FUTURES AND OPTIONS

By:
Sandeep Shrivastava

RISK IS THE BASIS OF BANKING

TO WIN WITHOUT RISK IS TO TRIUMPH WITHOUT GLORY

No
Risk !!!!

NO GAIN!!

INTRODUCTION- RISK MANAGMENT

Risk management is a discipline that helps bringing risks to manageable extent .

One risk does not get transformed into undesirable risk.

PLAYERS:
Hedgers, Speculators and Arbitrageurs - Market Role

Hedgers and investors provide the economic substance to any financial market. Without them the markets would lose their purpose and become mere tools of gambling. (E.g. Banks) Speculators provide liquidity and depth to the market. Arbitrageurs

VARIOUS TYPES OF RISKS IN BANKS

Solvency Risks- Risk of total financial failure of a bank. Liquidity Risk- Inability to meet the repayment requirements Credit Risk- Loss of Bank as a result of default Interest Rate Risk- Changes in Interest rate. Price Risks- Risk of loss/gain in value of assets & liabilities due to volatility in exchange rates. Operating Risks- Risks arising from out of failures in operations, supporting system, sabotage, fraud etc. Market & Foreign exchange Risk.

Process of Risk Management in Banks

Identification of risks Quantification of risks Policy Formulation Strategy Formulation Derivatives come in play Monitoring Risks

STRATEGIES OF RISK MANAGEMENT IN BANKS.

Hedging the Risk . Derivatives

Forwards Futures Options Swaps Credit Derivatives (Not available in India)

DERIVATIVES

Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more basic underlying assets (often simply known as the underlying). These contracts are legally binding

agreements, made on the trading screen of stock exchanges, to buy or

sell an asset in future. The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil, soybean, cotton, coffee and what have you. A very simple example of derivatives is curd, which is derivative of milk. The price of curd depends upon the price of milk which in turn depends upon the demand and supply of milk.

MOTIVES OF USING DERIVATIVES

Spreads trade Currency risk management. Interest risk Real time trading in the market ( Treasury Activities)

HISTORY OF DERIVATIVES AND THE MARKET IN INDIA

According to Mr. Asani Sarkars research work, Derivatives market has been in existence in India since 1875 He also mentions that in early 1900s India had the largest Futures Industry In 1952, Indian Government banned the options and futures trading But, by 2000 various reforms assisted in lifting all such bans and the derivatives market is booming since then The exchange traded derivative market is the largest in terms of number of contracts made In 2004, the daily trading value was 30 billion USD The commodities eligible for futures trading was 8 and in 2004 it was increased to 80

FORWARDS

A forward contract is a customized contract between the buyer and the seller where settlement takes place on a specific date in future at a price agreed today. The rupeedollar exchange rate is a big forward contract market in India with banks, financial institutions, corporate and exporters being the market participants.

Features of forward contract

It is a negotiated contract between two parties and hence exposed to counter party risk.

eg: Trade takes place between A&B@ 100 to buy & sell x commodity.After 1 month it is trading at Rs.120. If A was he buyer he would gain Rs. 20 & B Loose Rs.20. In case B defaults you are exposed to counter party Risk i.e. you will now entitled to your gains. In case of Future, the exchange gives a counter guarantee even if the counter party defaults you will receive Rs.20/- as a gain.

Features of forward contract

Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc. A contract has to be settled in delivery or cash on expiration date. In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation can command the price he wants.

FUTURES
Futures

are exchange-traded contracts to buy or sell an asset in future at a price agreed upon today. The asset can be share, index, interest rate, bond, rupee-dollar exchange rate, sugar, crude oil, soybean, cotton, coffee etc.

The standard Feature in any futures contract

Obligation to buy or sell Stated quantity At a specific price Stated date (Expiration Date) Marked to Market on a daily basis For example: when you are dealing in March 2002 Satyam futures contract, you know that the market lot, ie the minimum quantity you can buy or sell, is 1,200 shares of Satyam, the contract would expiry on March 28, 2002, the price is quoted per share, the tick size is 5 paise per share or (1200*0.05) = Rs60 per contract/ market lot, the contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

Motives behind using Futures

Hedging:

It provides an insurance against an increase in the price.

futures market has two main types of foreseeable risk: - price risk - quantity risk

The

Interest Rate Futures

An

interest rate futures contract is an agreement to buy or sell a standard quantity of specific interest bearing instruments, at a predetermined future date and a price agreed upon between parties

DIFFERENCE BETWEEN FORWARD AND FUTURE CONTRACT.

Customised

vs Standardised contract:

Counter

Party Risk

Liquidity

Squaring

off:

FUTURES TERMINOLOGY
CONTRACT

CYCLE TICKET SIZE DELIVERY UNIT BASIS COST OF CARRY INITIAL MARGIN MARKING TO MARKET MAINTENANCE MARGIN

OPTIONS
Options

contracts grant their purchasers the right but not the obligation to buy or sell a specific amount of the underlying at a particular price within a specified period.

OPTIONS Terminology
Commodity

options Stock Options Buyer of an option Writer of an option Call option Put option Option price

OPTIONS Terminology
Expiration

date Strike Price American option European option In-the-money option At-the-money option Out-of the-money option

Pay-off for Options

Buyer

of call options : long call Writer of call options : short call Buyer of put options : long put Writer of call options : short put

Buyer of call options : long call

Writer of call options : short call

Buyer of put options : long put

Writer of call options : short put

Long Straddle

Short Straddle

Long Strangle

Short Strangle

Others
Currency Caps Floors Collars

Options

Distinguishing Options & Futures