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Introduction
Derivatives are synthetic instruments They derive value from an underlying asset class Asset classes range from financial instruments to commodities to even classes such as weather and industrial effluents However the common underlying theme of derivatives is that they are leveraged products Derivatives are not always priced at respective asset value (fair value)
Derivative Market
The derivative market has its own dynamics Though the value of the derivative is derived, the market can and does move in complete tangent to the underlying asset class This is because the participants in the derivative market do not always hold positions in the underlying instrument and have different intentions on their positions
Financial Asset Classes Broadly categorised into equity, interest rates and currencies Equity as an asset class will include single stocks and equity indices Interest rates as an asset class will include government bonds, government bond benchmarks and money market benchmarks. Currencies as an asset class will include currency pairs such as USD/INR, USD/JPY etc Credits as defined by corporate bonds can also be categorised into financial assets and derivatives on them are called credit derivatives
Equity Derivatives
Equity derivatives can be classified into single stock derivatives and index derivatives Single stock derivatives are derivatives on specific stocks eg. Reliance Index derivatives are derivatives on stock exchange indices eg- nifty Hybrid derivatives on equity include convertible shares (partly or fully) Employee stock options are also equity derivatives
Currency Derivatives
Currency derivatives are based on currency pairs Currency forwards and options egUSD/INR forwards and options Currency derivatives are combined with interest rate derivatives to offer exotics Exotics include principle only swaps, currency swaps
Derivatives traded on an exchange such as NSE are exchange traded derivatives Derivatives not traded on exchange are over the counter derivatives eg- Overnight index swaps (OIS) Exchange traded derivatives are standardised in contract size, settlement, maturity OTC derivatives can be structured to suit different needs Equity and bond derivatives are usually exchange traded while interest rate swaps, currency derivatives and exotics are usually OTC derivatives
Derivative Exchanges
Derivative exchanges are separate from stock exchanges In US CBOT and CME are the largest exchanges for derivatives In UK LIFFE is the premier derivative exchange In India NSE is the largest equity derivative exchange while commodity exchanges are NCDEX and MCX What are the derivative exchanges in Japan and Singapore?
Hedging or Leveraging
Derivatives are viewed as a hedging instrument The holder of an underlying asset can hedge fluctuations in prices of the asset using derivatives However derivatives are increasingly being used for taking up leveraged positions in an underlying asset This enables higher returns for taking on higher risk
Derivatives in India
The structured derivative market in India is relatively new (about 7 years old) However derivatives have caught the fancy of the market and exchange traded equity and commodity derivatives are vibrant Interest rate derivatives have not taken off on an exchange platform though the OTC market for Interest rate derivatives is active Currency derivatives are dominated by currency forwards though options are starting to come of age at present
Homework
What are most active derivative exchanges in USA, UK, Japan, Singapore, Germany and India What are the three most active contracts traded in these exchanges What is the volume (average monthly volumes over the last one year) in USD Billion in these exchanges What are the volumes (average monthly volumes) in Nifty index futures, Nifty index options, single stock futures and single stock options in the NSE over the last one year in USD Billion
Introduction to Futures
Futures are essentially deferred spot contracts Spot is the immediate delivery for settlement of a bond or stock Futures are purchase or sale contracted for settlement for a later date Futures are exchange traded derivatives Forwards are the OTC version of futures Futures are traded on margin
Futures give ability to leverage positions Futures can also lead to large gains or losses without any floor or ceiling How? An example If I buy 10 contracts of Nifty index near month futures at Rs 2900 For every 1 point move in the index I stand to lose or gain Rs 1000 (10*100) If index falls 100 points, then I have lost Rs 100,000. My investment for 10 contracts was Rs 400,000 (margin money)
Futures
Futures
Future contracts have maturities ranging from one month to one year or more In India futures contracts have a maximum tenor of three months Future price and spot price converge on settlement date Futures are marked to market on a daily basis and settlement of mark to market profit or loss is also on a daily basis Futures can be cash settled or settled by physical delivery- In India futures are cash settled
Pricing of Futures
Futures should theoretically trade at a fair price The fair price is the price adjusted for cost of carry for delivery at a later date The cost of carry is the interest cost on the amount actually paid for an asset on a spot purchase Cost of carry is adjusted for any dividends receivable in case of equities Cost of carry = Interest cost over period expected dividend yield The fair price of a future contract is always at a premium to the spot price
Introduction to Options
Options give the right but not the obligation to buy or sell an asset at a future date Options are either call or put options Call options give the holder the right to buy an asset at a future date Put options give the holder the right to sell an asset at a future date
Options
Options can be American or European American options allow the buyer to exercise the option before expiry date European options give the buyer the right to exercise the option only on expiry date Index options in India are European options while stock options are American options
Options
Options protect downside risk to the buyer The buyer of the option limits losses to the premium paid on the purchase of the options Eg. If I buy a nifty 2900 put at Rs 34, my loss is limited to Rs 34 while gain potential is limitless If the price goes above Rs 2900 I do not exercise the option limiting my loss to the premium paid
Options
Options have a buyer and a writer The option writer receives premium for giving the buyer the right but not the obligation to sell an asset at a future date The option writer is not protected on the downside risk Option writers have to settle mark to market profit or loss on a daily basis Options can be cash settled or settled by physical delivery Options in India are cash settled
Option Pricing
Black Scholes formula is the most widely used for pricing options The factors going into the pricing of options are the share price(S), time to expiry (t), risk free rate of interest r, and risk of underlying asset measured by standard deviation or volatility These are also called the greeks as changes in any one of these variables affect the option price Options contracts can be classified into out of the money, at the money and in the money
The Greeks
Delta is the change in option price to the change in the underlying Gamma is the rate at which an options delta changes as the price of the underlying changes Theta is the time decay factor and is the rate at which option loses value as time passes Vega or Kappa is the change in option price to change in the volatility of the option Rho is the change in value of option to change in interest rates
Currency Forwards
Currency forwards are the most widely used currency derivatives The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date The prices are determined by the cost of carry that is the interest payable on paying or receiving forwards
Nifty Index Futures 29h June 2006 Series Open Interest '000* Change in Open Price of future Change over the Nifty Index Interest over contract Rs week % the week Spread between future price and spot price Rs
16-Jun-06 23-Jun-06
27685 28767
-4.51% 3.91%
2909 3065
2.97% 5.36%
-4.00 9.00
CE CE CE PE PE PE PE
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