Derivatives. | Know the details of Derivatives Market.

 

Derivative meaning

A derivative refers to a financial product whose value is derived from another. A derivative is always created with reference to the other product, also called the underlying.

A derivative is a risk management tool used commonly in transactions where there is risk due to an unknown future value. For example, a buyer of gold faces the risk that gold prices may not be stable. When one needs to buy gold on a day far into the future, the price may be higher than today. The fluctuating price of gold represents risk. Gold represents the ‘underlying’ asset in this case. A derivative market deals with the financial value of such risky outcomes. A derivative product can be structured to enable a pay-off and make good some or all of the losses if gold prices go up as feared.

Derivatives are typically used for three purposes: hedging, speculation and arbitrage.

Hedging

When an investor has an open position in the underlying, he can use the derivative markets to protect that position from the risks of future price movements.

Example: An investor has saved for the education of his child. The portfolio is made up of an index fund that invests in the Nifty 50. The investor has been systematically investing in this product over the last 15 years. In the next three months, the child would enter college and the investor is keen to liquidate the investment to fund the education expense. The current value of the investment is Rs.10 lakhs. The risk the investor faces is that the value of the portfolio will reduce over the three months if there is fall in the market index. The investor can enter into a contract to sell his portfolio three months from now, at a price to be determined today. By doing this the investor has hedged or insured himself against the risk of a decrease in the value of the portfolio.

Speculation

A speculative trade in a derivative is not supported by an underlying position in cash, but simply implements a view on the future prices of the underlying, at a lower cost.

Example: A speculator believes that the stock price of a particular company will go up from Rs. 200 to Rs. 250 in the next three months and wants to act on this belief by taking a long position in that stock. If he buys 100 shares of this company in spot market (delivery), he needs Rs.200 x 100 = Rs.20,000 to enter into this position. If his prediction comes true and the stock price moves up from Rs.200 to Rs.250, he will make a profit of Rs.50 per share and total profit of Rs.50 x 100 shares = Rs.5,000 over an investment of Rs.20,000 which is a return of 25%.

Alternatively, he can take a long position in that stock through futures market as well. Suppose he buys a three months futures contract of that stock (1 lot of 100 shares), he need not pay the full amount today itself and pays only the margin amount today. If the margin required for this stock is 10%, then he needs Rs.200 x 100 x 10% = Rs.2000 to take this long position in futures contract. If the stock price moves to Rs.250 at the end of three months, he makes a profit of Rs.50 x 100 = Rs.5000 from this contract. Since his initial investment was only Rs.2000, his returns from the futures position will be 5,000/2,000 = 250%. This difference in returns between the spot position and futures position is due to the leverage provided by the futures contracts. This leverage makes the derivatives a preferred product of speculators. However, the same leverage makes the derivatives products highly risky. If the market had moved against his prediction, the losses that investor would have incurred would have been many times the loss on the spot market position.

Arbitrage

If the price of the underlying is Rs.100 and the futures price is Rs.110, anyone can buy in the cash market and sell in the futures market and make the riskless profit of Rs.10. This is called arbitrage. 

The Rs.10 difference represents the cost of buying at Rs.100 today, selling at Rs.110 in the future, and repaying the amount borrowed to buy in the cash market with interest.

Arbitrageurs are specialist traders who evaluate whether the Rs.10 difference in price is higher than the cost of borrowing. If yes, they would exploit the difference by borrowing and buying in the cash market, and selling in the futures market at the same time (simultaneous trades in both markets). If they settle both trades on the expiry date, they will make the gain of Rs.10 less the interest cost, irrespective of the settlement price on the contract expiry date, as long as both legs settle at the same price.

After necessary approvals from SEBI, derivative contracts in Indian stock exchanges began trading in June 2000, when index futures were introduced by the BSE and NSE. In 2001, index options, stock options and futures on individual stocks were introduced. India is one of the few markets in the world where futures on individual stocks are traded. Equity index futures and options are among the largest traded products in derivative markets world over. In the Indian markets too, volume and trading activity in derivative segments is far higher than volumes in the cash market for equities. Other highly traded derivatives in global markets are for currencies, interest rates and commodities.

Futures

A futures is a contract for buying or selling a specific underlying, on a future date, at a price specified today, and entered into through a formal mechanism on an exchange. The terms of the contract (such as order size, contract date, delivery value and expiry date) are specified by the exchange.

Example:

• FUTIDX NIFTY 23 Feb 2018 is a futures contract on the Nifty index that expires on 23rd Feb 2018.
• The value is 8075, which means a buyer or seller agrees to buy or sell Nifty for a delivery value of 8939 on a future date.
• It is available to trade from the date it is introduced by the exchange to its expiry date on 23rd Feb 2018.
• On expiry, the settlement price at which this future contract will be settled may be higher or lower than 8939. If it is higher, any investor who had bought the future contract at a price of 8939 would have made profits and a seller at that price would have made losses. If the settlement price is lower, then the situation is reversed for the buyer and seller. 

A futures contract can be bought or sold on the exchange in the derivative segment of the market. Orders placed by buyers and sellers on the electronic trading screen are matched. The price of the futures contract moves based on trades, just as it does in the cash or spot market for stocks. 

An important feature of an exchange-traded futures contract is the clearing house/corporation. The counterparty for each transaction is the clearing-house/clearing corporation. Buyers and sellers are required to maintain margins with the clearing-house, to ensure that they honour their side of the transaction. The counterparty risks are eliminated using the clearing-house/corporation mechanism.

Options

Options are derivative contracts, which splice up the rights and obligations in a futures

contract. The buyer of an option has the right to buy (in case of “call”) or sell (in case of “put”) an underling on a specific date, at a specific price, on a future date. The seller of an option has the obligation to sell (in case of “call”) or buy (in case of “put”) an underlying on a specific date, at a specific price, on a future date. An option is a derivative contract that enables buyers and sellers to pick up just that portion of the right or obligation, on a future date.

A buyer of an option has the right to buy (in case of call) or sell (in case of put) the underlying at the agreed price. He is however not under obligation to exercise the option. The seller of a call option has to complete delivery as per the terms agreed. For granting this right to the buyer, the seller collects a small upfront payment, called the option premium, when he sells the option.

A call option represents a right to buy a specific underlying on a later date, at a specific price decided today. A put option represents a right to sell a specific underlying on a later date, at a specific price decided today.

Option Terminology

Arvind buys a call option on the Nifty index from Salim, to buy the Nifty at a value of 8900, one month from today. Arvind pays a premium of Rs.85 to Salim. What does this mean?

• Arvind is the buyer of the call option.
• Salim is the seller or writer of the call option.
• The contract is entered into today, but will be completed one month later on the settlement date.
• 8900 is the price Arvind is willing to pay for Nifty, one month from today. This is called the strike price or exercise price.
• Arvind may or may not exercise the option to buy Nifty at 8900 on the settlement date.
• But if he exercises the option, Salim is under obligation to sell the Nifty at 8900 to Arvind.
• Arvind pays Salim Rs.85 as the upfront payment. This is called the option premium. This is also called as the price of the option.
• On settlement date, Nifty is at 9000. This means Arvind’s option is “in the money.” He can buy the Nifty at 8900, by exercising his option.
• Salim earned Rs.85 as premium, but lost as he has to sell Nifty at 8900 to meet his obligation, while the market price is 9000.
• On the other hand, if on the settlement date, the Nifty is at 8800, Arvind’s option will be “out of the money.”
• There is no point paying 8900 to buy the Nifty, when the market price is 8800. Arvind will not exercise the option. Salim will retain the Rs.85 he collected as premium.

Buy a Call option:

This gives the buyer of the option the right to buy a security on a specified date in future at the specified price, also known as strike price. The buyer of option pays a premium to the seller of option (also known as writer). The buyer of the option exercises his right if on the specified date the strike price is lower than the market price (spot price) of the security.

Buy a Put option:

This gives the buyer of the option the right to sell a security on a specified date in future at the specified price (strike price). The buyer of option pays a premium to the seller of option. The buyer exercises the right if on the specified date the strike price is higher than the market price (spot price) of the security.

Sell a Call option:

This obligates the seller (writer) of the option to sell a security on a specified date in future at the specified price (strike price), if the buyer of the option exercises the right to transact. The seller of option receives a premium from the buyer of option. The buyer exercises the right if on the specified date; the strike price is lower than the market price (spot price) of the security.

Sell a Put option:

This obligates the seller (writer) of the option to buy a security on a specified date in future at the specified price (strike price), if the buyer of the option exercises the right to transact. The seller of option receives a premium from the buyer of option. The buyer exercises the right if on the specified date; the strike price is higher than the market price (spot price) of the security.

As seen from the above examples, option buyer has limited loss (premium paid) and

unlimited profit whereas option seller/writer has unlimited loss and limited profit (premium received). 

Structured products are hybrid securities that combine the features of debt and exchange traded derivatives. These products are typically privately placed and offer market linked returns on debt securities by taking exposure to derivatives. SEBI has prescribed eligibility and disclosure norms to protect the investors in such instruments. The products have to be mandatorily credit rated and will have the prefix- ‘PP-MLD’ followed by the rating assigned to it. The minimum allotment size for such products shall be Rs.10 lakhs in any issue. The issuer has to provide an analysis to the investors on the value of the security under different market conditions. The instrument should be valued by a credit rating agency and the value provided each week. The securities are listed on a stock exchange.

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