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Derivatives Operations in

National Stock Exchange


Submitted to
Prof. K.M. Bhattacharya
What is a
Derivative?
Derivative is a product whose value is derived from the value of the
underlying asset.
Underlying asset can be equity, forex, commodity, or any other asset
say an agreement with your neighbour for 2 bags of sugar next week.

Financial transaction whose value depends on the underlying


value of the
reference asset concerned.

A contract that specifies the rights and obligations between


two parties to
receive or deliver future cash flows (or exchange of other
securities or assets)
based on some future event.
Derivatives – Perception &
Reality
Perception
• Derivatives are risky and short term
• Peripheral to genuine investment
• Funds and investors who use them
have something to hide
(unregulated, offshore and
complicated)
Reality
• Derivatives are flexible, efficient
and open up new investment
opportunities
• The extraordinary growth of
derivatives markets tells its own story
• Mainstream funds wish to increase
their derivatives usage to meet
their investment objectives. Domicile
of new funds determined
principally by regulatory and tax
environment
The Derivatives Revolution – The
Big Questions
Why are they so important to
investors?
The Derivatives Revolution:
The Big Numbers (US$ trillion)
Derivative Concepts
• Forwards - A forward contract is a customized
contract between two entities, where settlement
takes place on a specific date in the future at
today’s pre-agreed price
• Futures - A future contract is an agreement
between two parties to buy or sell an asset at a
certain time in the future at a certain price.
Futures are refined forward contracts .Main
differences:
•Future contracts are standard in terms of quality,
quantity and delivery
•Future are traded on organized exchanges
whereas
Forwards are traded on Over the counter
Basic terminology
Call-option to buy an asset
put-option to sell an asset
Exercise price-price at which option holder
can buy or sell
maturity date-date when the option expires
or matures
Exchange traded option-options traded on
exchange
Over the counter options –options not traded
on exchange
Options : tools which provides owner the right to sell or buy an underlying asset on a pre-
agreed
Price within a certain period

CALL :Calls 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 given future date.

PUT :Puts give the buyer the right but not the obligation
to
sell a given quantity of the underlying asset, at a given
price on or before a given future date.

• Warrants. Longer -dated options are called warrants


and
are generally traded over-the-counter (OTC)
• Baskets : Basket options are options on portfolios
of underlying assets. The underlying asset is usually a
moving average of a basket of assets. Equity index
options are a form of basket options.

• Swaps are private agreements between two


parties to exchange cash flows in the future
– Agreement on formula to be used for exchange of
cash-flows is determined in advance
• Swaptions are options to buy or sell a swap that will
become operative at the expiry of the options.
Swaption is nothing but an option on a forward swap.
– Receiver Swaption is an option to receive fixed and
pay floating.
– Payer Swaption is an option to pay fixed and receive
floating.
• Options Options are of two types:
– Calls & Puts
Calls 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 given future date.
Puts give the buyer the right but not the obligation to sell a given quantity
of the underlying asset, at a given price on or before a given future date.
• Warrants. Longer -dated options are called warrants and are generally
traded over-the-counter (OTC)
• LEAPS Long-Term Equity Anticipation Securities. These are options having
a maturity of up to three years.
• Baskets Basket options are options on portfolios of underlying assets.
The underlying asset is usually a moving average of a basket of assets.
Equity index options are a form of basket options.
• Swaps are private agreements between two parties to exchange cash
flows in the future
– Agreement on formula to be used for exchange of cash-flows is
determined in advance
• Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Swaption is nothing but an option on a forward
swap.
– Receiver Swaption is an option to receive fixed and pay floating.
– Payer Swaption is an option to pay fixed and receive floating.
Economic functions of Derivative market
• Derivatives help in discovery of future as well as
current prices.
• The derivatives market helps to transfer risks
from those who have them but may not like
them in comparison to those who have an
appetite for them.
• Speculative trades shift to a more controlled
environment of derivatives market.
• Act as a catalyst for new entrepreneurial
activity.
Uses of
Derivatives
• Hedging
• Speculating
• Arbitrage
• Accessing remote markets
• Distribution of risk as securities
i.e. “Securitisations”
1. Hedging
• Done by parties who seek to offset their existing risks by entering
into a derivatives transaction.
• Existing risks could be an investment portfolio, price changes in oil
for a petroleum mining company or perhaps investments in a foreign
country.
2. Speculating
• Speculation is more commonly used by hedge funds or traders who
aim to generate profits with only a marginal Investment
3. Arbitrage
• Arbitragers work at making profits by taking advantage of
discrepancy between prices of the same product across different
markets.
• Practitioners working within risk finance or quantitative finance
often develop models to price various assets being traded across the
markets
Are Derivatives Dangerous?
-"We view them as time bombs both for the parties that deal in them and
the economic system .. In our view ... derivatives are financial weapons of
mass destruction, carrying dangers that, while now latent, are potentially
lethal."
- Warren Buffett, the Chairman of Berkshire Hathaway and his critique of the
derivatives market.
-Are derivatives dangerous?
-That's almost like asking if water is dangerous.
-Derivatives can be dangerous if used incorrectly - as several large
companies and individuals have found out in recent history.
•Derivatives contribute to the 'completeness' of the global
markets, and without them, loopholes within the financial
industry would exist.
• Even through numerous financial disasters ala Barings,
LTCM, Enron and others related to the mismanagement of
derivatives
• It is key to consider that it has not been the use of
derivatives as a tool which has led to the downfall of these
companies - but rather, the misuse and compromise of such
instruments.
Growth Driving Factors
• Increased volatility in asset prices in Financial Markets
• Increased integration between International Markets
• Exponential improvement in communication at
exceptionally reduced costs
• Development of more sophisticated Risk Management
tools, providing economic agents a wider choice of Risk
Management strategies
• Innovations in the derivatives markets, which optimally
combine the risks and returns over a large number of
financial assets leading to higher returns, reduced risk as
well as transactions cost as compared to individual
financial assets
Participants in Derivatives
Market
Hedgers
Speculators
Arbitrageurs
OTC Derivatives

OTC Derivatives
Characteristics of OTC Derivatives market:
– The management of counter-party (credit)
risk
is located within individual institutions. No
formal limit on individual positions, leverage,
or margining.
– No formal rules of risk and burden sharing
– No formal rules for ensuring market stability
and integrity
– Lack of regulator, although they are affected
indirectly by national legal systems, banking
supervision and market surveillance.
Exchange Traded Derivatives Market
• Individuals trade standardized contracts
that have been defined by the exchange.
(First Futures contract were traded in
1865 in CBOT) (www.cbot)
NSE’s derivatives market
Commencement of derivative trading with
S & P CNX Nifty Index futures on 12/06/2000.
Trading in index options commenced on 04/06/2001.
Single Stock trading in options started on 02/07/2001
Single Stock trading in futures started on 09/11/2001.
NSE’s Derivatives Market
2 tier Membership Structure
Trading Mechanism

NEAT F&O
Features

Fully Automated
Screen Based F&O Trading
Anonymous order driven Market
Transparency in Operations
Operates on Price – Time priority
NEAT Corporate Hierarchy

Corporate Manager
Branch Manager
Dealer
Futures Terminology

Spot Price
Futures Price
Contract Cycle
Expiry Date
Contract Size
Basis
Cost of Carry
Initial Margin
MTM
Maintenance Margin
Options Terminology
Index Options
Stock Options
Buyer of an option
Writer of an option
Call Option
Put Option
Option Price / Premium
Expiration Date
Strike price
American Option
European Option
In the money Option
At the money Option
Out of the money Option
Time Value of an option
Payoff Model
Long
Futures
Short
Futures
Long Call
Short Call
Long Put
Derivative Greeks
Delta - measure of how option value changes with changes in underlying
asset e.g. share price
Theta - measure of change in option value with change in time to
maturity
Vega - change in option value with change volatility of underlying asset
Rho - change in option with respect to interest rates (in the case of a
share option where delta relates to stock)
Gamma - Delta is not static. Gamma is a measure of how the delta itself
changes with changes in
Types of Orders
Time Conditions
•Day Orders
•Immediate or Cancel (IOC)
Price Conditions
•Stop Loss
Other Conditions
•Market Price
•Trigger Price
•Limit Price
•Pro
•Cli
Contract Details

Present Month
Next Month
Far Month
Criteria for Stock qualifying for
Derivative segment Trading

Top 500 stocks in terms of Average Daily market capitalisation and


Average daily Traded value in previous 6 month on rolling basis
Quarter Sigma order size over the last six months should not be less
than Rs. 1 Lakh
Market wide position limit in stock should not be less than Rs. 50 crore

Disqualification
Failure to meet the above criteria for 3 consecutive months
Criteria for Index qualifying for
Derivative segment Trading

80% of the stocks contributing to the index are eligible for derivative
trading
No single ineligible stock in the index should have a weight age of
more than 5% in the Index

Disqualification
Failure to meet the above criteria for 3 consecutive months
Clearing and Settlement
Clearing Members

SCM
TM – CM
PCM
NSCCL

Functions
Clearing
Settlement
Risk Management
Clearing Mechanism

Tables – 6.1, 6.2 & 6.5


Settlement of futures Contract

MTM – Table 6.6


Settlement for
Futures
Settlement for Options

Daily Premium Settlement


Exercise Settlement
Interim Exercise Settlement
Interim Exercise Settlement
Exercise Process
Assignment Process
Exercise Settlement Computation

Special Facilities for


Settlement of the institutional
Deals
Adjustments for Corporate
actions
Strike Price
Position
Market lot / Multiplier
Risk Management

Financial Soundness of the members


Specific Initial Margin Requirements for all Open
Positions
Upfront Initial Margin for all the open positions
MTM Based contract Settlement
MTM Settled in Cash on T+1
Predefined limits
Settlement Guarantee Funds
PRISM
SPAN
Factors Affecting SPAN

Underlying
Strike Price
Volatility
Expiry
Interest Rate
Types of Margins

Initial Margin
Premium Margin
Assignment Margin
Client Margin

Overall Portfolio Margin


Requirements
Derivative Trading Regulations
For Exchanges to Start
Derivatives Trading
L.C. Gupta Committee
SEBI Approval
Minimum 50 Members
All member should fulfill eligibility conditions
SEBI Approved Clearing house
Brokers / Dealers and Clearing Members have to be registered with
SEBI
Minimum Net worth for clearing Members is Rs.300 lakhs
Minimum contract values is Rs.2 lakh
Strict Know your client norms
Derivatives trading to be done by certified professional
Eligibility Criteria for F&O
membership

Table – 7.1 & 7.2


Position Limit

Trading Member Position Limit


Client level Position Limit
Market wide Position Limit
FII and Sub Account Position Limit
Mutual Funds Position Limit

Reporting of Client Margins


Accounting for Futures

At the inception of the


contract
At the time of Daily
Settlement
Open Positions
Final Settlement
Default Accounting

Disclosure
Requirements
Accounting for Options

At the inception of the contract


At the time of Payment or Receipt of Margin
Open Positions as on balance sheet dates
Final Settlement
Squaring off Options contract
Taxation of Profit / Loss on
Derivative transactions

STT on Derivative
transactions
Regulatory Framework

Securities Contract (Regulation) Act, 1956


Securities Contract (Regulation) Act, 1957
Securities and Exchange Board of India Act, 1992
The Indian Contract Act, 1872
8 Index Derivatives on NSE
233 Stock Derivatives on NSE
The Derivatives Revolution - The Big “Must
Knows”
Tomorrow (future) versus today (present)
“I look to the future because that’s where
I’m going to spend the rest of my life”
- George Burns
Ownership versus exposure