Agenda

Introduction to Derivatives Market Index Introduction To Future & Options Application of Future & Options Trading Clearing & Settlement

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Introduction to Derivatives

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Derivatives.

Are not dangerous

Unless misused

Are not necessarily risky

- They are often used to reduce risk - Can be understood without advanced mathematics

Are not only for rocket scientists

Are not scary

- As long as you take time to educate yourself

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Should not be used without understanding

Derivatives defined

Derivative products emerge as tool to reduce risk against uncertainties arising out of fluctuations in asset price. Derivative is a product, whose value is derived from the value of one or more basic

variable.

The underlying asset can be equity, forex, commodity or any other asset.

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Types of derivatives
Types
Forwards

Features
Customized contract between two entities Settlement takes place at a future date Agreement between two parties to buy or sell an asset at a certain time in the future at a certain price Standardized exchange-traded contracts Two types - calls and puts

Futures

Options

Calls give the buyer the right but not the obligation to buy

Puts give the buyer the right, but not the obligation to sell

Warrants LEAPS Swaps Swaptions

Longer-dated options are called warrants Generally traded Over The Counter (OTC) LEAPS means Long Term Equity Anticipation Securities Having a maturity of upto three years

Private agreements between two parties to exchange cash flows in the future according to a prearranged formula
Two commonly known swaps interest rate swaps and currency swaps Swaptions are options to buy or sell a swap
Version 1.0 The swaptions market has receiver swaptions and payer swaptions

Participants in the derivatives markets

Speculators- Bet on the future movements in the price of an asset Arbitrageurs Take advantage of a discrepancy between prices in two different markets

Hedgers- Face risk associated with the price of an asset

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Introduction to Future & Option

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Forward contracts
Salient features: Bilateral contracts and hence exposed to counter-party risk

Customized contract hence

Contract price not available in public domain On expiry, settlement is by delivery If the party wants to reverse the contract, it has to go to the same counterparty

Buyer

Seller

Limitations:

Lack of centralization
Illiquidity Counter party risk.
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Futures

A future contract is an agreement between two parties to buy or sell an asset, at a certain time in the future at certain price.

Future contracts are standardized and exchange traded.

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Future terminology

Spot price: The price at which an asset traded in spot market.

Future price: The price at which the futures contract trades in the futures market.
Contract cycle: The future contracts on the NSE have one-month, two-months ,and three-months expiry cycles, these expire on the last Thursday of specified month. Expiry date: It is the date specified in the future contract. This is last day on which the contract will be traded. Contract size: The amount of asset that has to be delivered under one contract. Famously known as lot size.
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Future terminology

Basis: Basis can be defined as the future price minus the spot price.

Cost of carry: It is the cost incurred over the storage, finance and interest paid for the asset. This is the relationship between the spot and future prices.
Initial margin: The amount that must be deposited in the margin account at the time a future contract is first entered into. Marking-to-market: At the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the future closing price. Maintenance margin: This is set to ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance Version 1.0 margin, the investor receives a margin call.

Options
Options are derivative instruments where one party has a right to buy/sell the underlying while the other party has an obligation to buy/sell

Types of options

Based on the right: - Call option - Put option

Based on the exercise: - American ( Individual Securities) - European (S&P CNX Nifty)

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Option terminology

Index options: This option have the index as the underlying. Stock options: Stock Options are options on individual stocks. Buyer of an option: The Buyer of an option is the one who by paying the option premium buys the right. Writer of an option: The writer is seller of the option who receives premium. Option price: Option price is the price which the option buyer pays to option seller. Famously known as premium. Expiration date: The date specified in the option contract is known as maturity date. Strike price: The price specified in the option contract is known as strike price.
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Option terminology

In-the-money option: An in-the-money option is an option that would lead to a positive cash flow to the holder if it is exercised immediately.

For a call : spot price > strike price. For a put: spot price < strike price.

At-the-money options: An at-the-money option is an option that would lead to zero cash flow if it were exercised immediately.

For both call and put: spot price = strike price.

Out-of-the-money options: An out-of-the-money option is an option that would lead to a negative cash flow if it were exercised immediately.

For a call: spot price < strike price For a put: spot price > strike price

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Option terminology

Intrinsic value of an options: The option premium can be broken down into two components

Intrinsic value Time value.

For call intrinsic value is as follows: The intrinsic value of a call is the amount the option is In-the-money. If call is out-of the money then intrinsic value is zero.

For put intrinsic value is as follows: The intrinsic value of a put is the amount the option is in- the-money. If put is out-of the money then intrinsic value is zero.

Time value of an option: The time value of money is the difference between its premium and its intrinsic value.

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Difference between futures and option Future

Option

Exchange traded

Same as future

Exchange defines the product

Prize is zero, strike price moves Prize is zero

Same as future
Strike price is fixed, price moves Prize is always positive

Linear payoff
Both long and short at risk

Nonlinear payoff
Only short at risk

Future
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Index derivatives

Index derivatives are derivative contract which derive their value from and underlying index.

Advantages of Index derivatives

Provides portfolio-hedging facility and it is more cost-effective than derivatives based on individual stocks.

Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.
Stock index is less volatile than individual stock prices. Index derivatives are cash settled and hence do not suffer from settlement delays.

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Application of Future and Option

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Trading underlying vs single stock futures

Trade in Securities

Trade in Futures

A customer must of trading and demat account Buying securities means putting money at one go.

A customer can only open trading account Buying a future means paying margin money.

Purchase of shares makes holder owner.

Privileges of dividend, attending annual meeting and power to vote Short selling is permitted but needs to give securities on pay-in day

Purchase of future does not make holder owner

No privileges are available Selling future is easy as holder can buy the position at any time

Securities

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Future payoffs

Future contracts have linear payoffs. Profits as well as losses for the buyer and the seller of a future contract are unlimited

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Payoff for long Nifty at 5000

Profit

+60 0 -60 3940 4000 4060 Nifty

Loss
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Payoff for short Nifty at 4000

Profit

+60 0 -60 3940 4000 4060 Nifty

Loss
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Application of futures

Hedging: Long Security, sell futures: Speculation: Bullish security, buy future: Speculation: Bearish Security, Sell future: Arbitrage

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Option payoffs

Options results in a non-linear payoff. It means losses for the buyer of an option are limited and profits are unlimited. For seller, it is exact opposite.

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Payoff for buyer of call option

Profit

0 60

4000 Nifty

Loss
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Payoff for seller of call option

Profit

60 0 4000 Nifty

Loss
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Payoff for buyer of put option

Profit

0 60

4000 Nifty

Loss
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Payoff for the writer of put option

Profit

60 0 4000 Nifty

Loss

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Application of options

Hedging: Have underlying buy puts Speculation: Bullish Security, Buy Calls or sell puts Speculation: Bearish security, sell calls or buy puts.

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Trading

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Future and option trading system:

The futures & options trading system of NSE provides a fully automated screenbased trading for Nifty futures & options and stock futures and options on a nationwide basis as well as an online monitoring and surveillance mechanism.

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Order types and conditions

Time Conditions

Day Order IOC

Price Conditions

Stop Loss Market Price Limit Price

Other Conditions

Pro CLI

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The trade workstation:

Title Bar Ticket window of futures and options market

Ticker window of underlying (Capital) market

Tool bar Market watch window Inquiry window Snap quote Order/Trade window System message window

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NEAT
Inquiry Window
Ticker

Market Watch

Market By Price (F6)

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NEAT

Market Inquiry (F11)

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Futures and options market instruments:

Index based futures

Index based options

Individual stock options Individual stock futures

Contract Specifications for Index futures:

NSE trades Nifty, CNX IT and Bank Nifty futures contracts having one-month, twomonth and three-month expiry cycles. All the contracts expire on the last Thursday of every month.

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Contract specification: S&P CNX Nifty Futures

Underlying Index : Exchange of trading: Security descriptor:

S&P CNX Nifty National Stock Exchange of India Limited N FYTIDX NIFTY

Contract Size:
Price steps: Price bands: Trading Cycle: Expiry Day : Settlement Basis: Settlement Price:

Permitted lot size shall be 50(Minimum Value Rs. 2 Lakh)

0.05 Not applicable Maximum of three month trading cycle Last Thursday of the expiry month or the previous trading day if the last Thursday is a trading holiday. Market to Market and final settlement will be cash settle on T+1 Basis Daily settlement price will be the closing price of the futures contracts for the trading day and final settlement price shall be the closing value of the underlying index on the last trading day.

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Contract specification: S&P CNX Nifty Options

Underlying Index : Exchange of Trading: Security descriptor:

S&P CNX Nifty National Stock Exchange of India Limited N OPTIDX NIFTY

Contract Size:
Price Steps: Price Bands: Trading Cycle: Expiry Day: Settlement basis: Style of option: Strike Price Interval: Daily settlement price: Final Settlement price:

Permitted lot size shall be 50

Rs.0.05 Not Applicable The option contracts will have a maximum of three month trading cycle. The last Thursday of the expiry month or previous trading day if the last Thursday is a trading holiday Cash settlement on T+1 basis European Rs. 10 Premium value Closing value of the index on the last trading day.

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Contract Specification
Contract specification for stock futures:

Trading in stock futures commenced on the NSE from November 2001. Cash settled contracts on T+1 basis The expiration cycle for stock futures is last Thursday of the month.

Contract specific for stock option:

Trading in stock options commenced on the NSE from July 2001.

These contracts are American style and are settled in cash.

Minimum seven strike price are available for this contract.
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Clearing and Settlement

Settlement mechanism:

All futures and option contracts are cash settled.

Settlement of future contract:

Marked to Market settlement Final settlement

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Clearing and Settlement

MTM settlement: All futures contracts for each member are marked-to-market to the daily settlement price. The profit and loss are computed as the difference between:

For Fresh Open position: Difference between trade price and the days settlement price For Brought forward position: Difference between previous days settlement price and current days settlement price. For squared up position: Difference between buy price and sell price

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Clearing and Settlement

Final Settlement for futures:

On expiry day the future contracts are cash settled. In final settlement loss/profit amount is debited/credited to the relevant CMs clearing bank account on T+1 Basis.

Settlement price for Futures:

Daily Settlement price on a trading day is the closing price of the respective future contract. Final settlement price is the closing price of the relevant underlying in capital market segment.

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Clearing and Settlement

Settlement of Option Contract: Option contract have four types of settlement:

Daily Premium Settlement

Exercise Settlement Interim Exercise settlement Final settlement

Exercise Process:

American option European option

Assignment process:

Random Basis
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Clearing and Settlement

Exercise settlement computation

The exercise settlement value for

Call Option = Closing price of the security on the day of exercise Strike price Put Option = Strike price Closing price of the security on the day of exercise

All open long position at in-the-money strike price are automatically exercised on the expiration day and assigned to short position in option contract.

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Concept of margin

Margin is a deposit which the customer pays for taking exposure in the derivatives segment. Our risk management policy ensures that the client can trade in derivatives only if he has adequate margin. Margins are the brokers safety net else the customer will run away without paying Types of margin:

Initial margin: Amount that is deposited in the margin account at the time a futures contract is first entered. It is calculated using a software called SPAN, short for Standardized Portfolio Analysis of Risk. The SPAN system, through its algorithms, sets the margin of each position to its calculated worst possible one-day move. It is revised 6 times in a day by the exchange Exposure margin: In addition to initial margin, exposure margin is also collected by the exchange for the broker Mark to market margin: At the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the future closing price

You can view the SPAN details for stock and indices on http://www.5paisa.com/5pit/spma.asp

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