Derivatives Market Dealers Module PDF

Derivatives Market (Dealers) Module (DMDM) NCFM Module Examination Details Allowable access to Candidate at Sr. Module Name Test No. Of...

Derivatives Market (Dealers) Module (DMDM) NCFM Module Examination Details Allowable access to Candidate at Sr. Module Name Test No. Of Maxi- Nega- Pass Test Centre NO Dura- Ques- mum tive marks Normal Regular tion (in tions Marks Mark- Open Distri- /Sci- Finan- min- ing Office bution entific cial utes) Spread Table Calcu- Calcu- Sheet lator lator FOUNDATION 1 Financial Markets: A Beginners’ Module 120 60 100 NO 50 NO NO YES NO 2 Mutual Funds : A Beginners' Module 120 60 100 NO 50 NO NO YES NO 3 Currency Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO 4 Equity Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO 5 Interest Rate Derivatives: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO 6 Commercial Banking in India: A Beginner’s Module 120 60 100 NO 50 NO NO YES NO 7 FIMMDA-NSE Debt Market (Basic) Module 120 60 100 YES 60 YES NO YES NO 8 Securities Market (Basic) Module 120 60 100 YES 60 NO NO YES NO 9 Clearing Settlement and Risk Management Module 60 75 100 NO 60 YES NO YES NO 10 Banking Fundamental - International 90 48 48 YES 29 YES NO YES NO 11 Capital Markets Fundamental - International 90 40 50 YES 30 YES NO YES NO INTERMEDIATE 1 Capital Market (Dealers) Module 105 60 100 YES 50 NO NO YES NO 2 Derivatives Market (Dealers) Module 120 60 100 YES 60 NO NO YES NO 3 Investment Analysis and Portfolio Management 120 60 100 YES 60 NO NO YES NO 4 Fundamental Analysis Module 120 60 100 YES 60 NO NO YES NO 5 Operation Risk Management Module 120 75 100 YES 60 NO NO YES NO 6 Options Trading Strategies Module 120 60 100 YES 60 NO NO YES NO 7 Banking Sector Module 120 60 100 YES 60 NO NO YES NO 8 Treasury Management Module 120 60 100 YES 60 YES NO YES NO 9 Insurance Module 120 60 100 YES 60 NO NO YES NO 10 Macroeconomics for Financial Markets Module 120 60 100 YES 60 NO NO YES NO 11 NSDL–Depository Operations Module # 75 60 100 YES 60 NO NO YES NO 12 Commodities Market Module 120 60 100 YES 50 NO NO YES NO 13 Surveillance in Stock Exchanges Module 120 50 100 YES 60 NO NO YES NO 14 Technical Analysis Module 120 60 100 YES 60 NO NO YES NO 15 Mergers and Acquisitions Module 120 60 100 YES 60 NO NO YES NO 16 Back Office Operations Module 120 60 100 YES 60 NO NO YES NO 17 Wealth Management Module 120 60 100 YES 60 NO NO YES NO 18 Project Finance Module 120 60 100 YES 60 NO NO YES NO 19 Venture Capital and Private Equity Module 120 70 100 YES 60 NO NO YES NO 20 Financial Services Foundation Module ### 120 45 100 YES 50 NO NO YES NO 21 NSE Certified Quality Analyst $ 120 60 100 YES 50 NO NO YES NO 22 NSE Certified Capital Market Professional (NCCMP) 120 60 100 NO 50 NO NO YES NO 23 US Securities Operation Module 90 41 50 YES 30 YES NO YES NO ADVANCED 1 Algorithmic Trading Module 120 100 100 YES 60 YES NO YES NO 2 Financial Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO 3 Securities Markets (Advanced) Module 120 60 100 YES 60 YES NO YES NO 4 Derivatives (Advanced) Module 120 55 100 YES 60 YES YES YES NO 5 Mutual Funds (Advanced) Module 120 60 100 YES 60 YES NO YES NO 6 Options Trading (Advanced) Module 120 35 100 YES 60 YES YES YES YES 7 Retirement Analysis and Investment Planning 120 77 150 NO 50 YES NO YES YES 8 Retirement Planning and Employee Benefits ** 120 77 150 NO 50 YES NO YES YES 9 Tax Planning and Estate Planning ** 120 77 150 NO 50 YES NO YES YES 10 Investment Planning ** 120 77 150 NO 50 YES NO YES YES 11 Examination 5/Advanced Financial Planning ** 240 30 100 NO 50 YES NO YES YES 12 Equity Research Module ## 120 49 60 YES 60 YES NO YES NO 13 Financial Valuation and Modeling 120 100 100 YES 60 YES NO YES YES 14 Mutual Fund and Fixed Income Securities Module 120 100 60 YES 60 YES NO YES YES 15 Issue Management Module ## 120 55 70 YES 60 YES NO YES NO 16 Market Risk Module ## 120 40 65 YES 60 YES NO YES NO 17 Financial Modeling Module ### 120 30 100 YES 50 YES NO YES NO 18 Business Analytics Module ### 120 66 100 NO 50 YES NO YES NO # Candidates securing 80% or more marks in NSDL-Depository Operations Module ONLY will be certified as ‘Trainers’. ### Module of IMS Proschool ## Modules of Finitiatives Learning India Pvt. Ltd. (FLIP) ** Financial Planning Standards Board India (Certified Financial Planner Certification) FPSB India Exam $ SSA Business School The curriculum for each of the modules (except Modules of Financial Planning Standards Board India, Finitiatives Learning India Pvt. Ltd. and IMS Proschool) is available on our website: www.nseindia.com Preface About NSE Academy NSE Academy is a subsidiary of National Stock Exchange of India. NSE Academy straddles the entire spectrum of financial courses for students of standard VIII and right up to MBA professionals. NSE Academy has tied up with premium educational institutes in order to develop pool of human resources having right skills and expertise which are apt for the financial market. Guided by our mission of spreading financial literacy for all, NSE Academy has constantly innovated its education template, this has resulted in improving the financial well-being of people at large in society. Our education courses have so far facilitated more than 41.8 lakh individuals become financially smarter through various initiatives. NSE Academy’s Certification in Financial Markets (NCFM) NCFM is an online certification program aimed at upgrading skills and building competency. The program has a widespread reach with testing centers present at more than 154+ locations across the country. The NCFM offers certifications ranging from the Basic to Advanced. One can register for the NCFM through: Online mode by creating an online login id through the link ‘Education’>‘Certifications’ > ‘Online Register / Enroll’ available on the website www.nseindia.com Offline mode by filling up registration form available on the website www.nseindia.com > ‘Education’ >’Certifications’ >‘Register for Certification’ Once registered, a candidate is allotted a unique NCFM registration number along with an online login id and can avail of facilities like SMS alerts, online payment, checking of test schedules, online enrolment, profile update etc. through their login id. CHAPTER 4: APPLICATION OF FUTURES CONTRACTS............................................ 33 4.1 Understanding Beta (β).................................................................................. 33 4.2 Numerical illustration of applications of stock Futures......................................... 33 4.3 Hedging using stock index Futures................................................................... 36 4.4 CONCLUSION................................................................................................ 38 CHAPTER 5: OPTIONS CONTRACTS, MECHANISM AND APPLICATIONS.................. 39 5.1 Option Terminology....................................................................................... 39 5.2 Comparison between Futures and options......................................................... 40 5.3 Options Payoffs............................................................................................. 42 5.4 Application Of Options.................................................................................... 46 5.5 Popular Options Trading Strategies................................................................... 56 5.6 CONCLUSION................................................................................................ 62 CHAPTER 6: PRICING OF OPTIONS CONTRACTS, VOLATILITY AND OPTION GREEKS..... 63 6.1 Variables Affecting Option Pricing.................................................................... 63 6.2 Option Price Limits........................................................................................ 64 6.3 The Black scholes Merton Model for Option Pricing (BSO).................................... 64 6.4 The Greeks................................................................................................... 65 6.5 Volatility of Options....................................................................................... 67 CHAPTER 7: TRADING OF DERIVATIVES CONTRACTS............................................ 69 7.1 Futures And Options Trading System................................................................ 69 7.2 Client Broker Relationship in Derivative Segment............................................... 72 7.3 Order Types and Conditions............................................................................ 72 7.4 Order Processing and Matching....................................................................... 73 7.5 The Trader Workstation.................................................................................. 74 7.6 Futures and options Market instruments........................................................... 78 7.7 Criteria for Stocks and Index Eligibility for Trading............................................. 84 7.8 Charges....................................................................................................... 86 7.9 INTRODUCTION OF DERIVATIVE CONTRACTS ON FOREIGN STOCK INDICES......... 87 7.10 CONCLUSION................................................................................................ 87 2 CHAPTER 8: CLEARING AND SETTLEMENT............................................................. 88 8.1 Clearing Entities............................................................................................ 88 8.2 Clearing Mechanism....................................................................................... 89 8.3 Settlement Procedure.................................................................................... 91 8.4 Risk Management.......................................................................................... 95 8.5 NSSCL SPAN................................................................................................. 97 8.6 Cross Margining...........................................................................................102 CHAPTER 9: REGULATORY FRAMEWORK..............................................................104 9.1 Securities Contracts (Regulation) Act, 1956.....................................................104 9.2 Securities And Exchange Board Of India Act, 1992............................................105 9.3 Regulation for Derivatives Trading...................................................................106 9.4 Requirements for F&O Trading At NSE.............................................................107 9.5 Position limits..............................................................................................110 9.6 Reporting of client margin.............................................................................113 9.7 Conclusion...................................................................................................114 CHAPTER 10: ACCOUNTING FOR DERIVATIVES....................................................115 10.1 Key Accounting Principles..............................................................................115 10.2 Applicability.................................................................................................115 10.1 Synthetic Accounting....................................................................................116 10.2 Hedge Accounting........................................................................................116 10.6 Presentation in The Financial Statements.........................................................118 10.7 Disclosures in Financial Statements................................................................119 10.8 Taxation Of Derivative Transaction In Securities................................................120 Chapter 11: Investor Services......................................................................122 11.1 Commencing Trading on the NSE Derivatives Segment......................................122 11.2 Model Risk Disclosure Document....................................................................123 11.3 Do’s and Don’t’s for Investors........................................................................124 11.4 SEBI Measures for Investor Rights Protection...................................................125 REFERENCES........................................................................................................126 MODEL TEST PAPER.............................................................................................127 3 Distribution of weights of the Derivatives Market (Dealers) Module Curriculum Chapter No Title Weights (%) 1 Introduction to Derivatives 5 2 Understanding Interest Rates and Stock Indices 5 3 Futures Contracts, Mechanism and Pricing 5 4 Application of Futures Contracts 10 5 Options Contracts, Mechanism and Applications 10 6 Pricing of Options Contracts and Greek Letters 10 7 Trading of Derivatives Contracts 20 8 Clearing and Settlement 20 9 Regulatory Framework 10 10 Accounting for Derivatives 5  andidates are advised to refer to website: www.nseindia.com while preparing for Note: - C NCFM test (s) for announcements pertaining to revisions/updations in NCFM modules or launch of new modules, if any. Copyright © 2018 by NSE Academy Limited NSE Academy Limited is a subsidiary of NSE Exchange Plaza, Bandra Kurla Complex, Bandra (East), Mumbai 400 051 All content included in this book, such as text, graphics, logos, images, data compilation etc. are the property of NSE Academy Ltd. This book or any part thereof should not be copied, reproduced, duplicated, sold, resold or exploited for any commercial purposes. Furthermore, the book in its entirety or any part cannot be stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise. 4 CHAPTER 1: INTRODUCTION TO DERIVATIVES The term ‘Derivative’ stands for a contract whose price is derived from or is dependent upon an underlying asset. The underlying asset could be a financial asset such as currency, stock and market index, an interest bearing security or a physical commodity. Today, around the world, derivative contracts are traded on electricity, weather, temperature and even volatility. According to the Securities Contract Regulation Act, (1956) the term “derivative” includes: 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; a contract which derives its value from the prices, or index of prices, of underlying securities. The concept of derivatives can be traced back to the Mesopotamian era when the sixth Babylonian king allowed sale of goods and assets at a pre-agreed price, delivered at a future date. This is nothing but a derivative. The working of a derivative contract of this nature is very simple. Let us understand this with the help of an illustration. Illustration: Consider that you are a farmer who has 10 acres of land. You can either cultivate rice in all 10 acres or cultivate rice in 5 acres and wheat in the remaining 5. If you cultivate rice in all 10 acres, and the demand for wheat is high that year, it would mean that you lose out on potentially high profits that you could have made if you had cultivated wheat. If you cultivate rice and wheat, and if the demand and price for rice is very high that year, then you lose out on potentially high profits arising from rice. So how do you resolve this issue? You can enter into a contract with a distributor to purchase all your produce – whether it be all rice or 50% rice and 50% wheat, at the beginning itself, before you even begin cultivation. This way, you are assured that whatever is agreed upon, if you cultivate it, it will be sold in its entirety. Even the price that you will get for it is agreed upon in the beginning itself. Thus, you don’t incur any risk from the decision, that your produce may not get sold. This agreement is a derivative contract, where the underlying asset is the produce! Why is it Important to learn about Derivatives? In the past two decades, there has been exponential growth in the volume of international trade and business due to the adoption of globalization and liberalization all over the world. The demand for the international money and financial instruments increased significantly at global level. In turn, change in exchange rates, interest rates and stock prices of different financial markets have increased the financial risk to the corporates and investors globally. Adverse changes in any of these threatened the survival of business world. Therefore, in order to manage such risk, the new instruments have been developed in the financial markets, which are popularly known as financial derivatives at national and international financial market. The primary purpose of these instruments is to ensure commitments to prices for 5 future dates for giving protection against adverse movements in future prices to reduce the extent of financial risk in financial markets. Now there is a faster development in derivatives products as well as trading as they are very significant for every corporates and investors. In India, emergence and growth of derivative market is completely new phenomenon. The introduction of equity derivatives was essentially the beginning of a new era in the Indian Capital Market. With the launch of Index Futures in June 2000, as the first derivative product, SEBI expanded the portfolio by quickly adding index options, individual stock options and individual stock futures. So now, the growth of this market has been quite significant. With these products in place, Indian Capital Market is at par with any other Capital Market across the globe. The Indian derivative market has exhibited exponential growth in terms of volume and number of contracts traded. The market turnover of NSE has grown from Rs 2,365 crores in 2000-01 to Rs 3, 82, 11,408.05 crores in 2013-14 and BSE market turnover also increased from Rs 5021.81 crores in 2003-04 to Rs 92, 19,434.32 crores in 2013-14. Within a short span of fourteen years, there is a substantial development in derivatives trading in terms of turnover and number of contracts traded in India. As derivatives are new products in Indian capital market, most of the investors are not aware about such a new products. Thus, there is a need to make the sense of availability of these new financial products and their usefulness particularly among medium and retail investors. 1.1 Types of Derivative Contracts 1. Derivatives can be classified in 3 ways: On the basis of the nature of the derivative contract 2. On the basis of the Underlying asset 3. On the basis of the place of trading 1.1.1 Classification basis nature of contract Derivatives can be broadly classified into 2 types based on the nature of contract as can be seen from the diagram below. All types of derivatives fall into either of these 2 categories Derivatives Forward Contingent Commitment Claim Forwards Options Futures Swaps Swaps 6 Forward Commitment These derivatives comprise of an assured occurrence in the future. The underlying asset will get exchanged at a fixed future time, at a fixed price, agreed upon by both parties at the time of entering into the contract. Since the exchange is fixed at a future time, it is called a Forward Commitment. Neither party can back out of the contract once it has been entered into, except under mutual consent. Futures, Forwards and Swaps are three main types of derivatives that fall under this category. We will discuss each of these in detail in subsequent sessions. Contingent Claim These derivatives comprise of an exchange subject to a certain event occurring at a future time. If the event occurs, then the underlying asset will be exchanged at a fixed future time, at a fixed price, agreed upon by both parties at the time of entering into the contract. Since the exchange is contingent on the occurrence of an event, it is known as contingent claim. If the event does not occur, the contract becomes null and void and will expire on the expiration date. Options and swaps come under this category. 1.1.2 Classification basis Underlying Another way of classifying derivatives, is on the basis of the Underlying Asset. The types are as follows: Type of Derivative Underlying Asset Equity Stock / Share Index Any broad-spectrum or sectoral index Interest rate Debt instrument – loans / asset backed securities Currency Foreign Exchange Commodities Any commodity 1.1.3 Classification on the basis of place of trade Derivatives can either be traded over the counter (OTC) or on an organized exchange. Based on the place of trade, they are called OTC derivatives and Exchange traded derivatives respectively. Usually forwards, some types of options, swaps exotic products are OTC derivatives. Futures, exchange-traded options are exchange traded derivatives. 7  Box 1.1: Over the Counter (OTC) Derivative Contracts Derivatives that trade on an exchange are called exchange traded derivatives, whereas privately negotiated derivative contracts are called OTC contracts. The OTC derivatives markets have the following features compared to exchange-traded derivatives: (i) The management of counter-party (credit) risk is decentralized and located within individual institutions, (ii) There are no formal centralized limits on individual positions, leverage, or margining, (iii) There are no formal rules for risk and burden-sharing, (iv) There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and (iv) The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization. They are however, affected indirectly by national legal systems, banking supervision and market surveillance. 1.2 Basic Derivatives Over the past couple of decades several exotic contracts have also emerged but these are largely the variants of these basic contracts. Let us briefly define some of these abovementioned contracts Forward Contracts: These are promises to deliver an asset at a pre- determined date in future at a predetermined price. Forwards are highly popular on currencies and interest rates. The contracts are traded over the counter (i.e. outside the stock exchanges, directly between the two parties) and are customized according to the needs of the parties. Since these contracts do not fall under the purview of rules and regulations of an exchange, they generally suffer from counterparty risk i.e. the risk that one of the parties to the contract may not fulfill his or her obligation. Futures Contracts: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. These are basically exchange traded, standardized contracts. The exchange stands guarantee to all transactions and counterparty risk is largely eliminated. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. It should be noted that this is similar to any asset market where anybody who buys is long and the one who sells in short. Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets. They are highly popular on stock indices, interest rates and foreign exchange. Option Contracts: Options give the buyer (holder) a right but not an obligation to buy or sell an asset in future. Options are of two types - calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price 8 on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. One can buy and sell each of the contracts. When one buys an option he is said to be having a long position and when one sells he is said to be having a short position. It should be noted that, in the first two types of derivative contracts (forwards and futures) both the parties (buyer and seller) have an obligation; i.e. the buyer needs to pay for the asset to the seller and the seller needs to deliver the asset to the buyer on the settlement date. In case of options only the seller (also called option writer) is under an obligation and not the buyer (also called option purchaser). The buyer has a right to buy (call options) or sell (put options) the asset from / to the seller of the option but he may or may not exercise this right. In case the buyer of the option does exercise his right, the seller of the option must fulfill whatever is his obligation (for a call option the seller has to deliver the asset to the buyer of the option and for a put option the seller has to receive the asset from the buyer of the option). An option can be exercised at the expiry of the contract period (which is known as European option contract) or anytime up to the expiry of the contract period (termed as American option contract). Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 1.3 History of Financial Derivatives Markets Financial derivatives have emerged as one of the biggest markets of the world during the past two decades. A rapid change in technology has increased the processing power of computers and has made them a key vehicle for information processing in financial markets. Globalization of financial markets has forced several countries to change laws and introduce innovative financial contracts which have made it easier for the participants to undertake derivatives transactions. Early forward contracts in the US addressed merchants’ concerns about ensuring that there were buyers and sellers for commodities. ‘Credit risk’, however remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848. The primary intention of the CBOT was to provide a centralized location (which would be known in advance) for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first ‘exchange traded” 9 derivatives contract in the US. These contracts were called ‘futures contracts”. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest “financial” exchanges of any kind in the world today. The first exchange-traded financial derivatives emerged in 1970’s due to the collapse of fixed exchange rate system and adoption of floating exchange rate systems. As the system broke down currency volatility became a crucial problem for most countries. To help participants in foreign exchange markets hedge their risks under the new floating exchange rate system, foreign currency futures were introduced in 1972 at the Chicago Mercantile Exchange. In 1973, the Chicago Board of Trade (CBOT) created the Chicago Board Options Exchange (CBOE) to facilitate the trade of options on selected stocks. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and EuroDollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc. Futures contracts on interest-bearing government securities were introduced in mid-1970s. The option contracts on equity indices were introduced in the USA in early 1980’s to help fund managers to hedge their risks in equity markets. Afterwards a large number of innovative products have been introduced in both exchange traded format and the Over the Counter (OTC) format. Box 1.2: History of Derivative trading at NSE The derivatives trading on the NSE commenced on June 12, 2000 with futures trading on Nifty 50 Index. Subsequent trading in index options and options on individual securities commenced on June 4, 2001 and July 2, 2001. Single stock futures were launched on November 9, 2001. Ever since the product base has increased to include trading in futures and options on CNX IT Index, Bank Nifty Index, Nifty Midcap 50 Indices etc. Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India. The derivatives contracts have a maximum of 3-month expiration cycles except for a long dated Nifty Options contract which has a maturity of 5 years. Three contracts are available for trading, with 1 month, 2 months and 3 months to expiry. A new contract is introduced on the next trading day following the expiry of the near month contract. The OTC derivatives have grown faster than the exchange-traded contracts in the recent years. Table 1.1 gives a bird’s eye view of these contracts as available worldwide on several exchanges. 10 Table 1.1: Spectrum of Derivative Contracts Worldwide Underlying Type of Derivative Contract asset Exchange- Exchange- OTC swap OTC forward OTC option traded traded futures options Equity Index future Index option Equity swap Back to Stock Stock future back repo options agreement Warrants Interest rate Interest Options on Interest rate Forward rate Interest rate rate futures futures swaps agreement caps, floors linked to & collars. MIBOR Swaptions Credit Bond future Option on Credit Repurchase Credit Bond future default swap agreement default Total return option swap Foreign Currency Option on Currency Currency Currency exchange future currency swap forward option future The above list is not exhaustive. Several new and innovative contracts have been launched over the past decade around the world including option contracts on volatility indices. 1.4 Participants in a Derivative Market 1. As with the regular financial markets, derivatives markets have the following participants: Stock Exchange: Where the derivatives are created and traded. 2. Investors: Investors in derivatives could be retail investors, institutional investors, banks, corporates. Each investor has different objectives of investing in derivatives. The types of investors are detailed below. 3. Regulatory Authorities: They ensure smooth functioning of the markets and ensures fair practices are being followed by all participants. SEBI regulates the equity derivative markets, RBI the interest rate and currency derivative markets and FMC (Forward Markets Commission) the commodity markets. FMC is now merged with SEBI, and hence SEBI overlooks both parts of the derivative markets. 4. Others: Other participants such as Clearing and settlement agencies, credit rating agencies, investor grievances etc are shared between the financial markets and the derivatives markets. Types of Investors: The derivatives market is similar to any other financial market and has following three broad categories of investors: 11  Hedgers: These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios. Banks, treasury of companies etc fall under this category. Speculators: These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset. Retail investors who invest for the purpose of making profits on gains fall under this category. Arbitrageurs: They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit. Institutional players, proprietary dealers may fall under this category. 1.5 Economic Function of the Derivative Market The derivatives market performs a number of economic functions. In this section, we discuss some of them. Prices in an organized derivatives market reflect the perception of the market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus derivatives help in discovery of future as well as current prices. The derivatives market helps to transfer risks from those who have them but do not like them to those who have an appetite for them. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes. This is because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Speculative trades shift to a more controlled environment in derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. In a nut shell, derivatives markets help increase savings and investment in the long run. A key aspect of use of derivatives is Leverage, which allows investors to actually transact in higher 12 amounts than what they are investing. Transfer of risk also enables market participants to expand their volume of activity. 1.6 Conclusion Derivatives are contracts in which there is an underlying asset in the form of a stock, bond, currency, commodity or another derivative. The price of the derivative is dependent on the price of the underlying asset. Derivatives are classified in various ways. One the basis of the place of trade, there are 2 types – Exchange traded derivatives and Over the Counter derivatives. On the basis of nature of the contract, there are 2 types – Forward commitment and Contingent Claim. Derivatives are also classified on the basis of nature of the underlying asset. The 4 major types of derivative contracts are – Forwards, Futures, Options and Swaps. Derivatives originated first in the commodities market in the US, then transgressed into currencies and finally into the capital markets with stocks and bonds as underlyings. In India, currently there are various futures and options traded on the major stock exchanges in stocks, indices, bonds and currencies. Derivatives serve various economic functions such as transfer of risk, moving speculation to a controlled environment and higher trading volumes due to leverage. 13 CHAPTER 2: UNDERSTANDING INTEREST RATES AND STOCK INDICES Interest rates and Indices are two types of Underlying assets we will see commonly in various derivatives. Other assets such as Equity, commodities and currency you would be familiar with already. In this chapter we will discuss the interest rates and market index related issues, since it will help better understand the functioning of derivatives markets. We will also learn about derivative contracts on indices which have the index as underlying. 2.1 Understanding Interest Rates Interest rate is the return on any equity or debt investment. Interest rates can be discrete or continuous. When people invest in financial markets (such as equity shares), returns on assets change continuously. Here, we find that continuous compounding of returns (the interest rate on equity) takes place. On the other hand a fixed deposit is discretely compounded and the frequency could be from annual to quarterly to daily. A continuously compounded investment will always give higher returns than a discretely compounded investment, irrespective of frequency of compounding, for the same investment period. Interest rates are always quoted in percentage terms on per annum basis. However, they also indicate the frequency along with the per annum rates. Example: The statement that interest rate on a given deposit is equal to 10% per annum implies that the deposit provides an interest rate of 10% on an annually compounded basis (using the formula A=P*(1+r/t)t ) where P is the principal, r is the rate of interest and t is the time. Thus, if Rs 100 is deposited in a fixed deposit it would give a return of Rs 100*(1+0.1) = Rs 110. However the final amount will be different if the compounding frequency changes. For instance, if the compounding frequency is changed to semi annual and the rate of interest on Rs.100 is 10% then the amount on maturity would be Rs. 110.250 (calculated as 100*(1+0.1/2)^2). The returns on investment are influenced by the rate of interest and the compounding frequency. Higher the interest rate and higher the compounding frequency, higher the returns on investment! The table 2.1 below shows the change in amount when the same interest rate is compounded more frequently i.e. from annual to daily and finally continuous compounding. 14 Table 2.1: Interest rate and Compounding Frequency Principal Interest Compounding Calculation Amount in (rs) rate (%) Frequency one year (Rs) 100 10% Annual 100(1+10%) 110.000 100 10% Semi Annual 100[1+(10%/2)]2 110.250 100 10% Quarterly 100[1+(10%/4)]4 110.381 100 10% Monthly 100[1+(10%/12)]12 110.471 100 10% Daily 100[1+(10%/365)]365 110.516 100 10% Continuously 100 * e(10% * 1) 110.517 It should be noted that daily compounding is the new norm for calculating savings accounts balances by banks in India (starting from April 1, 2010). The continuous compounding is done by multiplying the principal with ert where r is the rate of interest and t the time period. e is exponential function which is equal to 2.718. Illustration 2.1 What is the equivalent rate for continuous compounding for an interest rate which is quoted: a. 8% per annum semi annual compounding? b. 8% per annum annual compounding? Solution: a. 2 * ln(1+0.08/2)=0.078441=7.844% b. ln(1+.08) =0.07696=7.696% Illustration 2.2 A bank quotes you an interest rate of 10% per annum with quarterly compounding. What is the equivalent rate when it is: a. Continuous compounding b. Annual compounding. Solution: a. 4 * ln (1+0.10/4)=0.098770=9.877% b. (1+0.10/4)4 - 1= 10.38% Part (b) of Illustration 2.2 is also called effective annual rate calculation. By this method any given interest rate or return can be converted to its effective annual interest rate or effective annual return. 2.2 Understanding The Stock Index An index is a number which measures the change in a set of values over a period of time. A stock index represents the change in value of a set of stocks which constitute the index. 15 More specifically, a stock index number is the current relative value of a weighted average of the prices of a pre-defined group of equities. A stock market index is created by selecting a group of stocks that are representative of the entire market or a specified sector or segment of the market. It is calculated with reference to a base period and a base index value. The beginning value or base of the index is usually set to a number such as 100 or 1000. The main index of the NSE is the Nifty 50. The Nifty 50 is a well diversified 50 stock index accounting for 13 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. The base value of the Nifty, which is the benchmark broad-based index of the National Stock Exchange, was set to 1000 on the start date of November 3, 1995. Thereafter, changes in the values of the group of equities used to create the index will be reflected on this base number in weighted average percentage terms. Broad-based market indices are meant to capture the overall behavior of equity markets. Stock market indices are useful for a variety of reasons. Some uses of them are: As a barometer for market behaviour, As a benchmark for portfolio performance, As an underlying in derivative instruments like Index futures, Index options, and In passive fund management by index funds/ETFs Sectoral indices capture the behavior of a particular sector, just as market indices capture behavior of the overall market. For eg: The Bank Nifty / Nifty Bank Index, which is a banking sector index of the NSE, which contains the 12 most liquid and large capitalised stocks from the banking sector which trade on the National Stock Exchange (NSE). It provides investors and market intermediaries a benchmark that captures the capital market performance of Indian banking sector. 2.3 Economic Significance of Index Movements Index movements reflect the changing expectations of the stock market about future dividends of the corporate sector, just as how stock values reflect expectations of investors about a particular company. The index goes up if the stock market perceives that the prospective dividends in the future will be better than previously thought. When the prospects of dividends in the future become pessimistic, the index drops. The ideal index gives us instant picture about how the stock market perceives the future of corporate sector. Every stock price moves for two possible reasons: News about the company- micro economic factors (e.g. a product launch, or the closure of a factory, other factors specific to a company) News about the economy – macro economic factors (e.g. budget announcements, changes in tax structure and rates, political news such as change of national government, other factors common to all companies in a country) 16 The index captures the second part, the movements of the stock market as a whole (i.e. news about the macroeconomic factors related to entire economy). This is achieved by averaging. Each stock contains a mixture of two elements - stock news and index news. When we take an average of returns on many stocks, the individual stock news tends to cancel out and the only thing left is news that is common to all stocks. The news that is common to all stocks is news about the economy. The correct method of averaging is that of taking a weighted average, giving each stock a weight proportional to various aspects like its market capitalization, price and so on. Example: Suppose an index contains two stocks, A and B. A has a market capitalization of Rs.1000 crore and B has a market capitalization of Rs.3000 crore. Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B. We will study more on how indices are constructed and the issues therein in the next section. 2.4 Index Construction A good index is a trade-off between diversification and liquidity. A well diversified index is more representative of the market/economy. There are however, diminishing returns to diversification. Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost zero reduction in risk. Hence, there is little to gain by diversifying beyond a point. The more serious problem lies in the stocks which are included into an index when it is broadened. If the stock is illiquid, the observed prices yield contaminated information and actually worsen an index. The computational methodology followed for construction of stock market indices are (a) Free Float Market Capitalization Weighted Index, (b) Market Capitalization Weighted index and the (c) Price Weighted Index. Free Float Market Capitalisation Weighted index: The free float factor (Investible Weight Factor), for each company in the index is determined based on the public shareholding of the companies as disclosed in the shareholding pattern submitted to the stock exchange by these companies1. The Free float market capitalization is calculated in the following manner: Free Float Market Capitalisation = Issue Size * Price * Investible Weight Factor The Index in this case is calculated as per the formulae given below: Free float current market capitalization Index = × Base Value Free Float Base Market Capitalization 1 The free float method excludes (i) Government holding in the capacity of strategic investor, (ii) Shares held by promoters through ADRs/GDRs, (iii) Strategic stakes by corporate bodies/Individuals /HUF, (iv) Investments under FDI Category, (V) Equity held by associate /group companies 17 The India Index Services Limited (IISL), a a subsidiary of NSE Strategic Investment Corporation Limited, introduced the free float market capitalization methodology for its main four indices, viz., Nifty 50, Nifty 50 USD, Nifty Next 50 and Nifty 100. With effect from May 4, 2009 Nifty 50 Junior and with effect from June 26, 2009, Nifty 50, Nifty 100 and Nifty 50 USD are being calculated using free float market capitalisation. Market Capitalisation Weighted index: In this type of index calculation, each stock in the index affects the index value in proportion to the market value of all shares outstanding. In this the index would be calculated as per the formulae below: Current market capitalization Index = × Base Value Base Market Capitalization Where, Current market capitalization - Sum of (current market price * Issue size) of all securities in the index. Base market capitalization - Sum of (market price * issue size) of all securities as on base date. Price Weighted Index: In a price weighted index each stock influences the index in proportion to its price per share. The value of the index is generated by adding the prices of each of the stocks in the index and dividing then by the total number of stocks. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index. 2.5 Desirable Attributes Of An Index A good market index should have the following attributes: It should capture the behaviour of a large variety of different portfolios in the market. The stocks included in the index should be highly liquid. It should be professionally maintained. A single stock or a small group of stocks in the index should not move the index significantly. Otherwise, the shifts in other stocks will not be sufficiently captured in the index In brief the level of diversification of a stock index should be monitored on a continuous basis. It should ensure that the index is not vulnerable to speculation. Stocks with low trading volume or with very tight bid ask spreads are illiquid and should not be a part of index. The index should be managed smoothly without any dramatic changes in its composition. Box 2.1 describes how Nifty 50 addresses these issues. 18  Box 2.1: The Nifty 50 The Nifty 50 is a float-adjusted market capitalization weighted index derived from economic research. It was designed not only as a barometer of market movement but also to be a foundation of the new world of financial products based on the index like index futures, index options and index funds. A trillion calculations were expended to evolve the rules inside the Nifty 50 index. The results of this work are remarkably simple: (a) the correct size to use is 50, (b) stocks considered for the Nifty 50 must be liquid by the ‘impact cost’ criterion, (c) the largest 50 stocks that meet the criterion go into the index. The research that led up to Nifty 50 is well-respected internationally as a pioneering effort in better understanding how to make a stock market index. The Nifty 50 covers 21 sectors of the Indian economy and offers investment managers exposure to the Indian market in one efficient portfolio. It is used for a variety of purposes, such as benchmarking fund portfolios, index based derivatives and index funds. The Nifty is uniquely equipped as an index for the index derivatives market owing to its low market impact cost and (b) high hedging effectiveness. The good diversification of Nifty generates low initial margin requirement. Impact cost Impact cost represents the cost of executing a transaction in a given stock, for a specific predefined order size, at any given point of time. Impact cost is a practical and realistic measure of market liquidity; it is closer to the true cost of execution faced by a trader in comparison to the bid-ask spread. In mathematical terms it is the percentage mark up observed while buying / selling the desired quantity of a stock with reference to its ideal price (best buy + best sell) / 2. Example A: ORDER BOOK SNAPSHOT Buy Quantity Buy Price Sell Quantity Sell Price 1000 98 1000 99 2000 97 1500 100 1000 96 1000 101 19 TO BUY 1500 SHARES 99 + 98 Ideal Price = = 98.5 2 (1000 × 99) + (500 × 100) Actual Buy Price = = 99.33 1500 99.33 – 98.50 IMPACT COST (FOR 1500 shares) = × 100 = 0.84 % 98.50 Impact cost of the Nifty 50 for a portfolio size of Rs.50 lakhs is 0.06% for the month March 2015. 2.6 Applications Of Index Besides serving as a barometer of the economy/market, the index also has other applications in finance. Various products have been designed based on the indices such as the index derivatives, index funds2 and the exchange traded funds3. We here restrict our discussion to only index derivatives. 2.6.1 Index Derivatives Index derivatives are derivative contracts which have the index as the underlying. The most popular index derivative contracts the world over are index futures and index options. NSE’s market index, the Nifty 50 was scientifically designed to enable the launch of index-based products like index derivatives4 and index funds. Following are the reasons of popularity of index derivatives: Institutional and large equity-holders need portfolio-hedging facility. Index- derivatives are more suited to them and more cost-effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes. Index derivatives offer ease of use for hedging any portfolio irrespective of its composition. Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. 2 An index fund is a fund that tries to replicate the index returns. It does so by investing in index stocks in the proportions in which these stocks exist in the index. 3 ETFs are just what their name implies: baskets of securities that are traded, like individual stocks, on an exchange. Unlike regular open-end mutual funds, ETFs can be bought and sold throughout the trading day like any stock. 20  Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates. It is easier for retail investors to understand indices and track their movements, than pick stocks and track them. Hence, index derivatives are more popular amongst retail investors than stock indices. Index futures and options are traded on the stock exchanges in India. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with index futures on June 12, 2000. The futures contracts on the NSE are based on the Nifty 50. The exchange introduced trading on index options based on the Nifty 50 on June 4, 2001. Additionally, exchange traded derivatives contracts linked to Nifty 50 are traded at Singapore Exchange Ltd. (SGX), Chicago Mercantile Exchange Inc. (CME) and Osaka Exchange Inc. (OSE). 2.7 CONCLUSION Interest rates are the return on any investment to an investor. In case of funds lent, it is the return to the lender on account of the risk taken by lending the funds to the borrower. Interest rates may be fixed or floating. They may also be continuous or discreet in frequency. The frequency of the interest rate influences the returns on the investment, i.e. higher the frequency, higher the returns, sum, period and rate of interest being the same. Indices are a broad market measure tool composed of representative stocks that map market behavior. They may be either broad market indices or sectoral indices, i.e. representative of a single sector. The important characteristics to be borne in mind while composing an index is that the index should truly mirror the performance of the market it represents, the stocks it is composed of must be liquid and no single / set of stocks must significantly move the index. Index derivatives and Interest rate derivatives are traded on both the major stock exchanges in India. 21 Chapter 3: F  utures Contracts, Mechanism And Pricing In recent years, derivatives have become increasingly important in the field of finance. As we saw in the first chapter, futures and options are now actively traded on many exchanges, forward contracts are popular on the OTC market. We shall first discuss about forward contracts along with their advantages and limitations. We then introduce futures contracts and describe how they are different from forward contracts. The terminology of futures contracts along with their trading mechanism has been discussed next. The key idea of this chapter however is the pricing of futures contracts. The concept of cost of carry for calculation of the forward price has been a very powerful concept. One would realize that it essentially works as a parity condition and any violation of this principle can lead to arbitrage opportunities. The chapter explains mechanism and pricing of both Index futures and futures contracts on individual stocks. 3.1 Forward Contracts A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. Hence, it’s a Forward Commitment type of derivative. One of the parties to the contract assumes a long position (buy position) and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position (sell position) and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges, in the OTC market. The salient features of forward contracts are as given below: They are bilateral contracts and hence exposed to counter-party risk. Counter-party risk is the risk that the other party to the contract may not honour their part of the agreement. This is significant especially in case of Forward contracts as it can be entered into between any 2 individuals / companies / institutions, and it is not overseen by the exchanges and other regulatory bodies. Standard contract laws apply to these contracts though. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. Even the delivery and storage terms may be negotiated mutually and built into the contract. This gives higher flexibility to the parties to the contract, which is not true in case of futures, as we will see later. The contract price is generally not available in public domain as these contracts are privately negotiated. On the expiration date, the contract has to be settled by delivery of the asset. It may also be cash-settled, as agreed by the parties at the inception of the contract. In cash 22  settlement, the parties pay / receive the loss or gain arising from the contract to them in cash to the other party. If the party wishes to reverse the contract, it has to compulsorily go to the same counter- party, which often results in high prices being charged. This is because, since these contracts are highly customized, it would be very difficult to find another counterparty with the exact same terms as the original contract to enter into an equal and opposite transaction. Forward contract Illustration The working of a forward / futures contract can be depicted as follows: At the beginning of the transaction: Buyer Seller Fixed price contract for exchange of securities at a fixed time in the future No money or asset is exchanged at this juncture On expiry of the futures contract, i.e. the fixed date in the future as per the contract: Pays the amount agreed in the contract Buyer Seller Delivers the physical asset as per the terms of contract 3.2 Limitations Of Forward Markets Forward markets world-wide are posed by several problems: Lack of centralization of trading, - Each contract is bilaterally negotiated and is not listed on any centralized platform, like a stock exchange Illiquidity – due to the customized nature of each contract, it would be difficult to trade it in the open market as specifications would be different from one investor to another. Counterparty risk – risk of default by any party to the transaction In the first two of these, the basic problem is that of too much flexibility and generality. The forward market is like a real estate market, in which any two consenting adults can form contracts against each other. This often makes them design the terms of the deal which are convenient in that specific situation, but makes the contracts non-tradable. Counterparty risk is quite high in case of Forward contracts. When one of the two sides to the transaction declares bankruptcy, the other suffers. When forward markets trade standardized contracts, though it avoids the problem of illiquidity, still the counterparty risk remains a very serious issue. Futures contracts aim to disperse some of these issues with forward contracts. 23 3.3 Introduction To Futures A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. The futures contracts are created by the Stock exchange and made available for trade in the open market. , each set by the stock exchange. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are: Quantity of the underlying Quality of the underlying The date and the month of delivery The units of price quotation and minimum price change Location of settlement 3.4 Distinction Between Futures And Forwards Contracts Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer more liquidity. Table 3.1 lists the distinction between the forwards and futures contracts. Table 3.1: Distinction between Futures and Forwards Futures Forwards Trade on an organized exchange OTC in nature Standardized contract terms Customised contract terms More liquid Less liquid Requires margin payments No margin payment Follows daily settlement Settlement happens at end of period Lower counter-party risk High counter-party risk 3.5 Futures Terminology Long position: The investor who buys the contract, and therefore the underlying asset, is said to assume a long position in the transaction Short position: The investor who sells the contract, and therefore the underlying asset, is said to assume a short position in the transaction. These are terms also used in case of other derivative contracts. 24  Spot price: The price at which an underlying asset trades in the spot market. Futures price: The price that is agreed upon at the time of the contract for the delivery of an asset at a specific future date. Contract cycle: It is the period over which a contract trades. The index futures contracts on the NSE have one-month, two-month and three-month expiry cycles which expire on the last Thursday of the month. Thus a January expiration contract expires on the last Thursday of January and a February expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. Expiry date: is the date on which the final settlement of the contract takes place. Contract size: The amount of asset that has to be delivered under one contract. This is also called as the lot size. Basis: Basis is defined as the futures price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. Cost of carry: Measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. Initial margin: The amount that must be deposited in the margin account at the time a futures contract is first entered into is known as initial margin. Marking-to-market: In the futures market, at the end of each trading day, the margin account is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking-to-market. Maintenance margin: Investors are required to place margins with their trading members before they are allowed to trade. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day. 3.6 Trading Underlying Vs. Trading Single Stock Futures The single stock futures market in India has been a great success story. One of the reasons for the success has been the ease of trading and settling these contracts. To trade securities, one must open a security trading account with a securities broker and a demat account with a securities depository. Buying security involves putting up all the money upfront. With the purchase of shares of a company, the holder becomes a part owner of the company. The shareholder typically receives the rights and privileges associated with the security, which may include the receipt of dividends, invitation to the annual shareholders meeting and the power to vote. 25 Selling securities involves buying the security before selling it. Even in cases where short selling is permitted, it is assumed that the securities broker owns the security and then “lends” it to the trader so that he can sell it. To trade in futures, one must open a futures trading account with a derivatives broker. Buying futures simply involves putting in the margin money. This margin money is a form of security that the broker takes from the investor for the transaction. The broker in turn has to put up margin money with the stock exchange. They enable the futures traders to take a position in the underlying security without having to open an account with a securities broker. With the purchase of futures on a security, the holder essentially makes a legally binding promise or obligation to buy the underlying security at some point in the future (the expiration date of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a shareholder. Only when on expiration of the contract he actually gets delivery of the stocks, is he considered a shareholder of the company. However, in India, all futures are cash-settled, i.e. the investor does not get physical delivery of shares on expiration of the contract. Instead, he either receives or has to pay cash equivalent to his loss / gain on account of the futures purchase as against the prevailing spot market prices. This happens on an on-going basis through a process called Mark-to-Market, defined earlier. 3.7 Futures Payoffs Payoff means the returns from either buying or selling a futures contract as against buying or selling the underlying asset. Payoff is positive if the position held brings profits to the holder, the payoff is negative if the position held brings losses to the holder. Futures contracts have linear or symmetrical payoffs. It implies that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs. Payoff for buyer of futures: Long futures The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 6000. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. 26 Figure 3.1: Payoff for a buyer of Nifty futures The figure 3.1 above shows the profits/losses for a long futures position. The investor bought futures when the index was at 6000. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Payoff for seller of futures: Short futures The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 6000. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure 3.2: Payoff for a seller of Nifty futures The figure 3.2 shows the profits/losses for a short futures position. The investor sold futures when the index was at 6000. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. 27 3.8 Pricing Futures Pricing of futures contract is very simple. The important concept here is the Cost of Carry Logic. Simply put, cost of carry is the cost incurred when you hold a certain investment position. This includes interest costs, margin expenses, financial expenses for advisors, fees etc. In case of commodities, it also includes cost of storage, insurance and so on. Essentially, it encompasses all such costs incurred to hold a particular position in futures. Using the cost-of-carry logic, we calculate the fair value of a futures contract. Every time the observed price deviates from the fair value, arbitragers would enter into trades to capture the arbitrage profit. This in turn would push the futures price back to its fair value. The cost of carry model used for pricing futures is given below: F = SerT where: r Cost of financing (using continuously compounded interest rate) T Time till expiration in years e 2.71828 Example: Security XYZ Ltd trades in the spot market at Rs. 1150. Money can be invested at 11% p.a. The fair value of a one-month futures contract on XYZ is calculated as follows: F = SerT 1 = 1150*e0.11*12 F = 1160 3.8.1 Pricing Equity Index Futures A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks. In their short history of trading, index futures have had a great impact on the world’s securities markets. Its existence has revolutionized the art and science of institutional equity portfolio management. The main differences between commodity and equity index futures are that: - There are no costs of storage involved in holding equity. - Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock. Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with equity futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures price. 28 3.8.2 Pricing index futures given expected dividend amount The pricing of index futures is based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the portfolio underlying the index, minus the present value of dividends obtained from the stocks in the index portfolio. This has been illustrated in the example below. Illustration: Nifty futures trade on NSE as one, two and three-month contracts. Money can be borrowed at a rate of 10% per annum. What will be the price of a new two-month futures contract on Nifty? 1. Let us assume that ABC Ltd. will be declaring a dividend of Rs.20 per share after 15 days of purchasing the contract. 2. Current value of Nifty is 6000 and Nifty trades with a multiplier of 50. 3. Since Nifty is traded in multiples of 50, value of the contract is 50*6000 = Rs.300,000. 4. If ABC Ltd. Has a weight of 7% in Nifty, its value in Nifty is Rs.21,000 i.e.(300,000 * 0.07). 5. If the market price of ABC Ltd. is Rs.140, then a traded unit of Nifty involves 150 shares of ABC Ltd. i.e. (21,000/140). 6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.3000 i.e. (150*20). The dividend is received 15 days later and hence compounded only for the remainder of 45 days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 50. 7. Thus, the futures price is calculated as; F = 6000 * e0.1 * 60/365 – [ 150 * 20 * e0.1 * 45/365 50 [ = 6,038.7 3.8.3 Pricing Index Futures Given Expected Dividend Yield If the dividend flow throughout the year is generally uniform, i.e. if there are few historical cases of clustering of dividends in any particular month, it is useful to calculate the annual dividend yield. F = Se(r – q) * T where: F futures price S spot index value r cost of financing q expected dividend yield T holding period 29 Example: A two-month futures contract trades on the NSE. The cost of financing is 10% and the dividend yield on Nifty is 2% annualized. The spot value of Nifty 6000. What is the fair value of the futures contract? Fair value = 6000 * e(0.1-0.02) × (60/365) = Rs. 6079.43 The cost-of-carry model explicitly defines the relationship between the futures price and the related spot price. As we know, the difference between the spot price and the futures price is called the basis. Nuances: As the date of expiration comes near, the basis reduces - there is a convergence of the futures price towards the spot price. On the date of expiration, the basis is zero. If it is not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference between prices of two futures contracts) during the life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can be exploited. Figure 3.3: variation of basis over time The figure 3.3 above shows how basis changes over time. As the time to expiration of a contract reduces, the basis reduces. Towards the close of trading on the day of settlement, the futures price and the spot price converge. The closing price for the June 28 futures contract is the closing value of Nifty on that day. 3.8.4 Pricing Stock Futures A futures contract on a stock gives its owner the right and obligation to buy or sell the stocks. Like index futures, stock futures are also cash settled; there is no delivery of the underlying stocks. Just as in the case of index futures, the main differences between commodity and stock futures are that: 30 - There are no costs of storage involved in holding stock. - Stocks come with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock. Therefore, Cost of carry = Financing cost - Dividends. Thus, a crucial aspect of dealing with stock futures as opposed to commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures price. 3.8.5 Pricing Stock Futures When No Dividend Expected The pricing of stock futures is also based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the stock, minus the present value of dividends obtained from the stock. If no dividends are expected during the life of the contract, pricing futures on that stock involves multiplying the spot price by the cost of carry. It has been illustrated in the example given below: Example: XYZ Ltd.’s futures trade on NSE as one, two and three-month contracts. Money can be borrowed at 10% per annum. What will be the price of a unit of new two-month futures contract on XYZ Ltd. if no dividends are expected during the two-month period? Assume that the spot price of XYZ Ltd. is Rs. 228. Thus, futures price F = 228 * e0.1*(60/365) = Rs. 231.90 3.8.6 Pricing Stock Futures When Dividends Are Expected When dividends are expected during the life of the futures contract, pricing involves reducing the cost of carry to the extent of the dividends. The net carrying cost is the cost of financing the purchase of the stock, minus the present value of dividends obtained from the stock. This is explained in the illustration below: Example: XYZ Ltd. futures trade on NSE as one, two and three-month contracts. What will be the price of a unit of new two-month futures contract on XYZ Ltd. if dividends are expected during the two-month period? Let us assume that XYZ Ltd. will be declaring a dividend of Rs. 10 per share after 15 days of purchasing the contract. Assume that the market price of XYZ Ltd. is Rs. 140. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.10. The dividend is received 15 days later and hence compounded only for the remainder of 45 days. 31 Thus, futures price F = 140 * e(0.1 * 60/365) – 10 * e(0.1*45/35) = Rs.132.20 3.9 Conclusion Forwards and futures are forward commitment type of derivatives. Forwards are over-the- counter contracts wherein parties to the contract agree to exchange the underlying asset at a future date at a fixed price. These contracts are bilaterally negotiated and not listed on an exchange. The forward price is not available in the public domain. These contracts are illiquid and exposed to counter-party risk. Futures contracts are exchange traded derivatives that are by nature the same as forward contracts. The main difference is that the contracts are introduced on an exchange with standardized terms such as price, quantity, quality of underlying asset and so on. The counterparty risk in futures is lower and they are more liquid than forward contracts. Pricing of index and stock futures is done by the cost of carry method, viz F = SerT where: r Cost of financing (using continuously compounded interest rate) T Time till expiration in years e 2.71828 32 CHAPTER 4: APPLICATION OF FUTURES CONTRACTS This chapter begins with a brief introduction of the concept of Beta (β) which indicates the sensitivity of an individual stock or portfolio’s return to the returns on the market index. Thereafter hedging strategies using individual stock futures has been discussed in detail through numerical illustrations and payoff profiles. 4.1 Understanding Beta (β) Beta measures the sensitivity of stocks responsiveness to market factors. Generally, it is seen that when markets rise, most stock prices rise and vice versa. Beta measures how much a stock would rise or fall if the market rises / falls. The market is indicated by the index, say Nifty 50. The index has a beta of one. A stock with a beta of 1.5% will rise / fall by 1.5% when the Nifty 50 rises / falls by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (β = 1.5%) in the same direction as the index. A stock with a beta of - 1.5% will rise / fall by 1.5% when the Nifty 50 falls / rises by 1%. Which means for every 1% movement in the Nifty, the stock will move by 1.5% (β = 1.5%) in the opposite direction as the index. Similarly, Beta of a portfolio, measures the portfolios responsiveness to market movements. In practice given individual stock betas, calculating portfolio beta is simple. It is nothing but the weighted average of the stock betas. If the index moves up by 10 percent, the portfolio value will increase by 10 percent. Similarly if the index drops by 5 percent, the portfolio value will drop by 5 percent. A portfolio with a beta of two, responds more sharply to index movements. If the index moves up by 10 percent, the value of a portfolio with a beta of two will move up by 20 percent. If the index drops by 10 percent, the value of a portfolio with a beta of two will fall by 20 percent. Similarly, if a portfolio has a beta of 0.75, a 10 percent movement in the index will cause a 7.5 percent movement in the value of the portfolio. 4.2 Numerical Illustration Of Applications Of Stock Futures Futures are popularly used as a risk management tool in companies, banks, public departments and investors. They are also used for speculation and making profits out of market movements. There are various strategies which can be adopted for achieving these objectives. Let us look at each of them now. 4.2.1 HEDGING: Long Security, Sell Futures Futures can be used as a risk-management tool. Investors can hedge their risk of making losses in transactions by simultaneously taking opposite positions in the spot and futures market. 33 For example, an investor who holds the shares of a company sees the value of his security falling from Rs. 450 to Rs.390. In the absence of stock futures, he would either suffer the discomfort of a price fall or sell the security in anticipation of a market upheaval. With security futures he can minimize his price risk. All he needs to do is enter into an offsetting stock futures position, in this case, take on a short futures position. Assume that the spot price of the security which he holds is Rs.390. Two-month futures cost him Rs.402. For this he pays an initial margin. Now if the price of the security falls any further, he will suffer losses on the security he holds. However, the losses he suffers on the security will be offset by the profits he makes on his short futures position. Take for instance that the price of his security falls to Rs.350. The fall in the price of the security will result in a fall in the price of futures. Futures will now trade at a price lower than the price at which he entered into a short futures position. Hence his short futures position will start making profits. The loss of Rs.40 incurred on the security he holds, will be made up by the profits made on his short futures position. 4.2.2 SPECULATION: Bullish Security, Buy Futures Investors can speculate on underlying assets by investing in the futures instead of the actual security. Here, leverage helps them by increasing the total exposure to the asset as compared to what they could take in the spot market. Take the case of a speculator who has a view on the direction of the market. He would like to trade based on this view. He believes that a particular security that trades at Rs.1000 is undervalued and expect its price to go up in the next two-three months. How can he trade based on this belief? In the absence of a derivative product, he would have to buy the security and hold on to it. Assume that he buys 100 shares which cost him one lakh rupees. His hunch proves correct and two months later the security closes at Rs.1010. He makes a profit of Rs.1000 on an investment of Rs. 100,000 for a period of two months. This works out to an annual return of 6 percent. Today a speculator can take exactly the same position on the security by using futures contracts. Let us see how this works. The security trades at Rs.1000 and the two-month futures trades at 1006. Just for the sake of comparison, assume that the minimum contract value is 100,000. He buys 100 security futures for which he pays a margin of Rs. 20,000. Two months later the security closes at 1010. On the day of expiration, the futures price converges to the spot price and he makes a profit of Rs. 400 on an investment of Rs. 20,000. This works out to an annual return of 12 percent. Because of the leverage they provide, security futures form an attractive option for speculators. 4.2.3 SPECULATION: Bearish Security, Sell Futures In the previous section we saw speculation where the investor believed the security would increase in value over a period of time. Now consider the opposite scenario where the investor 34 believes that a particular security is over- valued and is likely to see a fall in price. How can he trade based on his opinion? In the absence of a derivative product, there wasn’t much he could do to profit from his opinion. Today all he needs to do is sell stock futures. Let us understand how this works. Simple arbitrage ensures that futures on an individual securities move correspondingly with the underlying security, as long as there is sufficient liquidity in the market for the security. If the security price rises, so will the futures price. If the security price falls, so will the futures price. Now take the case of the trader who expects to see a fall in the price of ABC Ltd. He sells one two-month contract of futures on ABC at Rs.240 (each contact for 100 underlying shares). He pays a small margin on the same. Two months later, when the futures contract expires, ABC closes at 220. On the day of expiration, the spot and the futures price converges. He has made a clean profit of Rs.20 per share. For the one contract that he bought, this works out to be Rs. 2000. 4.2.4 ARBITRAGE: Overpriced Futures: Buy Spot, Sell Futures As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the spot price. Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. If you notice that futures on a security that you have been observing seem overpriced, how can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1 On day one, borrow funds, buy the security on the cash/spot market at 1000. 2 Simultaneously, sell the futures on the security at 1025. 3 Take delivery of the security purchased and hold the security for a month. 4 On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5 Say the security closes at Rs.1015. Sell the security. 6 Futures position expires with profit of Rs. 10. 7 The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures position. 8 Return the borrowed funds. If the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it makes sense for you to arbitrage. In the real world, one has to build in the transactions costs into the arbitrage strategy. 4.2.5 ARBITRAGE: Underpriced Futures: Buy Futures, Sell Spot Whenever the futures price deviates substantially from its fair value, arbitrage opportunities arise. It could be the case that you notice the futures on a security you hold seem underpriced. 35 How can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem underpriced. As an arbitrageur, you can make riskless profit by entering into the following set of transactions. 1. On day one, sell the security in the cash/spot market at 1000. 2. Make delivery of the security. 3. Simultaneously, buy the futures on the security at 965. 4. On the futures expiration date, the spot and the futures price converge. Now unwind the position. 5. Say the security closes at Rs.975. Buy back the security. 6. The futures position expires with a profit of Rs.10. 7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures position. If the returns you get by investing in riskless instruments is more than the return from the arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and- carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot market. As more and more players in the market develop the knowledge and skills to do cash-and-carry and reverse cash-and-carry, we will see increased volumes and lower spreads in both the cash as well as the derivatives market. 4.3 Hedging Using Stock Index Futures As we have seen previously, hedging is a risk mitigation mechanism. A certain exposure in a security can hedged by an equal and opposite transaction in the futures for the same security. But what is the risk that is mitigated? Broadly there are two types of risks (as shown in the figure below) and hedging is used to minimize these risks. Risk Unsystematic Systematic Unsystematic risk is also called as Company Specific Risk or Diversifiable Risk. Systematic Risk is the market-wide risk. Let us understand both these with some examples. Suppose, an investor holds shares of steel company and has no other investments. Any change in the government policy would affect the price of steel and the companies share price. This is considered as Unsystematic Risk. This risk can be reduced through appropriate diversification. The investor can buy more stocks of different industries to diversify his portfolio so that the price change of any one stock does not affect his portfolio. However, 36 diversification does not reduce risk in the overall portfolio completely. Diversification reduces unsystematic risk. There is another risk associated with the overall market returns, which is called as the Systematic Risk or Market Risk or Non-diversifiable Risk. It is that risk which cannot be reduced through diversification. Given the overall market movement (falling or rising), stock portfolio prices are affected. Generally, a falling overall market would see most stocks falling (an