Main Menu
Home > Equity> Derivatives > Class Room
19 August 2017

Class Room

What is a derivative?

A derivative is a financial contract, between two or more parties, which is derived from the future value of an underlying asset.

What are the types of derivatives available?

There are four main types of derivatives traded today. They are
  • Forward Contracts
  • Futures Contracts
  • Option Contracts
  • Swap transactions

What is a Forward Contract?

A forward contract is a transaction in which the buyer and the seller agree upon the delivery of a specified quality (if commodity) and quantity of underlying asset at a predetermined rate on a specified future date.

What is a Futures Contract?

A futures contract is a firm contractual agreement between a buyer and seller for a specified asset on a fixed date in the future. The contract price will vary according to the market place, but it is fixed when the trade is made. The contract also has a standard specification so both parties know exactly what is being traded.

What is an Option Contract?

An Option Contract confers the right, but not the obligation, to buy (Call) or sell (Put) a specific underlying instrument or asset at a specific price - the strike or exercise price - up until or on a specific future date - the expiry date.

What is a Swap transaction?

A Swap transaction is the simultaneous buying and selling of a similar underlying asset or obligation of equivalent capital amount where the exchange of financial arrangement with more favourable conditions than they would otherwise expect.

Importance of Derivatives

Derivatives are very important financial instruments of risk management as they allow risks to be separated and more precisely controlled. Derivatives are used to shift elements of risk and therefore act as a form of insurance.

Participants in the Derivatives Market

A party who is exposed to an unwanted risk and who wants to pass this risk on to another party, willing to accept it, can use derivatives. In this case he will be called a Hedger. A Speculator takes the opposing position to a hedger and exposes himself / herself in the hope of profiting from price changes to his or her advantage. There are also arbitrageurs who trade derivatives with a view to exploit any price differences within different derivatives markets or between the derivative instruments and cash or physical prices in the underlying assets.

How are Derivatives traded?

Traders are market players who buy and sell derivatives contracts on behalf of their clients or on their own account in the financial and commodity markets. There are three basic ways in which trading can take place: Over The Counter (OTC); on an exchange floor using open outcry; and using an electronic, automated matching system. Usually brokers act as intermediaries between traders and clients. Brokers do not usually trade on their own account but earn commissions on the deals that they arrange.

What was the original use of forward and futures contracts in the commodities markets?

To hedge prices and therefore the risk of holding the commodity; and to enable the producer to sell today for a guaranteed price in the future.

How are Forward Contracts traded?

Forward contracts are traded between the two parties involved and not on an exchange. A Forward contract involves a credit risk to both counterparties. Forward contracts are not normally negotiable and when the contract is made, it has no value. No payment is involved, as the contract is simply an agreement to buy or sell at a future date. Therefore the contract is neither an asset nor a liability.

How are forward prices determined?

The forward price for a contract is determined by taking the spot or cash price at the time of the transaction and adding to it a 'cost of carry'. Depending on the asset or commodity, the cost of carry takes into account payments and receipts for matters such as storage, insurance, transport costs, interest payments, dividend receipts, etc.
Forward price = Spot or cash price + cost of carry

What are the major advantage and disadvantage of a forward contract?

The major advantage of a forward contract is that it fixes prices for a future date. The major disadvantage of a forward contract is that if spot prices move one way or the other at the settlement date, then there is no way out of the agreement for the counterparties. Both sides are subject to the potential of gains or losses which are binding.

What are the types of underlying assets exist?

There are two basic types of assets for which futures contracts exist. These are Commodity futures contracts and Financial futures contracts. Although, both contracts are similar in principle, the methods of quoting prices, delivery and settlement terms vary according to the contract being traded. Commodity futures comprise grains, oil seeds, energy, metals, coffee, sugar, cocoa, etc. Financial futures comprise Interest rates, Bond prices, Currency exchange rates and stock indices.

How are futures contract traded?

Both commodity and financial futures contracts are traded on exchanges, worldwide. Futures contracts share the following common features: they are standardised, traded on an exchange, their prices are published and organised by a Clearing House.

Is there Credit risk involved in Futures Contract also as in the Forward Contract?

No. There is no credit risk involved in a Futures Contract. This is because of the involvement of a Clearing House, which means that the contract is not directly between the buyer and the seller but between each of them and the Clearing House. The Clearing House acts as a counterparty to both sides which, provides protection to both sides and allows trading to take place more freely.

What is the distinction between forward and futures contracts?

The distinctions between forward and futures contracts are summarised below:
Futures contracts Forwards contracts
1. Are traded on an exchange 1. Are not traded on an exchange
2. Use a Clearing House which provides protection for both parties 2. Are private and are negotiated between the parties with no exchange guarantees
3. Require a margin to be paid 3. Involve no margin payments
4. Are used for hedging and speculating 4. Are used for hedging and physical delive
5. Are standardised and published 5. Are dependent on the negotiated contract conditions
6. Are transparent - futures contracts are reported by the exchange. 6. Are not transparent as they are all private deals

Who are Hedgers?

These are market players who wish to protect an existing asset position from future adverse price movements.

How does one hedge?

In order to hedge a position, a hedger needs to take an equal and opposite position in the futures market to the one held in the cash market. There are two types of hedges- short and long.

In a short hedge, one takes a short futures position to offset an existing long position in the cash market. For example, a fund manager with a portfolio of stocks could hedge against a decline in stock prices by selling stock index futures contracts. If the prices for the asset fall in the cash market then at the time one decides to sell futures, any loss on the cash market is offset by the profit made by the gains from the futures contract.

In a long hedge, one takes a long futures position to offset an existing short position in the cash market. For example, a crude oil refiner could lock in the buying price by buying crude oil futures contracts today. If the prices for the asset rise in the cash market, then at the time one decides to buy futures, any loss in the cash market is offset by the profit made from the gains from the futures contract.

Thus, the purpose of hedging is that any loss one makes in one market is offset by a profit made in the other market.

Who is a speculator?

A speculator is a one who accepts the risk that hedgers wish to transfer. Speculators have no position to protect and do not necessarily have the physical resources to make delivery of the underlying asset nor do they necessarily need to take delivery of the underlying asset. They take positions on their expectations of futures price movements and in order to make a profit. In general they buy futures contracts when they expect futures prices to rise and sell futures contract when they expect futures prices to fall.

Is a speculator must?

Yes. Speculators are a must because they provide liquidity to the markets and without them the price protection - insurance - required by hedgers would be very expensive.

Who are Arbitrageurs?

These are traders and market makers who deal in buying and selling futures contracts hoping to profit from price differentials between markets and/or exchanges.

Is there any relationship between cash price and futures price?

Yes. Futures price is spot price plus carrying cost. The futures price is, therefore, usually higher than the current spot price. When the futures price is higher than the spot price the situation is known as Contango. When the futures price is lower than the spot price the market is said to be in Backwardation. Backwardation occurs in times of shortage caused by strikes, under capacity, etc., but the futures price stays steady as more supplies are expected in the future.

What is Basis?

The difference between the futures and spot prices at any time is called the basis.

What are the various types of financial futures?

There are three broad types of financial futures as follows:
  • Currency futures:
    The International Monetary Market division of the Chicago Mercantile Exchange in 1972 first introduced these.
  • Interest rate futures:
    The Chicago Board of Trade first introduced these as futures on Government National Mortgage Association (GNMA) certificates known as Ginnie Maes in 1975. These contracts are no longer traded, but many exchanges now trade interest rate futures on both short- and long-term assets. Contracts on long-term assets having bonds as the underlying instrument are also known as bond futures.
  • Equity index futures:
    the International Options Market division of the Chicago Mercantile Exchange introduced these as contracts on the Standard & Poor's 500 Index in 1982.

What are the main differences between commodity and financial futures contracts?

The main difference between commodity and financial futures contracts are:
  • Financial futures usually have a limited range of delivery dates based on a 3-month cycle; commodity futures often have monthly or seasonal delivery dates.
  • Most financial futures are cash settled: commodity futures contracts specify a delivery location.

What are Call and Put Options?

Calls and puts are the two basic types of options and can, themselves, be bought and sold. This means that one can buy a Call and sell a Call. Similarly, one can buy a Put and sell a Put. A Call Option is an option where the Buyer of a Call option gets the right to buy the underlying asset. A Put Option is an option where the Buyer of a Put option gets the right to sell the underlying asset.

Who are holders and writers?

The buyer of an option is called a holder and the seller of an option is called a writer. The holder always has the right but not the obligation to exercise the contract. The writer has the obligation to perform the contract if the holder decides to exercise the same.

What is Option Premium?

Option Premium is an amount, which Buyer of an option gives to the Writer for getting the rights to perform the contract.

When is a market player said to be long or short?

If a market player buys a contract he is said to go long and if he sells they are said to go short.

What do we mean by naked or uncovered options?

Option writers who own the underlying instruments they are trading are said to issue naked or uncovered options.

What is the advantage of Exchange-traded Options?

The main advantage of Exchange traded Options is that buyers and sellers of options can off-set their positions before the expiry date in a similar way to off-setting futures contracts on exchanges. Option writers face unlimited risks, as they have to deliver or take delivery of the underlying instruments no matter what the circumstances.

WHAT IS MEANT BY THE TERMS OPENING PURCHASE, OPENING SALE, CLOSING SALE AND CLOSING PURCHASE OF OPTION?

Opening Purchase The buyer of an option becomes the holder
Opening Sale The seller becomes the writer of the option
Closing Purchase The holder of an option sells an option identical to that held - this removes the liablities of the writer
Closing Sale The writer buys an option identical to that written - this removes the liablities of the writer

What are the various styles of Options available?

There are three basic styles of options, which are as follows:
  • American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early.
  • European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early.
  • Exotic: These are options with a more complicated structure than a standard call and put, incorporating special elements or restrictions.

What is Expiry date?

The Expiry date is the date and time after which an option may no longer be exercised.

What is Strike or Exercise price?

The fixed agreed price at which the underlying instrument may be bought (called in) or sold (put out), on exercise of an option, is known as the strike or exercise price.

What do you mean by At-the-Money, In-The-Money and Out-of-The-Money?

The option that has a strike price at or close to the price of the underlying is known as At-The-Money or ATM. An option that has a strike price, such that if the option were exercised immediately, a profit would be made, is known as In-The-Money or ITM. For the situation where no profit would be made immediately, the option is known as Out-of-The Money or OTM.
  CALL PUT
ITM Underlying instrument price is greater than the strike pric Underlying instrument price is less than the strike price
ATM Underlying instrument price is equal to or near the strike price Underlying instrument price is equal to or near the strike price
OTM Underlying instrument price is less than the strike price Underlying instrument price strike prices - the value must always be positive number is greater than the strike price.

How is Premium calculated?

The premium of an option has two components:

Premium = Intrinsic Value + Time Value

The Intrinsic Value of an option is the difference between the current price of the underlying and the strike price of the option, floored to zero. The Intrinsic Value is a measure of how much an option is In-The-Money.

Intrinsic Value = Difference between strike and underlying prices.

What are the different types of swap transactions?

The different types of swap transactions are explained as below:
SWAP PARTY A payment based on: PARTY B payment based on:
Interest Rate Fixed Or Floating Interest Rate Fixed Or Floating Interest Rate
Currency Interest On One Currency Interest On A Different Currency.
Commodity Price Of A Commodity Index Fixed Rate Or Some Other Floating Rate Or Price
Equity Rate Of Return Of A Stock Index Fixed Or Floating Rate Or Rate Of Return On Another Stock Index.

What is an Interest Rate Swap?

An Interest Rate Swap is an agreement between counterparties in which each party agrees to make a series of payments to the other on agreed future dates until maturity of the agreement. Each party's interest payments are calculated using different formulas by applying the agreement terms to the notional principal amount of the swap.

Is there any exchange of principal amount?

No exchange of principal occurs during the swap - no funds are lent or borrowed between the counterparties as part of swap. Any underlying loan or deposit is not affected by the swap. The swap is a separate transaction.

What is Currency Swap?

A Currency Swap is an agreement between counterparties in which one party makes payments in one currency and the other party makes payments in a different currency on agreed future dates until maturity of the agreement.

What is a Commodity Swap?

A Commodity Swap is an agreement between counterparties in which at least one set of payments involved is set by the price of a commodity index. It is usually a plain vanilla agreement that is purely financial involving no delivery of the physical commodity.

What is an Equity Swap?

An Equity Swap is an agreement between counterparties in which at least one party agrees to pay the other a rate of return based on a stock index, according to a schedule of future dates for the maturity period of the agreement. The other party makes payments based on a fixed or floating rate, or another stock index. The payments are based on an agreed percentage of an underlying notional principal amount. At least one payment is based on the rate of return of a Stock Index for an agreed percentage of a notional principal amount.

What are the general risks associated with derivative instruments?

The different types of risks associated with derivative instruments are as follows:
  • Credit risks
    These are the usual risks associated with counterparty default and which must be assessed as part of any financial transaction.
  • Market risks
    These are the usual risks associated with counterparty default and which must be assessed as part of any financial transaction.
  • Operational risks
    These are the risks associated with the general course of business operations and include
    • Settlement risks,
    • Legal risks, and
    • Deficiencies in information, monitoring and control systems, which result in fraud, human error, system failures, management failures etc. Settlement risk arises as a result of the timing differences between when an institution either pays out funds or deliverable assets before receiving a assets or payments from a counterparty. Legal risk arises when a contract is not legally enforceable, reason being,
      • Inadequate documentation
      • The counterparty lacks the required authority to enter into the transaction
      • The underlying transaction is not permission
      • Bankruptcy or insolvency of the counterparty changes the contract conditions
      • Strategic risks
    • These risks arise from activities such as:
      • Entrepreneurial behaviour of traders in financial institutions
      • Misreading client requests
      • Costs getting out of control
      • Trading with inappropriate counterparties

How are derivatives different from badla?

Badla facilitates borrowing and lending of shares and funds. The borrower of shares pays a fee for the borrowing. When badla works without a strong margining system, it generates counterparty risk. Futures may seem to be like badla, the difference of which is being given below. The option is obviously not at all like badla.
BADLA FUTURES
  1. Expiration date unclear
  2. Spot market and different expiration dates are mixed up
  1. Expiration date known
  2. Spot market and different expiration dates of all trade distinct from each otherFall in Currency value
  1. Identity of counterparty often known
  2. Counterparty risk present
  1. Clearing corporation is counterpa
  2. No counterparty risk
  1. Badla financing is additional source of risk
  2. Badla financing contains default-risk premia
  3. Asymmetry between long and short
  4. Position can breakdown if borrowing /lending proves infeasible
  1. No additional risk
  2. Financing cost is riskless due to counterparty guarantee
  3. Long and short are symmetric
  4. One can hold till expiration date for sure, if required.
Toll Free number: 1800-425-5501 / 1800-103-5501
FINANCIAL TOOLS