in two markets.

Need for futures market

-Allows hedging against price changes - Helps in price discovery - helps in optimal allocation of resources - speedier and less costly

Products
Futures
an agreement between two entities, where settlement takes place on a specified date in the future as todays pre-agreed price

Options
Call - gives 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 given future date Put gives the buyer the right but not the obligation to sell the a given quantity of the underlying asset at a given price on or before a given date

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Types of Options
Call option right to buy Put option right to sell European -style options exercised only on the maturity date American- style options exercised any time before and on the expiry date

Features of Options
- Fixed maturity date - Exercise price - Option writer : seller of an option - Option premium - Value of option i.e. premium depends on : exercise price, time of expiration, price of the asset, variance of returns of the asset, risk free rate and dividends expected

Moneyness
http://www.nseindia.com/live_market/dynaContent/live_watch/fxTracker/optChainDataByExpDates.jsp

Moneyness
Call Option Put Option
Spot price of Spot price of underlying asset underlying asset In-the-money > Strike price < Strike price (S>X) (S<X) Spot price of Spot price of underlying underlying At-the-money* asset=Strike asset=strike price. price. Spot price of Spot price of * Out-of-theunderlying asset underlying asset money < Strike price > Strike price (S<X) (S>X).

When market price is very near to the strike price, option is called near-the-money option

Pay-off Profile of Call Stock Options

Pay-off Profile of Put Options

Comparing Futures and Options

Futures
Obligation to buy/sell Symmetric risk profile for both buyer & seller Price of the underlying asset is the major influencer No costs to enter into a futures contract Less regulatory complexities

Options
Right to buy/sell Asymmetric risk profile for both seller and buyer Prices exposed to a number of dimensions Premium to be paid More regulatory complexities

OTC derivatives
via telephone, fax and electronic means more flexible than exchange traded absence of regulatory authority create turbulence in financial system In India, illegal

Economic benefits of Derivatives

- Reduce risk - Enhance liquidity - Lower transactions costs - Enhance price discovery process - Hedge stock portfolio - Provide information

Need for financial derivatives

Shift three types of price risk
- Market risk - Interest rate risk - Exchange rate risk

History of Derivatives Trading

In ancient Greece and Rome forward delivery contracts existed. Chicago Board of Trade (CBOT), first formal commodities exchange set up in 1848 Emergence of formal futures commodities trading in 1860s Chicago Mercantile Exchange (CME) formed in 1919 Stock index futures and options emerged in 1982 First account of options published in Aristotle Polictics in332 BC First call and put options in 1872 Chicago Board Options Exchange (CBOE) set up on April 26, 1973

Derivatives Trading in India

At present,179 scrips are traded in the derivatives segment - Sectoral indices permitted for derivatives trading in December 2002 - Trading in - - Stock Index Options - Individual Stock options - Stock Index Futures - Stock Futures

Derivative markets in India

Milestone Index Futures Trading Index Options Trading Individual stock options Individual stock futures Date June 2000 June 2001 July 2001 November 2001

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