Financial Engineering

By CA. Pradeep Kumar Gupta (CA., CS., B.com)

Financial Market
Capital

Market (SEBI) Money Market (RBI)

Capital Market
Primary

Market (IPO) Secondary Market (FPO)

Secondary Market
Cash

Market Derivative Market

Stock Exchanges of India (under SEBI)

BSE

(Bombay Stock Exchange) NSE (National Stock Exchange)

Commodity Exchange of India ( under Forward Market Commission)

NCDEX

(National Commodity & Derivatives Exchange) (Agriculture Products) (Index-Dhanya) MCX (Multi Commodity Exchange) (Metals) 0nly future trading is permitted in Indian commodity exchanges. (Index Comdex)

What is derivatives
The

word derivatives originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of an underlying assets. The underlying assets can be equity, commodity, or any other assets.

Types of Derivatives
Forward Future Option

Forward Contract
Forward

contract is a agreement to buy or sell an assets at a certain future time for a certain price.

Parties of Forward Contract

Buyer-One

of the parties to a forward Contract assumes a Buying Position (Long Position) and agrees to buy the underlying assets on a certain specified future date for a certain specified price.

 Seller-Other

parties to contract i.e.the seller assumes a short position and agrees to sale the assets on the same date for the same price. Example-on a 01/08/2011 ABC Ltd. enters into a forward contract with PQR.Ltd for buying USD 1 crore at Rs.45 per USD on 30/09/2011.

Features of the forward contract

Quantity

of the Commodity to be delivered Quality of the commodity to be delivered Price which the buyer would pay Counter parties risk involved Over the counter agreement

Future Contract
Future

contract is standardized Forward contract .In future trading there is usually a contract which is essentially an agreement between two parties to buy or sell an underlying assets at a certain time in the future at a certain price.

Feature of future contract

A

future contract usually has a standardized date and month of delivery quantity and price. Future trading are traded on exchange. Three series of future contract are always available and have one-month, two month, and three month expiry cycles.

 Example-on

a 3rd August 2011,Arvind enters into a August 2011 Future contract for buying 1000 shares of Wipro Ltd.

Comparison of forward and futures contract

Forward Private Contract between two parties Not standardized Usually one specified delivery date Settled at the end of contract Future Traded on an exchange Standardized Contract Range of delivery dates Settled daily

Delivery or final cash settlement usually Contract is usually closed out prior takes place to maturity Some credit risk Virtually no credit risk

Index Future
Index

future are the future contract which underlying assets is a market index. For a example future contract on Senesx and Nifty are called index future.

Option
Option

is a derivatives instrument that gives the holder a right, without any obligation to perform. Option are basically contracts which give to the buyer a facility which is similar to buy or sell certain asset (underlying) but the buyer of an option has limited risk & unlimited profit.

Types of option (Based on Nature of Activity)

Call

Option Put Option

Call Option

A call option gives the buyer the right to buy in the underlying assets at the strike price specified in the option. The profit /loss that the buyer makes on the option depend upon the spot price of the underlying. If upon expiration the spot price exceeds the strike price he makes a profit.if the spot price of the underlying assets is less than the strike price the premium of that option will become zero & maximum loss in this case is the premium he paid for buying the option.

Put Option

A put option gives the buyer the right to sell in the underlying assets at the strike price specified in the option. The profit /loss that the buyer makes on the option depend upon the spot price of the underlying. If upon expiration the spot price below the strike price he makes a profit. if the spot price of the underlying assets is exceeds than the strike price the premium of that option will become zero & maximum loss in this case is the premium he paid for buying the option.

Comparison between Call Option & Put Option

Call Option Put Option

Option which gives the holder right to Option which gives the holder right BUY an assets but not an obligation to SELL an assets but not an to buy. obligation to SELL. Call option will be exercise only when the exercise price is lower than the market price. Put option will be exercise only when the exercise price is Higher than the market price.

Seller/writer is under obligation to sell Seller/writer is under obligation to the underlying assets if the buyer sell the underlying assets if the exercise his option to buy the shares buyer exercise his option to sell . the shares .

(Based on the Exercising the Option)

American

Types of the Option

Option European Option

American Option
Option

under which holder can exercise his right at any time before expiry date.

European Option
Option

under which holder can exercise his right only on the expiry date.

Types of Players/Trader
Hedgers Speculators Arbitrageurs

Example of hedging using forward contract

Payment $100000 Received $100000

Speculators
Whereas

hedgers want to avoid exposure to adverse moment in the price of an assets, speculators wish to take a position in the market. Either they are betting that the price of the assets will go up or they are betting that it will go down. Example:-future and option both

Arbitrageurs
Arbitrageurs are a careful lot who keep constant vigil on the market, across products and locations to identify temporary imperfection and convert such opportunities into risk less profit. In the pure form of arbitraging, the operator: 1-has no investment; and 2-simultaneously buys and sells in different markets and /or different period which ensure risk less profit to him. (example $ in diff. mkt)

Types of Order

Market Order-Buy or sell the rate prevailing in the market at the time of placing the order. Limit Order-Buy/Sell order at specified time limit irrespective of the rate prevailing in the market at the time of placing order. Stop loss order-Order where the trader wants to restrict his loss by specifying the limit for closing his deal.

 Market-if-Touched

order: These are similar to stop loss order.This will become market order if certain price is reached. Example:sell when Wipro Future reaches Rs.2500. Spread order-when customer order to buy future in one delivery month and sell in another delivery month, they are termed as spread order.

 Scale

Order-when customer wishes to make a gradual entry or exit from the market rather than execute the trade at just one price.

 Strike

Price/Exercise Price: It is the price at which the contract is entered into. There can be several strike prices at which one can enter into in contract in the option market. Spot price: The spot price of the underlying asset in the cash market..

Types of Margin
Initial

Margin Mark to Market Margin Maintenance Margin Additional Margin Cross Margin

Initial Margin
Whenever

a client (both buyer & seller) books future contract he is required to deposit a certain % of contract price(Ex20%) as margin money which is called initial margin.

Variation/Mark to market margin

It

is paid to/received from the client daily and is calculated on the basis of daily settlement price.

Maintenance Margin
Some

exchange in the world work on the system of maintenance margin, which is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the margin limit.

 For

example if the initial margin is fixed at 100 and maintenance margin is 80 then the broker is permitted to trade till such time limit that the balance in this initial margin account 80 or more. If it drops below 80 say it drops to 70 then a margin of 30(and not 10) is to be paid to replenish the levels of initial margin.

Additional Margin
In

case of sudden higher than expected volatility ,additional margin may be called by the exchange. This is generally imposed when the exchange fears that the market have become too volatile and may result in some crises, like payment crisis.

Cross Margin
This

is a method of calculating margin money account balance and this takes into account combined position in future, Option, Cash market etc. Hence the total margin requirement reduces due to cross hedges. It is also not use in India.

Comparison of Stock Market and commodity market

Stock Market Commodity Market

Future trading Settlement at Every Last Month Different dates (As.Metal 5th of the next of Thursday month, Agriculture Product 20th of the month, Electricity 15th of the month) Time 9.30 to 3.30 Monday to Friday Future trading available only upto 3 months Delivery not possible Top cities-Ahemdabad,Mumbai,Delhi. Controlled by SEBI 10am to 11.55pm Monday to Saturday Future trading available only upto 10-12 months Delivery also possible. Top cities-Ahemdabad, Rajkoat,Indore Controlled by FMC (forward Market Commission)