Introduction to derivatives

By. Prof. Samie A Sayed

Prof. Samies Bio

Qualifications : M.Com (Mumbai University), MBA (Finance ITM EEC in collaboration with SNHU), BSBA (City University of New York) More than 10 years of corporate experience

Also, worked as a visiting faculty at IMT Ghaziabad. Visiting faculty at ITM ECC.

Started career as Sales and Design Mechanical Engineer. Started Business studies in New York On return from US, Joined Royal Bank of Scotland (ABN AMRO) in 2004. Worked across various departments of the offshoring division of RBS including Credit Analytics, Strategy and Planning, Project Management and the last two years in Investment Banking. Currently working as Consulting Director Research and Strategy for Delhi based Wealth Management and Investment Firm.

The need for derivatives

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years. After World War II, a global economic order emerged. In our global economy, we have market determined rates. Market determined rates make it hard for businesses to estimate their future revenues and production costs.
Price fluctuations

The Origins
A Derivative can be defined as a financial instrument whose value depends the values of an underlying variable. Derivative exchanges have been existed for a long time in the US and India. The Chicago Board of Trade (CBOT) was established in 1848 to bring farmers and merchants together. Initially its main task was to standardize the quantities and qualities of grains that were traded.

The Origins
Within a few years, the first futures type contract was developed. It was known as a to-arrive contract. A standard -to-arrive contract is a contract in which the farmer promises to deliver a stated quantity of grain for a price linked to the price of a future date contract that expires in the delivery month. From the farmer's perspective, such a contract shifted the risk of fall in market price before delivery to the buyer. From the buyer's perspective, the contract facilitated hedging or speculation.

The Origins
A rival exchange to CBOT, Chicago Mercantile Exchange (CME) was set up in 1898. Since then, CME has established itself to be the worlds largest exchange for futures and options trading with the largest options and futures contracts open interest (number of contracts outstanding) of any futures exchange in the world. On 12 July 2007, CBOT merged with CME to form CME Group, a CME/Chicago Board of Trade Company.

Derivatives categories
Derivatives fall into three categories : OTC, Exchange Traded, Cleared Derivatives. The first is over-the-counter (OTC) derivatives, which are customized, bilateral agreements that transfer risk from one party to the other.. The second category consists of standardized, exchangetraded derivatives, which known generically as listed derivatives or futures. In contrast with OTC derivatives, listed derivatives are executed over a centralized trading venue known as an exchange and then booked with a central counterparty known as a clearing house. Finally, the third category is cleared derivatives, which like OTC derivatives are negotiated bilaterally, but like listed derivatives are booked with a clearing house.

Differences in categories
OTC Trades negotiated overthe-counter Customized contracts are broken down by trading desk into tradable risks and hedged in liquid markets Traded between dealers as principals Dealer is normally counterparty to all trades Margin (collateral) often exchanged but subject to negotiation between counterparties Cleared Trades negotiated overthe-counter Trades limited to standardized contracts All trades are booked with clearinghouse, which is counterparty to all trades Mandatory margin requirements Initial margin Variation margin Daily settlement (mark to market) and margin calls Exchange-traded Trades executed on organized exchanges Trades limited to standardized contracts All trades are booked with exchanges clearinghouse, which is counterparty to all trades Mandatory margin requirements Initial margin Variation margin Daily settlement (mark to market) and margin calls

Source : ISDA

OTC Market size SIZE DOES MATTER !!

OTC Derivates Market Types of Contracts Foreign Exchange Interest Rate Equity Linked Commodity Credit Default Swaps Unallocated Total
Data for six month period ending Dec 2010

US$tn Notional Amount Outstanding 49.181 449.875 5.937 2.944 32.693 63.27 603.9

OTC Derivates Market Types of Contracts Foreign Exchange Interest Rate

US$tn Notional Amount Outstanding 53.1 451.8

Equity Linked
Commodity Credit Default Swaps Unallocated Total

6.3
2.9 30.3 38.3 582.7

Data for six month period ending June 2010

The total notional amount outstanding for OTC Derivative contracts for the year 2010 was US$600tn which was almost 10 times our world GDP which is estimated to be around US$60tn.
Source : BIS

OTC Market size

Credit Default Swaps, 5.2% Commodity , 0.5% Equity Linked , 1.1% Unallocated, 6.6%

Foreign Exchange, 9.1%

Unallocated 10% Credit Default Commodity 1% Swaps 5%

Foreign Exchange 8%

Equity Linked 1%

Interest Rate 75% Interest Rate, 77.5%

Data ending June 2010

Source : BIS

Data ending Dec 2010

Exchange traded markets

Futures North America Europe Asia and Pacific Other Notional Outstanding (US$tn) 10.72 8.05 2.41 0.5554 Notional Outstanding (US$tn) 11.86 6.33 3.17 0.9453

Total
Options North America Europe Asia and Pacific Other Total Exchange Traded Total Notional Outstanding (US$tn)

21.74
Notional Outstanding (US$tn)

22.32

23.87 26.322 0.310 0.871 51.4 72.29

24.35 19.21 0.3848 1.67 45.62 67.93

Major trading on exchanges occurs in interest rate derivatives, currencies and equity indices.

Source : BIS

Investment Banks Leading the way

In 2009, a Financial Crisis Inquiry Commission was set up to probe the role of Investment Banks in the 2008 financial crisis. Wall Streets most profitable bank in 2009, Goldman Sachs stated during the inquiry that up to 35% of its revenues were generated from derivatives business that was approximately US$16bn. JPMorgan Chase & Co. managed to generate $5 billion in profit during the worst year in Wall Street history by trading over-the-counter fixed-income derivatives.

The origins INDIA

Derivatives have had a long presence in India organized trading in cotton was conducted at Cotton Trade Association which was established in 1865. SEBI took the first towards establishing derivatives trading in India by setting up a committee under Dr. L.C.Gupta in 1996 to establish appropriate regulatory framework. This was followed by Prof. J.R.Verma committee which set up the operational framework in 1998. Securities Contract Regulation Act was amended in December 1999 to treat derivatives as securities and a regulatory framework was set to govern derivatives trading.

Derivatives Indian perspective

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines "derivative" to include 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 or A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

Major players in derivatives

There are three major types of players in the derivatives market:
Hedgers Arbitragers Speculators

Hedgers
Hedgers are those who protect themselves from the risk associated with the increase or decrease in the price of an asset by using derivatives. For example, corporates keep a close watch upon the prices discovered in trading of their products and when the comfortable price is reflected according to their wants, the corporate sells futures contracts. In this way, the corporate gets an assured fixed price of his produce. In general, hedgers use futures for protection against adverse future price movements in the underlying cash segment. Hedgers are often businesses, or individuals, who at one point or another deal in the underlying cash market. (Example: IT companies hedge their revenues in US$).

Speculators
Speculators are never interested in actually owing the underlying asset in the cash market. They will just buy from one end and sell it to the other in anticipation of future price movements. They take calculated bets on the future movement in the price of an asset. If the speculators judgment is good, then the speculator stands to make the make the maximum profit as compared to other traders in the derivatives market.

Arbitrageurs
Arbitrage involves the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. Given the advancement in technology it has become extremely difficult to profit from mispricing in the market. Algo trading is the flavour among derivatives traders to monitor fluctuations in similar financial instruments.

Factors driving derivatives

Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are:

Increased volatility in asset prices in financial markets, Increased integration of national financial markets with the international markets, Marked improvement in communication facilities and sharp decline in their costs, Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 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 costs as compared to individual financial assets.

Derivatives Types

Forwards A derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Futures An exchange traded derivative instrument, or financial contract, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. Options An exchange traded contract, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) or sell (put) financial instruments or physical commodities at an agreed-upon price within a certain period or on a specific date. Swaps A swap is an OTC derivative in which two counterparties agree to exchange one stream of cash flows against another stream.

Forwards
A forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Futures
A futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) but with delivery occurring at a specified future date. In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all that is, for financial futures, the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. A futures contract working is very similar to a forward contract but there are major differences at an operational level.

The Shift

Forwards vs. futures

Forwards

Futures
Exchange traded contracts Contracts decided by exchanges Futures are settled on MTM basis SEBI overviews futures exchange traded contracts

Forwards is an OTC contract Tailor made contracts Forwards are usually settled on specified data and not on MTM

The Reserve Bank of India has permitted limited options, interest rate swaps, currency swaps and other risk reductions OTC derivative products
Counterparty risk OTC market has failed to pick up in India Margins may not be needed

No counterparty risk
India has the largest single stock futures market in the world The exchanges take margins from clients before allowing them to take positions

Overview of margins
In case of a futures contract, the stock exchange acts as a legal counterparty to every transaction and if any party fails to pay up, the exchange is legally bound to effect payments to the party who has made profits. To ensure that it can meet these commitments, the exchange levies margins on most players in the Derivatives Segment. In India, two kinds of margins are applicable Initial Margin payable at the point of entering into derivative transactions and Mark to Market Margins payable on a daily basis thereafter. Both these margins are calculated using a special software program called SPAN. Typically, margins are charged at a rate of 5-15% based on volatality of the underlying.

Options
An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him. Options are of two types - Calls and Puts options : "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 underlying asset at a given price on or before a given future date.

Swaps
A Swap is an OTC market contractual agreement between two parties in which each party agrees to exchange a stream of cash for a stipulated period of time based upon certain agreed-upon parameters with respect to price movements in the underlying asset. Interest rate swaps are the most popular swaps in the world. An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. The stream of cash flows in interest rate swaps have two interest streams fixed interest and variable where one party is willing to exchange fixed rate for floating rate and vice versa.

Landmarks india
Derivatives trading on exchanges commenced in India in June 2000. SEBI permitted trading of derivatives on two stock exchanges in India NSE and BSE S&P CNX Nifty Index as well as Sensex futures started trading on June 2000.

Trading in Index Options commenced in June 2001 Trading in Individual Stock Options commenced in July 2001 Single Stock Futures was launched in November 2001.

Conclusion
Derivatives market has become an integral part of our financial markets. The size of the derivatives market is massive and any structural issues in the derivatives market can lead to a systematic collapse of the financial system. As was the case, derivatives played a critical role in the 2008 financial crisis and the collapse of Lehman Brothers was attributed majorly to their derivatives trading business.