NISM-Series-VIII: Equity Derivatives Certification Examination Workbook PDF

VIII Equity Derivatives  Workbook for NISM-Series-VIII: Equity Derivatives Certification Examination National Institute of Securities Markets www.nism.ac.in...

VIII Equity Derivatives  Workbook for NISM-Series-VIII: Equity Derivatives Certification Examination National Institute of Securities Markets www.nism.ac.in 1 This workbook has been developed to assist candidates in preparing for the National Institute of Securities Markets (NISM) NISM-Series-VIII: Equity Derivatives Certification Examination (NISM-Series-VIII: ED Examination). Workbook Version: May 20231 Published by: National Institute of Securities Markets © National Institute of Securities Markets, 2023 5th Floor, NCL Co-operative Society, Plot No. C-6 E-Block, Bandra Kurla Complex, Bandra East, Mumbai – 400 051, India National Institute of Securities Markets Patalganga Campus Plot IS-1 & IS-2, Patalganga Industrial Area Village Mohopada (Wasambe) Taluka-Khalapur District Raigad-410222 Website: www.nism.ac.in All rights reserved. Reproduction of this publication in any form without prior permission of the publishers is strictly prohibited. 1 This version of the workbook is for candidates appearing for NISM Series VIII: Equity Derivatives Certification Examination on or after July 11, 2023. 2  Foreword NISM is a leading provider of high end professional education, certifications, training and research in financial markets. NISM engages in capacity building among stakeholders in the securities markets through professional education, financial literacy, enhancing governance standards and fostering policy research. NISM works closely with all financial sector regulators in the area of financial education. NISM Certification programs aim to enhance the quality and standards of professionals employed in various segments of the financial services sector. NISM’s School for Certification of Intermediaries (SCI) develops and conducts certification examinations and Continuing Professional Education (CPE) programs that aim to ensure that professionals meet the defined minimum common knowledge benchmark for various critical market functions. NISM certification examinations and educational programs cater to different segments of intermediaries focusing on varied product lines and functional areas. NISM Certifications have established knowledge benchmarks for various market products and functions such as Equities, Mutual Funds, Derivatives, Compliance, Operations, Advisory and Research. NISM certification examinations and training programs provide a structured learning plan and career path to students and job aspirants who wish to make a professional career in the Securities markets. Till March 2023, NISM has certified nearly 17 lakh individuals through its Certification Examinations and CPE Programs. NISM supports candidates by providing lucid and focused workbooks that assist them in understanding the subject and preparing for NISM Examinations. The book covers basics of the equity derivatives, trading strategies using equity futures and equity options, clearing, settlement and risk management as well as the regulatory environment in which the equity derivatives markets operate in India. It will be immensely useful to all those who want to have a better understanding of various derivatives products available in Indian equity derivatives markets. Dr. C. K. G. Nair Director 3 Disclaimer The contents of this publication do not necessarily constitute or imply its endorsement, recommendation, or favoring by the National Institute of Securities Markets (NISM) or the Securities and Exchange Board of India (SEBI). This publication is meant for general reading and educational purpose only. The statements/explanations/concepts are of general nature and may not have taken into account the particular objective/ move/ aim/ need/ circumstances of individual user/ reader/ organization/ institute. Thus, NISM and SEBI do not assume any responsibility for any wrong move or action taken based on the information available in this publication. Therefore, before acting on or following the steps suggested on any theme or before following any recommendation given in this publication user/reader should consider/seek professional advice. The publication contains information, statements, opinions, statistics and materials that have been obtained from sources believed to be reliable and the publishers of this title have made best efforts to avoid any errors. However, publishers of this material offer no guarantees and warranties of any kind to the readers/users of the information contained in this publication. Since the work and research is still going on in all these knowledge streams, NISM and SEBI do not warrant the totality and absolute accuracy, adequacy or completeness of this information and material and expressly disclaim any liability for errors or omissions in this information and material herein. NISM and SEBI do not accept any legal liability whatsoever based on any information contained herein. While the NISM Certification examination will be largely based on material in this workbook, NISM does not guarantee that all questions in the examination will be from material covered herein. 4 Acknowledgement This workbook has been jointly developed and reviewed by the Certification Team of NISM in coordination with its subject matter expert—Dr. Aparna Bhat. NISM gratefully acknowledges the contribution of the Examination Committee for NISM- Series-VIII: Equity Derivatives Certification Examination consisting of representatives of Stock Exchanges and Industry Experts. About NISM Certifications The School for Certification of Intermediaries (SCI) at NISM is engaged in developing and administering Certification Examinations and CPE Programs for professionals employed in various segments of the Indian securities markets. These Certifications and CPE Programs are being developed and administered by NISM as mandated under Securities and Exchange Board of India (Certification of Associated Persons in the Securities Markets) Regulations, 2007. The skills, expertise and ethics of professionals in the securities markets are crucial in providing effective intermediation to investors and in increasing the investor confidence in market systems and processes. The School for Certification of Intermediaries (SCI) seeks to ensure that market intermediaries meet defined minimum common benchmark of required functional knowledge through Certification Examinations and Continuing Professional Education Programmes on Mutual Funds, Equities, Derivatives Securities Operations, Compliance, Research Analysis, Investment Advice and many more. Certification creates quality market professionals and catalyzes greater investor participation in the markets. Certification also provides structured career paths to students and job aspirants in the securities markets. About the NISM-Series-VIII: Equity Derivatives Certification Examination The examination seeks to create a common minimum knowledge benchmark for associated persons functioning as approved users and sales personnel of the trading member of an equity derivatives exchange or equity derivative segment of a recognized stock exchange. The examination aims to enable a better understanding of various derivatives products available in equity derivatives markets, regulations and risks associated with the products and the exchange mechanisms of clearing and settlement. The examination also covers knowledge competencies related to the understanding of the financial structure in India and the importance of the different rules and regulations governing the Indian securities market, especially those related to the equity derivatives segment. 5 Examination Objectives On successful completion of the examination the candidate should: Know the basics of the Indian equity derivatives market. Understand the various trading strategies that can be built using futures and options on both stocks and stock indices. Understand the clearing, settlement and risk management as well as the operational mechanism related to equity derivatives markets. Know the regulatory environment in which the equity derivatives markets operate in India. Assessment Structure The NISM-Series-VIII: Equity Derivatives Certification Examination (NISM-Series-I: ED Examination) will be of 100 marks consisting of 100 questions of 1 mark each, and should be completed in 2 hours. There will be negative marking of 25% of the marks assigned to each question. The passing score for the examination is 60%. How to register and take the examination To find out more and register for the examination, please visit www.nism.ac.in Important Please note that the Test Centre workstations are equipped with either Microsoft Excel or OpenOffice Calc. Therefore, candidates are advised to be well versed with both of these softwares for computation of numericals. The sample case lets and multiple choice questions illustrated in the book are for reference purposes only. The level of difficulty may vary in the actual examination. 6 Contents Chapter 1: Basics of Derivatives................................................................................. 11 1.1 Basics of Derivatives................................................................................................... 11 1.2 Derivatives Market – History & Evolution.................................................................. 11 1.3 Indian Derivatives Market........................................................................................... 12 1.4 Market Participants.................................................................................................... 14 1.5 Types of Derivatives Market....................................................................................... 14 1.6 Significance of Derivatives.......................................................................................... 15 1.7 Various risks faced by the participants in derivatives................................................ 15 Chapter 2: Understanding the Index.......................................................................... 18 2.1 Introduction to an Index............................................................................................. 18 2.2 Significance of the stock index.................................................................................... 18 2.3 Types of Stock Market Indices.................................................................................... 18 2.4 Attributes of an Index................................................................................................. 21 2.5 Index management..................................................................................................... 23 2.6 Major Indices in India.................................................................................................. 24 2.7 Application of Indices.................................................................................................. 24 Chapter 3: Introduction to Forwards and Futures...................................................... 27 3.1 Introduction to forward contracts.............................................................................. 27 3.2 Futures contracts........................................................................................................ 28 3.3 Contract specifications of futures contracts............................................................... 29 3.4 Some important terminology associated with futures contracts............................... 32 3.5 Differences between Forwards and Futures.............................................................. 36 3.6 Payoff Charts for Futures contracts............................................................................ 37 3.7 Futures pricing............................................................................................................ 39 3.8 Price discovery and convergence of cash and futures prices on the expiry............... 44 3.9 Uses of futures............................................................................................................ 45 Chapter 4: Introduction to Options............................................................................ 55 4.1 Basics of options......................................................................................................... 55 4.2 Contract specifications of exchange-traded options.................................................. 59 4.3 Moneyness of an option............................................................................................. 61 4.4 Intrinsic value and time value of an option................................................................ 61 4.5 Payoff Charts for Options............................................................................................ 62 4.6 Distinction between futures and options contracts................................................... 70 4.7 Basics of Option Pricing and Option Greeks............................................................... 71 4.8 Option Pricing Models................................................................................................ 75 4.9 Implied volatility of an option..................................................................................... 76 4.10 Analysis of options from the perspectives of buyer and seller................................ 77 7 Chapter 5: Strategies using Equity futures and Equity options................................... 87 5.1 Futures contracts for hedging, speculation and arbitrage......................................... 87 5.2 Use of options for trading and hedging...................................................................... 96 5.3 Arbitrage using options: Put-call parity.................................................................... 120 5.4 Delta-hedging............................................................................................................ 121 5.5 Interpreting open interest and put-call ratio for trading strategies......................... 122 Chapter 6: Trading Mechanism................................................................................ 124 6.1 Trading Mechanism.................................................................................................. 125 6.2 Eligibility criteria for selection of stocks for derivatives trading.............................. 130 6.3 Selection criteria of Index for trading....................................................................... 130 6.4 Adjustments for Corporate Actions.......................................................................... 131 6.5 Trading costs............................................................................................................. 134 6.6 Algorithmic trading................................................................................................... 136 6.7 Tracking Futures and Options data........................................................................... 137 Chapter 7: Introduction to Clearing and Settlement System..................................... 140 7.1 Clearing Members..................................................................................................... 140 7.2 Clearing Mechanism................................................................................................. 141 7.3 Interoperability of clearing corporations.................................................................. 142 7.4 Settlement Mechanism............................................................................................. 143 7.5 Risk Management..................................................................................................... 148 7.6 Margining and mark to market under SPAN............................................................. 149 7.7 Position limits............................................................................................................ 156 7.8 Violations and Penalties............................................................................................ 158 7.9 Settlement of running account of Client’s funds lying with the TM:....................... 158 7.10 Settlement Guarantee Fund and Investor Protection Fund:.................................. 159 Chapter 8: Legal and Regulatory Environment......................................................... 161 8.1 Securities Contracts (Regulation) Act, 1956............................................................. 161 8.2 Securities and Exchange Board of India Act, 1992................................................... 162 8.3 Regulations in Trading.............................................................................................. 163 8.4 Regulations in Clearing & Settlement and Risk Management.................................. 165 8.5 Eligibility criteria for membership on derivatives segment...................................... 167 8.6 Standard Operating Procedure in the case of default by TM or CM........................ 167 8.7 Standard Operating Procedure (SOP) for handling stock exchange outage............. 168 Chapter 9: Accounting and Taxation........................................................................ 170 9.1 Accounting................................................................................................................ 170 9.2 Taxation of derivative transaction in securities........................................................ 178 Chapter 10: Sales Practices and Investors Protection Services.................................. 182 10.1 Understanding risk profile of the client.................................................................. 184 8 10.2 Risk Disclosure Document....................................................................................... 185 10.3 Written Anti Money Laundering Procedures.......................................................... 188 10.4 Investors Grievance Mechanism............................................................................. 195 9  Syllabus Outline with Weights Chapter No. Chapter Name Weightage Chapter 1 Basics of Derivatives 10 Chapter 2 Understanding Index 5 Chapter 3 Introduction to Forwards and Futures 20 Chapter 4 Introduction to Options 20 Chapter 5 Strategies using Equity Futures and Equity Options 10 Chapter 6 Trading Mechanism 10 Chapter 7 Clearing, Settlement and Risk Management 10 Chapter 8 Legal and Regulatory Environment 5 Chapter 9 Accounting and Taxation 5 Chapter 10 Sales Practices and Investor Protection Measures 5 10 Chapter 1: Basics of Derivatives LEARNING OBJECTIVES: After studying this chapter, you should know about: Meaning of derivatives and types of derivatives products History of derivatives market Significance of derivative markets Risks in derivatives trading 1.1 Basics of Derivatives A derivative is a contract or a product whose value is derived from the value of some other asset known as the underlying. Derivatives are based on a wide range of underlying assets. These include: Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead, etc. Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity, Natural Gas, etc. Agri commodities such as Wheat, Sugar, Coffee, Cotton, Pulses etc., and Financial assets such as Shares, Bonds and Foreign Exchange. 1.2 Derivatives Market – History & Evolution The history of derivatives may be mapped back to several centuries. Some of the specific milestones in evolution of the derivatives market worldwide are given below: 12th Century - In European trade fairs, sellers signed contracts promising future delivery of the items they sold. 13th Century - There are many examples of contracts entered into by English Cistercian Monasteries, who frequently sold their wool up to 20 years in advance, to foreign merchants. 1634-1637 - Tulip Mania in Holland: Fortunes were lost after a speculative boom in tulip futures burst. Late 17th Century - In Japan at Dojima, near Osaka, a futures market in rice was developed to protect rice producers from bad weather or warfare. In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various commodities. In 1865, the CBOT went a step further and listed the first “exchange traded” derivative contract in the US. These contracts were called “futures contracts”. 11 In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow futures trading. Later its name was changed to Chicago Mercantile Exchange (CME). In 1972, Chicago Mercantile Exchange introduced International Monetary Market (IMM), which allowed trading in currency futures. In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace for trading listed options. In 1975, CBOT introduced Treasury bill futures contract. It was the first successful pure interest rate futures. In 1977, CBOT introduced T-bond futures contract. In 1982, CME introduced Eurodollar futures contract. In 1982, Kansas City Board of Trade launched the first stock index futures. In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock indices with the S&P 100® (OEX) and S&P 500® (SPXSM) Indices. Factors influencing the growth of derivative market globally Over the last five decades, the derivatives market has seen a phenomenal growth. Many derivative contracts were launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: Increased fluctuations in underlying asset prices in financial markets. Integration of financial markets globally. Use of latest technology in communications has helped in reduction of transaction costs. Enhanced understanding of market participants on sophisticated risk management tools to manage risk. Frequent innovations in derivatives market and newer applications of products. 1.3 Indian Derivatives Market As the initial step towards introduction of derivatives trading in India, SEBI set up a 24– member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 recommending that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of derivatives. Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof. J. R. Varma, to recommend measures for risk containment in derivatives market in India. The committee submitted its report in October 1998. It worked out the operational details of margining system, methodology 12 for charging initial margins, membership details and net-worth criterion, deposit requirements and real time monitoring of positions requirements. In 1999, The Securities Contract Regulation Act (SCRA) was amended to include “derivatives” within the domain of ‘securities’ and a regulatory framework was developed for governing derivatives trading. In March 2000, the government repealed a three- decade-old notification, which prohibited forward trading in securities. The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and NSE to introduce the equity derivatives segment. To begin with, SEBI approved trading in index futures contracts based on Nifty and Sensex, which commenced trading in June 2000. Later, trading in Index options commenced in June 2001 and trading in options on individual stocks commenced in July 2001. Futures contracts on individual stocks started in November 2001. Metropolitan Stock Exchange of India Limited (MSEI) started trading in derivative products in February 2013. Products in the Derivatives Market Forwards It is a contractual agreement between two parties to buy/sell an underlying asset at a certain future date for a particular price that is pre-decided on the date of contract. Both the contracting parties are committed and are obliged to honour the transaction irrespective of the price of the underlying asset at the time of delivery. Since forwards are negotiated between two parties, the terms and conditions of contracts are customized. These are Over-the-counter (OTC) contracts. Futures A futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Futures are also standardized contracts (in terms of their lot size, maturity date, etc.) so that they can be traded on the exchange. Indeed, we may say futures are exchange traded forward contracts. Options An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. While the buyer of an option pays the premium and buys the right, the writer/seller of an option receives the premium with the obligation to sell/ buy the underlying asset, if the buyer exercises his right. Swaps A swap is an agreement made between two parties to exchange cash flows in the future according to a prearranged formula. Swaps are, broadly speaking, a series of forward 13 contracts. Swaps help market participants manage risks associated with volatile interest rates, currency exchange rates and commodity prices. 1.4 Market Participants There are broadly three types of participants in the derivatives market - hedgers, traders (also called speculators) and arbitrageurs. An individual may play different roles in different market circumstances. Hedgers They face risk associated with the prices of underlying assets and use derivatives to reduce their risk. Corporations, investing institutions and banks all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share prices, bond prices, currency exchange rates and commodity prices. Speculators/Traders They try to predict the future movements in prices of underlying assets and based on the view, take positions in derivative contracts. Derivatives are preferred over underlying asset for trading purpose, as they offer leverage, are less expensive (cost of transaction is generally lower than that of the underlying) and are faster to execute in size (high volumes market). Arbitrageurs Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets. Arbitrage originates when a trader purchases an asset cheaply in one location and simultaneously arranges to sell it at a higher price in another location. Such opportunities are unlikely to persist for very long, since arbitrageurs would rush into these transactions, thus closing the price gap at different locations. 1.5 Types of Derivatives Market In the modern world, a huge variety of derivatives products are available. They are either traded on organised exchanges (called exchange traded derivatives) or agreed directly between the contracting counterparties over the telephone or through electronic media (called Over-the-counter (OTC) derivatives). A few complex products are constructed on simple building blocks like forwards, futures, options and swaps to cater to the specific requirements of customers. The over-the-counter market is not a physical marketplace but a collection of broker- dealers scattered across the country. The main idea of the market is more a way of doing business than a place. Buying and selling of contracts are matched through negotiated bidding process over a network of telephone or electronic media that link thousands of intermediaries. OTC derivative markets have witnessed a substantial growth over the past 14 few years, very much contributed by the recent developments in information technology. The OTC derivative markets have banks, financial institutions and sophisticated market participants like hedge funds, corporations and high net-worth individuals. OTC derivative market is a less regulated market because these transactions occur in private among qualified counterparties, who are supposed to be capable enough to take care of themselves. In the OTC derivatives markets, transactions among the dealing counterparties, have the following features compared to exchange traded derivatives: Contracts are tailor made to fit in the specific requirements of dealing counterparties. The management of counter-party (credit) risk is decentralized and located within individual institutions. There are no formal centralized limits on individual positions, leverage, or margining. There are no formal rules or mechanisms for risk management to ensure market stability and integrity, and for safeguarding the collective interest of market participants. Transactions are private with little or no disclosure to the entire market. On the contrary, exchange-traded contracts are standardized, traded on organized exchanges with prices determined by the interaction of buyers and sellers through anonymous auction platform. A clearing corporation guarantees contract performance (settlement of transactions). 1.6 Significance of Derivatives Like other segments of Financial Market, the derivatives market serves the following specific functions: It helps in improving price discovery based on actual valuations and expectations. It enables the transfer of various risks from those who are exposed to risk but have a low risk appetite to participants with a high risk appetite. For example, hedgers want to give away the risk whereas traders are willing to take risk. It enables the shift of speculative trades from the unorganized market to the organized market. Risk management mechanism and surveillance of activities of various participants in the organized space provide stability to the financial system. 1.7 Various risks faced by the participants in derivatives Market participants must understand that derivatives, being leveraged instruments, have risks like counterparty risk (default by counterparty), price risk (loss on position because 15 of price move), liquidity risk (inability to exit from a position), legal or regulatory risk (enforceability of contracts), operational risk (fraud, inadequate documentation, improper execution, etc.) and may not be an appropriate avenue for someone of limited resources, or having limited trading experience, or with low risk tolerance. A market participant should therefore carefully consider whether such trading is suitable for him/her based on these parameters. Market participants, who trade in derivatives are advised to carefully read the Model Risk Disclosure Document, given by the broker to his clients at the time of signing agreement. A Model Risk Disclosure Document is issued by the members of Exchanges and contains important information on trading in Equities and F&O Segments of exchanges. All prospective participants should read this document before trading on Capital Market/Cash Segment or F&O segment of the Exchanges. Sample Questions 1. An index option is a __________________. 16 (a) Debt instrument (b) Derivative product (c) Cash market product (d) Money market instrument 2. The purchase of a share in one market and the simultaneous sale in a different market to benefit from price differentials is known as ____________. (a) Mortgage (b) Arbitrage (c) Hedging (d) Speculation 3. Financial derivatives provide the facility for __________. (a) Trading (b) Hedging (c) Arbitraging (d) All of the above 4. Operational risks include losses due to ____________. (a) Inadequate disaster planning (b) Too much of management control (c) Income tax regulations (d) Government policies 17 Chapter 2: Understanding the Index LEARNING OBJECTIVES: After studying this chapter, you should know about: The Index and its significance Different types of stock market indices Index management and maintenance Applications of indices 2.1 Introduction to an Index An index is a statistical indicator that measures changes in the economy in general or specific areas. In case of financial markets, an index is a portfolio of securities that represent a particular market or a portion of a market. Each index has its own calculation methodology and usually is expressed in terms of a change from a base value. The base value might be as recent as the previous day or many years in the past. Thus, the percentage change is more important than the actual numeric value. Financial indices are created to measure price movement of stocks, bonds, T-bills and other type of financial securities. More specifically, a stock index is created to provide market participants with the information regarding the average share price movement in the market. Broad indices are expected to capture the overall behaviour of equity market and need to represent the return obtained by typical portfolios in the country. 2.2 Significance of the stock index A stock index is an indicator of the performance of the overall market or a particular sector. It serves as a benchmark for portfolio performance - Managed portfolios, belonging either to individuals or mutual funds, use the stock index as a measure for evaluation of their performance. It is used as an underlying for financial application of derivatives – Various products in OTC and exchange traded markets are based on indices as the underlying asset. 2.3 Types of Stock Market Indices Indices can be designed and constructed in various ways. Depending upon their methodology, they can be classified as under: Market capitalization weighted index In this method of calculation, each stock is given a weight according to its market capitalization. So higher the market capitalization of a constituent, higher is its weight in the index. Market capitalization is the market value of a company, calculated by multiplying the total number of shares outstanding to its current market price. For example, ABC company with 5,00,00,000 shares outstanding and a share price of Rs 120 18 per share will have market capitalization of 5,00,00,000 x 120 = Rs 6,00,00,00,000 i.e., 600 Crores. Let us understand the concept with the help of an example: There are five stocks in an index. Base value of the index is set to 100 on the start date which is January 1, 1995. Calculate the current value of index based on following information: Stock price as Number Today’s Sr. Stock on January 1, of shares stock price No. Name 1995 (in Rs.) in lakhs (in Rs.) 1 AZ 150 20 650 2 BY 300 12 450 3 CX 450 16 600 4 DW 100 30 350 5 EU 250 8 500 The market capitalization of the index on January 1, 1995 is Rs. 18,800 which is the sum of the market price multiplied by the quantity of shares for each stock in the index. With the change in market prices, the market capitalization of these stocks increase from Rs.18,800 lakhs to Rs.42,500 lakhs. The market capitalization on January 1, 1995 is equated to 100. Hence, the new value of the index is calculated as (42500 lakhs / 18800 lakhs) * 100, which works out to 226.06. Since the index has risen from a base of 100 to a new value of 226.06, the change in the index value is 126.06 per cent. Old No. of Old M.Cap. Old New New M.Cap. New Stock Price Shares (in Rs lakhs) Weights Price (in Rs lakhs) Weights Name (Rs) (in lakhs) (Rs) AZ 150 20 3000 0.16 650 13000 0.31 BY 300 12 3600 0.19 450 5400 0.13 CX 450 16 7200 0.38 600 9600 0.23 DW 100 30 3000 0.16 350 10500 0.25 EU 250 8 2000 0.11 500 4000 0.09 18800 1.00 42500 1.00 Popular indices in India, Sensex and Nifty, were earlier designed on market capitalization weighted method. Free-Float Market Capitalization Index In various businesses, equity holding is divided differently among various stakeholders – promoters, institutions, corporates, individuals, etc. The market has started to segregate this on the basis of what is readily available for trading and what is not. The one available 19 for immediate trading is categorized as free float. And, if we compute the index based on weights of each security based on free float market cap, it is called free float market capitalization index. A majority of the stock indices globally, over a period of time, have moved to free float basis, including the Indian equity indices - Sensex, Nifty and SX40. Price-Weighted Index This is a stock index in which each stock influences the index in proportion to its price. Stocks with a higher price will be given more weight and therefore, will have a greater influence over the performance of the Index. Let us take the same data as above for calculation of price-weighted index: Stock price as Number Today’s Sr. Stock on January 1, of shares stock price No. Name 1995 (in Rs.) in lakhs (in Rs.) 1 AZ 150 20 650 2 BY 300 12 450 3 CX 450 16 600 4 DW 100 30 350 5 EU 250 8 500 The formula for calculating the value of a price-weighted index is as follows: Price index = (Sum of the prices of all stocks included in Index) / (No. of stocks in Index) Hence, the price index on January 1, 1995 = (150+300+450+100+250)/5 = 250. The current value of the index is the sum of the current prices of all stocks included in the index divided by the number of stocks. The current value of the index = (650+450+600+350+500) / 5 = 510. Thus, the increase in the value of the index is (510 - 250) / 250, i.e. 104%. This can be verified as follows: Stock Price on Weights Current Percent Percent change Name Jan 1, 1995 price Change in price in price * weight AZ 150 0.12 650 333.33% 40.00% BY 300 0.24 450 50.00% 12.00% CX 450 0.36 600 33.33% 12.00% DW 100 0.08 350 250.00% 20.00% EU 250 0.20 500 100.00% 20.00% 1250 1.00 2550 104.00% Dow Jones Industrial Average and Nikkei 225 are popular price-weighted indices. Equal Weighted Index 20 An equal-weighted index is one in which all stocks included in the index have the same weightage. The number of shares of each stock is adjusted in such a way that the weight of each stock in the index is the same. Subsequently, if there is any change in the market price of each stock, the weight of each stock will change. To maintain the same equal weights as earlier, the fund manager needs to sell those stocks that have increased in price and buy the stocks that have fallen in price. The following is an example of the computation of an equal weighted index: Stock Price Quantity Value as Weight Current Current Price Price name on Jan as on Jan on Jan on Jan price value change change 1, 1995 1, 1995 1, 1995 1, 1995 (= Qty * * Old Price) weight P 100 300 30000 0.25 150 45000 50.00% 12.50% Q 150 200 30000 0.25 130 26000 -13.33% -3.33% R 125 240 30000 0.25 200 48000 60.00% 15.00% S 200 150 30000 0.25 180 27000 -10.00% -2.50% 120000 1.00 146000 21.67% Consider an index constructed on January 1, 1995 with 4 stocks. The number of shares of each stock is adjusted in such a manner that the value of all stocks in the index is equal. Thus, each stock has the same weight in the index. With a change in the stock prices, the current value of the stocks in the index has changed from 120,000 to 146,000. If the old index value is equated to 100, the new index value will be 146000/120000*100, i.e. 121.67. As can be seen from the last column in the above table, this is simply the percentage change in the stock price multiplied by the original weight of each stock, which equals to a rise of 21.67%. With the changed prices, stock P and stock R have a weight greater than 25% while stock Q and stock S have a weight lower than 25%. The fund manager will then have to rebalance the index to restore equal weights. This can be done by selling appropriate quantities of stocks P and R and buying required quantities of stocks Q and S. 2.4 Attributes of an Index A good market index should have following attributes: It should reflect the market behaviour. It should be computed by independent third party and be free from influence of any market participant. It should be professionally maintained. Impact Cost 21 Liquidity in the context of stock market means a market where large orders are executed without moving the prices. Let us understand this with help of an example. The order book of a stock at a point in time is as follows: Buy Sell Sr. No. Quantity Price (in Rs.) Price (in Rs.) Quantity Sr. No. 1 1000 4.00 4.50 2000 5 2 1000 3.90 4.55 1000 6 3 2000 3.80 4.70 500 7 4 1000 3.70 4.75 100 8 In the order book given above, there are four buy orders and four sell orders. The difference between the best buy and the best sell orders is 0.50 - called bid-ask spread. If a person places a market buy order for 100 shares, it would be matched against the best available sell order at Rs. 4.50. He would buy 100 shares for Rs. 4.50. Similarly, if he places a market sell order for 100 shares, it would be matched against the best available buy order at Rs. 4 i.e. the shares would be sold at Rs. 4. Hence, if a person buys 100 shares and sells them immediately, he is poorer by the bid-ask spread i.e., a loss of Rs 50. This spread is regarded as the transaction cost which the market charges for the privilege of trading (for a transaction size of 100 shares). Now, suppose a person wants to buy and then sell 3000 shares. The sell order will hit the following buy orders: Sr. No. Quantity Price (in Rs.) 1 1000 4.00 2 1000 3.90 3 1000 3.80 While the buy order will hit the following sell orders: Quantity Price (in Rs.) Sr. No. 2000 4.50 5 1000 4.55 6 There is increase in the transaction cost for an order size of 3000 shares in comparison to the transaction cost for order for 100 shares. The “bid-ask spread” therefore conveys the transaction cost for a small trade. Now, we come across a term called impact cost. We must start by defining the ideal price as the average of the best bid and offer price. In our example it is (4+4.50)/2, i.e., Rs. 4.25. In an infinitely liquid market, it would be possible to execute large transactions on both 22 buy and sell at prices that are very close to the ideal price of Rs.4.25. However, while trading, you will pay more than Rs.4.25 per share while buying and will receive less than Rs.4.25 per share while selling. The percentage degradation, which is experienced vis-à- vis the ideal price, when shares are bought or sold, is called impact cost. Impact cost varies with transaction size. Also, it would be different for buy side and sell side. Buy Quantity Buy Price (in Rs.) Sell Price (in Rs.) Sell Quantity 1000 9.80 9.90 1000 2000 9.70 10.00 1500 3000 9.60 10.10 1000 To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85 Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.9333 Impact cost for (1500 shares) = {(9.9333 - 9.85)/9.85}*100 = 0.84 % 2.5 Index management Index construction, maintenance and revision process is generally done by specialized agencies. For instance, BSE indices are managed by Asia Index Pvt Ltd and NSE indices are managed by NSE Indices Limited. Index construction is all about choosing the index stocks and deciding on the index calculation methodology. Maintenance means adjusting the index for corporate actions like bonus issue, rights issue, stock split, consolidation, mergers etc. Revision of an index deals with change in the composition of index as such i.e., replacing some existing stocks by the new ones because of a change in the trading paradigm of the stocks, or a shift in the interest of market participants. Index Construction A good index is a trade-off between diversification and liquidity. A well-diversified index reflects the behaviour of the overall market/economy. While diversification helps in reducing risk, it may not help beyond a point. Going from 10 stocks to 20 stocks leads to a sharp reduction in risk. Going from 50 stocks to 100 stocks enables very little reduction in risk. Going beyond 100 stocks causes almost zero decline in risk. Hence, there is little to gain by diversifying beyond a point. Stocks in the index are chosen based on certain pre-determined qualitative and quantitative parameters, laid down by the Index Construction Managers. Once a stock satisfies the eligibility criteria, it is entitled for inclusion in the index. Generally, the final decision of inclusion or removal of a security from the index is taken by a specialized committee known as the Index Committee. Index Maintenance and Index Revision 23 Maintenance and revision of the indices is done with the help of various mathematical formulae. In order to keep the index comparable across time, the index needs to take into account corporate actions such as stock splits, share issuance, dividends and restructuring events. While index maintenance issue gets triggered by a corporate action, index revision is a continuous exercise to ensure that the index captures the most vibrant lot of securities in the market and continues to correctly reflect the market. 2.6 Major Indices in India These are some of the popular equity indices in India: S&P BSE Sensex Nifty 50 SX 40 S&P BSE Sensex Next 50 Nifty Next 50 S&P BSE 100 Nifty 100 S&P BSE 200 Nifty 200 S&P BSE 500 Nifty 500 2.7 Application of Indices Traditionally, indices were used as a measure to understand the overall direction of the stock market. However, a few applications have emerged in the investment field which are explained below: Index Funds These types of funds invest in a specific index with an objective to generate returns equivalent to the return on index. These funds invest in index stocks in the proportions in which these stocks exist in the index. For instance, Sensex index fund would get similar returns as that of Sensex index (except for a small “tracking error” which occurs due to fund management related expenses and cash holdings maintained to take care of redemptions). Since the Sensex has 30 shares, the fund will also invest in these 30 companies in the proportion in which they exist in the Sensex. Similarly, a Nifty index fund would invest in the 50 component companies of Nifty index in the same proportion in which they exist in the Nifty index and therefore generates similar returns as that of Nifty index (adjusted for tracking error). Index Derivatives Index Derivatives are derivative contracts which have the index as the underlying asset. Index Options and Index Futures are the most popular derivative contracts worldwide. Index derivatives are useful as a tool to hedge against the market risk. Exchange Traded Funds Exchange Traded Funds (ETFs) is basket of securities that trade like individual stocks, on an exchange. They have a number of advantages over other mutual funds as they can be 24 bought and sold on the exchange. Since, ETFs are traded on exchanges, intraday transaction is possible. Further, ETFs can be used as basket trading in terms of the smaller denomination and low transaction cost. Sample questions 25 1. State whether TRUE or FALSE: Impact cost is low when the liquidity in the system is poor. (a) True (b) False 2. Which of the following costs is not actually paid by the market participants but arises due to lack of liquidity? (a) Securities Transaction Tax (b) Impact cost (c) SEBI charges (d) Brokerage 26 Chapter 3: Introduction to Forwards and Futures LEARNING OBJECTIVES: After studying this chapter, you should know about: Meaning of forward and futures contracts Terminology related to futures contracts Payoff for a futures contract Pricing of a futures contract Applications of a futures contract by speculators, hedgers and arbitrageurs 3.1 Introduction to forward contracts A forward contract is an agreement made directly between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. Forwards are widely used in commodities, foreign exchange, equity and interest rate markets. Let us understand with the help of an example. What is the basic difference between cash market and forwards? Assume that on May 11, 2023 you want to purchase gold from a goldsmith. The market price for gold on this day is Rs. 62,130 for 10 grams of 24 carat gold and the goldsmith agrees to sell you gold at this price. You pay him Rs. 62,130 for 10 grams of gold and take delivery of the gold. This is a cash market transaction at a price (in this case Rs. 62,130) referred to as spot price. Now suppose you do not want delivery of the gold on May 11, 2023, but only after 1 month. The goldsmith quotes you Rs. 62,337 for 10 grams of gold. You agree to the forward price for 10 grams of gold and go away. Here, in this example, you have “bought a forward contract” or you are “long forward”, whereas the goldsmith has “sold a forward contract” or he is “short forward”. There is no exchange of money or gold at this point of time. After 1 month, you come back to the goldsmith pay him Rs. 62,337 and take 10 grams of gold from him. This is a forward, where both the parties are obliged to go through with the contract irrespective of the value of the underlying asset (in this case gold) at the time of delivery. Essential features of a forward are: It is a contract between two parties (a bilateral contract). All terms of the contract like price, quantity and quality of underlying, delivery terms like place, settlement procedure, etc. are fixed on the day of entering into the contract. In other words, forwards are bilateral over-the-counter (OTC) transactions where the terms of the contract, such as price, quantity, quality, time and place are negotiated between two parties to the contract. Any alteration in the terms of the contract is possible 27 if both parties agree to it. Corporations, traders and investing institutions extensively use OTC transactions to meet their specific requirements. The essential idea of entering into a forward is to fix the price and thereby avoid the price risk. Thus, by entering into forwards, one is assured of the price at which one can buy/sell an underlying asset. In the above-mentioned example, if after one month the gold trades at Rs. 62,700 in the cash market, the forward contract becomes favourable to you because you can then purchase gold at Rs. 62,337 under this forwards contract and sell that gold in the spot market at Rs. 62,700 i.e., net profit of Rs. 363 per 10 grams. Similarly, if the spot price is 62,100 on that day, then you incur a loss of Rs. 237 per 10 grams ( = buy price – sell price). Major limitations of forwards Liquidity Risk Liquidity refers to the ability of the market participants to buy or sell the desired quantity of an underlying asset. As forwards are tailor-made contracts i.e., the terms of the contract are according to the specific requirements of the parties, other market participants may not be interested in these contracts. Forwards are not listed or traded on exchanges, which makes it difficult for other market participants to easily access these contracts or contracting parties. The tailor-made contracts and their non-availability on exchanges creates illiquidity in the contracts. Therefore, it is very difficult for parties to exit from the forward contract before the contract’s maturity. Counterparty risk Counterparty risk is the risk of an economic loss from the failure of the counterparty to fulfil its contractual obligation. For example, A and B enter into a bilateral agreement, where A will purchase 100 kg of rice at Rs.40 per kg from B after 6 months. Here, A is counterparty to B and vice versa. After 6 months, if price of rice is Rs.50 in the market then B may decline his obligation to deliver 100 kg of rice at Rs.40 to A. Similarly, if price of rice falls to Rs.35 then A may purchase from the market at a lower price, instead of honouring the contract. Thus, a party to the contract may default on his obligation if there is incentive to default. This risk is also called default risk or credit risk. In addition to the illiquidity and counterparty risks, there are several issues like lack of transparency, settlement complications as it is to be done directly between the contracting parties. A simple solution to all these issues is to bring these contracts to the centralized trading platform. This is what futures contracts do. 3.2 Futures contracts Futures contracts were created to overcome the limitations of forwards. A futures contract is an agreement made through an organized exchange to buy or sell a fixed amount of a commodity or a financial asset on a future date at an agreed price. In simple 28 terms, futures are standardised forward contracts that are traded on an exchange. The clearing corporation associated with the exchange guarantees settlement of these trades. A trader, who buys futures contract, takes a long position and the one, who sells futures, takes a short position. The words buy and sell are figurative only because no money or underlying asset changes hand, between buyer and seller, when the deal is originated. Features of futures contracts In a futures market, the exchange decides all the terms of the contract other than price. Accordingly, futures contracts have following features: Contract between two parties through Exchange Centralised trading platform (i.e., Exchange) Price discovery through free interaction of buyers and sellers Margins payable by both the parties Quality decided today (standardized) Quantity decided today (standardized) Limitations of Futures Contract As futures are standardized contracts introduced by the exchanges, they too have certain limitations in the context of limited maturities, limited underlying set, lack of flexibility in contract design and increased administrative costs on account of MTM settlement, etc. 3.3 Contract specifications of futures contracts The exchange decides all terms and conditions of futures contracts other than the price of the futures contract. These terms and conditions are known as ‘contract specifications. Contract specifications include the salient features of a derivatives contract like contract maturity, contract multiplier or contract size, tick size, etc. Let us understand these contract specifications with an example of a Nifty futures contract traded on the NSE. Quotes given on the NSE website for Nifty futures as on May 10, 2023 1. Instrument type : Index futures 2. Underlying asset : Nifty 50 3. Expiry date : May 25, 2023 4. Open price (in Rs.) : 18325.00 5. High price (in Rs.) : 18358.50.00 6. Low price (in Rs.) : 18,255.55 7. Closing price (in Rs.) : 18345.50 8. No of contracts traded : 47,56,000 9. Turnover (in Rs. Lakhs) : 8,70,891.34 29 10. Underlying value (in Rs.) : 18315.10 Underlying instrument and underlying price: The underlying instrument refer to the index or stock on which the futures contract is traded. In the above example, the underlying asset is the Nifty 50 index. The underlying price is the spot price or the price at which the underlying asset trades in the cash market. In this example, the underlying price is the value of the Nifty index on May 10, 2023 which is 18315.10. Contract multiplier or Contract Size: Futures contracts are traded in lots. The lot size or contract size for the index and stock futures is determined by the exchange. Contract sizes are different for each stock and index traded in the derivatives segment. The contract size can be changed by the exchange from time to time, depending upon the changes in the index level and stock prices. To arrive at the contract value, we must multiply the futures price with the contract multiplier (i.e., multiply the futures price with the lot size). The contract size for the Nifty futures contract is currently 50. In the above example, the value of a Nifty futures contract can be calculated by multiplying the lot size with the closing futures price i.e., 50 * 18345.50 which works out to Rs. 9,17,275. Contract Cycle: It is a period over which a contract trade. Index and stock futures contracts traded on the NSE follow a three-month trading cycle. Thus, on May 10, 2023, index and stock futures contracts on the NSE are available for trading for the near month (May 2023), the next month (June 2023) and the far month (July 2023). The NSE and BSE offers trading on monthly as well as weekly futures contracts. Expiration Day: This is the day on which a derivative contract ceases to exist. It is the last trading day of the contract. On expiry date, all the contracts are compulsorily settled. If a position is to be continued, then it must be rolled over to another futures contract of the same underlying. For a long position, this means selling the expiring contract and buying the next contract. Both the sides of a roll over should be executed at the same time. The Nifty and the Bank Nifty futures contracts and the stock futures contracts listed on the NSE expire on the last Thursday of the respective month (or the day before if the last Thursday is a trading holiday). In the above example, the May Nifty futures contract will cease to trade on May 25, 2023 and all open positions of the May series will be compulsorily settled by the exchange. A new contract (in this example - August 2023) is introduced on the trading day following the expiry day of the near month contract. The monthly futures contracts on the Nifty Financial Services Index expire on the last Tuesday of their expiry month. Monthly and weekly futures contracts on the BSE Sensex and the BSE Bankex have different expiration dates as discussed later in this section. Tick Size: It is the minimum move allowed in the price quotations. Exchanges decide the tick sizes on traded contracts as part of contract specification. Tick size for Nifty futures is 30 5 paisa. Bid price is the price the buyer is willing to pay and ask price is the price at which the seller is willing to sell. Daily settlement price: The exchange follows a daily settlement procedure for open positions in equity index and stock futures contracts. All open positions are settled daily based on the daily settlement price of the futures contracts, which is calculated by the exchange on the basis of the last half-an-hour weighted average price of that futures contract. Thus, the daily settlement price is different for each futures contract of a different expiry month. In the above example, the daily settlement price of the May Nifty futures contract on May 10 is its closing price which is 18345.50. Final settlement price: This is the price at which all open positions in the near-month futures contracts are finally settled on the expiration day of the near-month futures contract. The final settlement price is the closing price of the relevant underlying index or stock in the cash segment on the last trading day of the futures contract. In the above example, the final settlement price for the May Nifty futures contract will be the closing spot value of Nifty on the expiration date, i.e., on May 25, 2023 which is the last Thursday of the expiry month. Trading hours: The equity futures contracts can be traded during the normal market hours between 9.15 am and 3.30 pm from Monday to Friday. The exchange publishes a list of annual trading holidays and clearing holidays for the information of the market participants. Trading holidays are days on which no trading is possible as the exchanges are closed while clearing holidays are days on which the exchanges are open, and trading is possible but no clearing and settlement takes place as banks are closed. The BSE Sensex futures contracts are based on the underying BSE Sensex. These contracts have specifications that are somewhat different from the Nifty futures contracts as follows: Underlying asset S&P BSE Sensex Contract size 10 Tick size Rs.0.05 Contract cycle 7 serial weekly and 3 serial monthly contracts Trading hours 9:15 a.m. to 3.30 p.m. 31  Expiration day Monthly contracts: last Friday of the contract month Weekly contracts: Friday expiry Final settlement Cash settlement based on the closing price of the underlying index on the expiration day The high correlation between the movements of the Sensex and Nifty enables market participants to trade in Nifty and Sensex futures as part of a pairs trading strategy. The availability of weekly futures contracts on the Sensex and a different expiration day (Friday) for the Sensex futures provides better trading and hedging opportunities to market participants. 3.4 Some important terminology associated with futures contracts Basis: The difference between the spot price and the futures price is called basis. If the futures price is greater than spot price, basis for the asset is negative. Similarly, if the spot price is greater than futures price, basis for the asset is positive. On May 10, 2023, spot price < futures price, thus basis for Nifty futures is negative (i.e., 18315.10 – 18345.50 = - 30.4). Importantly, basis for one-month contract would be different from the basis for two-or three-month contracts. Therefore, definition of basis is incomplete until we define the basis vis-a-vis a futures contract i.e., basis for one-month contract, basis for two-months contract, etc. It is also important to understand that the difference in the basis of a one month futures contract and two months futures contract should essentially be equal to the cost of carrying the underlying asset between first and second month. Indeed, this is the fundamental principle of linking various futures and underlying cash market prices together. During the life of the contract, the basis may become negative or positive, as there is a movement in the futures price and spot price. Further, whatever the basis is, positive or negative, it becomes zero at maturity of the futures contract i.e., there should be no difference between futures price and spot price at the time of maturity / expiry of contract. This happens because final settlement of futures contracts on last trading day takes place at the closing price of the underlying asset. Cost of Carry Cost of Carry is the relationship between futures prices and spot prices. It measures the storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the 32 asset till delivery, less the income earned on the asset during the holding period. For equity derivatives, carrying cost is the interest paid to finance the purchase less (minus) dividend earned. For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A person wishes to buy the share but does not have money. In that case he would have to borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for one year and in that year, he expects the company to give 200% dividend on its face value of Rs. 1 i.e., dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend received = 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104. It is important to note that cost of carry may be different for different participants. Margin Account As the exchange guarantees the settlement of all the trades, to protect itself against default by either counterparty, it charges various margins from brokers. Brokers in turn charge margins from their clients. Margins are briefly explained as follows: Initial Margin The amount one needs to deposit in the margin account at the time of entering into a futures contract is known as the initial margin. Let us take an example - On May 10, 2023 a person decided to enter into a futures contract. He expects the market to go up and so he takes a long Nifty Futures position for May expiry at Rs.18275. The contract value = Nifty futures price * lot size = 18275 * 50 = Rs 9,13,750. This is the contract value of the investor’s long position in one Nifty Future contract expiring on May 25, 2023. Assuming that the broker charges 10% of the contract value as initial margin, the investor has to give him Rs. 91,375 as initial margin. Both buyers and sellers of futures contract pay initial margin, as there is an obligation on both the parties to honour the contract. The initial margin is dependent on price movement of the underlying asset. As high volatility assets carry more risk, the exchange would charge higher initial margin on them. Marking to Market (MTM) In futures market, while contracts have maturity of several months, profits and losses are settled on day-to-day basis – called mark to market (MTM) settlement. The exchange collects these margins (MTM margins) from the loss-making participants and pays to the gainers on day-to-day basis. Let us understand MTM with the help of the example. Suppose a trader bought a futures contract on May 10, 2023 when the Nifty futures contract was trading at 18275. He paid an initial margin of Rs. 91,375 as calculated above. At the end of that day, Nifty futures 33 contract closed at 18345.50. This means that the trader benefitted due to the 70.50 points gain on Nifty futures contract. Thus, the trader’s MTM gain for the day was Rs 70.50 x 50 = Rs 3525. This money will be credited to the trader’s account and next day the trader’s position will start from 18345.50 (for the purpose of MTM computation). Open Interest and Volumes Traded The open interest is the total number of contracts outstanding (yet to be settled) for an underlying asset. It is important to understand that number of long futures as well as number of short futures is equal to the Open Interest. This is because total number of long futures will always be equal to total number of short futures. Only one side of contracts is considered while calculating/mentioning open interest. The level of open interest indicates depth in the market. Volumes traded give us an idea about the market activity with regards to specific contract over a given period – volume over a day, over a week or month or over the entire life of the contract. The following example explains the difference between open interest and traded volume. Date Trade Open Interest as on date Trading Volume for the day March 1 A shorts 50 contracts 50 50 B goes long in 50 contracts March 2 C goes long in 100 contracts OI increases to 150 as new long 100 D goes short in 100 contracts and short position are created March 3 A closes short position by OI remains at 150 because A’s 50 buying back 50 contracts short position is replaced by E’s E shorts 50 contracts short position March 4 C closes long position by OI falls to 50 as existing long 100 selling 100 contracts and D and short positions are closed closes short position by buying back 100 contracts Price band Price Band is essentially the price range within which a contract is permitted to trade during a day. The band is calculated with respect to the previous day’s closing price of a specific contract. For example, the previous day closing price of a contract is Rs.100 and the price band for the contract is 10%, then the contract can trade between Rs.90 and Rs.110 for next trading day. On the first trading day of the contract, the price band is decided based on the closing price of the underlying asset in cash market. For example, if 34 today is first trading day of a futures contract for an underlying asset i.e., company A, the price band for the contract is decided on the previous day’s closing price of company ‘A’ stock in cash market. Price band is clearly defined in the contract specifications so that all market participants are aware of the same in advance. Sometimes, bands are allowed to be expanded at the discretion of the exchanges with specific trading halts. Positions in derivatives market As a market participant, you will always deal with certain terms like long, short and open positions in the market. Let us understand the meanings of commonly used terms: Long position Outstanding / unsettled buy position in a contract is called “Long Position”. For instance, if Mr. X buys 5 contracts on Sensex futures, then he would be long on 5 contracts of Sensex futures. If Mr. Y buys 4 contracts on Nifty futures, then he has a long position in 4 contracts of Nifty futures. Short Position Outstanding / unsettled sell position in a contract is called “Short Position”. For instance, if Ms. P sells 5 contracts on Sensex futures, then she would be short on 5 contracts on Sensex futures. If Ms. Q sells 4 contracts on Nifty futures, then she would be short on 4 contracts of Nifty futures. Open position Outstanding / unsettled either long (buy) or short (sell) position in various derivative contracts is called “Open Position”. For instance, if Mr. X shorts 5 contracts on Infosys futures and goes long on 3 contracts of Reliance futures, he is said to be having open position, which is equal to short on 5 contracts of Infosys and long on 3 contracts of Reliance. If on the next day, he buys 2 Infosys contracts of same maturity, his open position would be – short on 3 Infosys contracts and long on 3 Reliance contracts. Naked and calendar spread positions Naked position in futures market simply means a long or short position in any futures contract without having any position in the underlying asset. Calendar spread position is a combination of two positions in futures on the same underlying - long on one maturity contract and short on a different maturity contract. For instance, a short position in near month contract coupled with a long position in far month contract is a calendar spread position. Calendar spread position is computed with respect to the near month series and becomes an open position once the near month contract expires or either of the offsetting positions is closed. 35 A calendar spread is always defined with respect to the relevant months i.e., spread between August contract and September contract, spread between August contract and October contract, or spread between September contract and October contract, etc. Opening a position Opening a position means either buying or selling a contract, which increases client’s open position (long or short). Closing a position Closing a position means either buying or selling a contract, which essentially results in reduction of client’s open position (long or short). A client is said to be closed a position if he sells a contract which he had bought before, or he buys a contract which he had sold earlier. 3.5 Differences between Forwards and Futures Feature Forward contracts Futures contracts Operational It is not traded on the It is an exchange-traded contract. mechanism exchanges. Contract Terms of the contracts differTerms of the contracts are specifications from trade to trade (tailor made standardized. Except the price, all contract) according to the need other terms of the contract are of the participants. already fixed (standardized). Counter-party Exists, but at times gets reduced The clearing agency associated risk by a guarantor. with exchange becomes the counter-party to all trades assuring guarantee on their settlement. Liquidity Low, as contracts are tailor- High, as contracts are profile made catering to the needs of standardised and exchange the parties involved. Further, traded. contracts are not easily accessible to other market participants. Price discovery Not efficient, as markets are Efficient, centralised trading scattered. platform helps all buyers and sellers to come together and discover the price through common order book. 36  Quality of Quality of information may be Futures are traded nationwide. information poor. Speed of information Every bit of relevant information and its dissemination is slow. is quickly disseminated. dissemination 3.6 Payoff Charts for Futures contracts Payoff Charts Payoff on a position is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset at expiry. The payoff diagram is a graphical representation showing the price of the underlying asset on the X-axis and profits/losses on the Y-axis. Payoff charts for futures In case of futures contracts, long as well as short position has unlimited profit or loss potential. This results into linear payoffs for futures contracts. Futures payoffs are explained in detail below: Payoff for buyer of futures: Long futures Let us say a person goes long in a futures contract at Rs.100. This means that he has agreed to buy the underlying at Rs. 100 on expiry. Now, if on expiry, the price of the underlying is Rs. 150, then this person will buy at Rs. 100, as per the futures contract and will immediately be able to sell the underlying in the cash market at Rs.150, thereby making a profit of Rs. 50. Similarly, if the price of the underlying falls to Rs. 70 at expiry, he would have to buy at Rs. 100, as per the futures contract, and if he sells the same in the cash market, he will receive only Rs. 70, translating into a loss of Rs. 30. This potential profit/loss at expiry when expressed graphically, is known as a payoff chart. The X Axis has the market price of the underlying at expiry. It increases on the Right-Hand Side (RHS). We do not draw the X Axis on the Left-Hand Side (LHS), as prices cannot go below zero. The Y Axis shows profit & loss. In the upward direction, we have profits and in the downward direction, we show losses in the chart. The below table and payoff chart show long futures pay offs: Long Futures at 100 Market price Long Futures at expiry Payoff 50 -50 60 -40 70 -30 80 -20 37  90 -10 100 0 110 10 120 20 130 30 140 40 150 50 60 Long Futures Payoff 40 20 Profit/Loss (Rs.) 0 50 60 70 80 90 100 110 120 130 140 150 CMP @ Expiry -20 -40 Long Futures Payoff -60 Short Futures payoff As one person goes long, some other person must go short, otherwise a deal will not take place. The profits and losses for the short futures position will be exact opposite of the long futures position. This is shown in the table and chart below: Short Futures at 100 Market price Short Futures at expiry Payoff 50 50 60 40 70 30 80 20 38  90 10 100 0 110 -10 120 -20 130 -30 140 -40 150 -50 60 Short Futures Payoff 40 20 Profit/Loss (Rs.) 0 50 60 70 80 90 100 110 120 130 140 150 CMP @ Expiry -20 -40 Short Futures Payoff -60 As can be seen, a short futures position makes profits when prices fall. If prices fall to 60 at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry and sell at 100, thereby making a profit of Rs. 40. This is shown in the above chart. 3.7 Futures pricing Pricing of a futures contract depends on the characteristics of underlying asset. There is no single way to price futures contracts because different assets have different demand and supply patterns, different characteristics and cash flow patterns. This makes it difficult to design a single methodology for calculation of prices of futures contracts. Market participants use different models for pricing futures. Here, our discussion is limited to only two popular models of futures pricing - Cost of Carry model and Expectations model. 39 Cost of Carry Model for Futures Pricing Cost of Carry model is also known as the no-arbitrage model. This model assumes that in an efficient market, arbitrage opportunities cannot exist. In other words, the moment there is an opportunity to make money in the market due to mispricing in the asset price and its replicas, arbitrageurs will start trading to profit from these mispricing and thereby eliminating these opportunities. This trading continues until the prices are aligned across the products/markets for replicating assets. Let us understand the entire concept with the help of an example. Practically, forward/ futures position in a stock can be created in the following manner: Enter into a forward/futures contract, or Create a synthetic forward/futures position by buying that stock in the cash market and carrying it to the future date. The price of acquiring the asset by a future date should be the same in both the cases i.e., cost of synthetic forward/futures contract ( = spot price + cost of carrying the asset from today to the future date) should be equivalent to the present price of the forward/ futures contract. If these prices are not the same, then it will trigger arbitrage and will continue until prices in both the markets are aligned. The cost of creating a synthetic futures position is the fair price of futures contract. Fair price of futures contract is nothing but the sum of spot price of underlying asset and cost of carrying the asset from today until delivery. Cost of carrying a financial asset from today to the future date would entail different costs like transaction cost, custodial charges, financing cost, etc. and for commodities, it would also include costs like warehousing cost, insurance cost, etc. Let us take an example from the bullion market. Assume that the spot price of gold is Rs 62,130 per 10 grams. The cost of financing, storage and insurance for carrying the gold for a period of three months is Rs 100 per 10 grams. Now you purchase 10 grams of gold from the market at Rs 62,130 and hold it for three months. We may now say that the expected value of the gold after 3 months would be Rs 62,230 per 10 grams. Assume the 3-month futures contract on gold is trading at Rs 62,280 per 10 grams. What should one do? Apparently, one should attempt to exploit the arbitrage opportunity present in the gold market by buying gold in the cash market and sell 3-month gold futures simultaneously. We borrow money to take delivery of gold in cash market today, hold it for 3 months and deliver it in the futures market on the expiry of our futures contract. Amount received on settling the futures contract could be used to repay the financier of our gold purchase. The net result will be a profit of Rs 50 without taking any risk. (Please note that we have not considered any transaction costs in this example). 40 Because of this mispricing, as more and more people come to the cash market to buy gold and sell in futures market, spot gold price will go up and gold futures price will come down. This arbitrage opportunity continues until the prices between cash and futures markets are aligned. Therefore, if futures price is more than the fair futures price, it will trigger “cash and carry arbitrage”, which will continue until the prices in both the markets are aligned. Similarly, if the futures price is less than the fair futures price, it will trigger “reverse cash and carry arbitrage” i.e., market participants will start buying gold in futures markets and sell gold in cash market. To do this, traders will borrow gold and deliver it to honour the contract in the cash market and earn interest on the cash market sales proceeds. After three months, they give gold back to the lender on receipt of the same in futures market. This reverse arbitrage will result in reduction of gold’s spot price and increase of its futures price, until these prices are aligned and there is no further arbitrage left. Cost of transaction and no-arbitrage bounds Cost components of futures transaction like margins, transaction costs (commissions), taxes etc. create distortions and move the markets away from equilibrium. In fact, these cost components create no-arbitrage bounds in the market i.e., if the futures price is within these bounds around the fair futures price, arbitrage will not take place. In other words, because of the frictions in the market, for arbitrage to get triggered, it is important for the futures price to fall outside the no-arbitrage bounds in either direction for the arbitragers to make profit from the arbitrage opportunities. Fair Price No-arbitrage bounds Practically, every component of carrying cost contributes towards widening of these no- arbitrage bounds. Here, we should appreciate that wider the no-arbitrage bounds, farther the markets are from the equilibrium. In other words, for the markets to be efficient, different costs of operating in the markets should be as low as possible. Lower costs would narrow the no-arbitrage bounds, which in turn would ensure the efficient price alignment across the markets. Extension of Cost of Carry model to the assets generating returns Let us extend the Cost of Carry model by adding the inflows during the holding period of underlying assets. For instance, underlying assets like securities (equity or bonds) may 41 have certain inflows, like dividend on equity and interest on debt instruments, during the holding period. These inflows are adjusted in the computation of the fair futures price. Thus, modified formula of fair futures price or synthetic futures price is: Fair futures price = Spot price + Cost of carry - Inflows In mathematical terms, F = S (1+r-q)T Where F is fair price of the futures contract, S is the Spot price of the underlying asset, q is expected return during holding period T (in years) and r is cost of carry. If we use the continuous compounding, we may rewrite the formula as: F= Se(r-q)*T Let us apply the above formula to the index futures market to find the fair futures price of an index. Suppose, you buy an index in cash market at 17500 level i.e., purchase of all the stocks constituting the index in the same proportion as they are in the index, cost of financing is 12% and the return on index is 4% per annum (spread uniformly across the year). Given this data, fair price of index three months down the line should be: = Spot price * (1 + cost of financing – holding period return) ^ (time to expiration / 365) = 17500 * (1+0.12-0.04) ^ (90/365) = Rs. 17835.26 [Alternatively, we could use exponential form for calculating the futures value as: Spot Price * e(r-q)T. Value in that case would have been: 17500*e((0.12-0.04)*90/365) = Rs. 17848.63]. If the index futures is trading above 17848.63, we can buy index stocks in the cash market and simultaneously sell index futures to lock the gains equivalent to the difference between futures price and fair futures price. Note that the cost of transaction, taxes, margins, etc. are not considered while calculating the fair futures price. Note: Cost of borrowing of funds and securities, return expectations on the held asset, etc. are different for different market participants. Perhaps the different fair values of futures contracts and no-arbitrage bounds for different market participants is what makes the market and trading take place on a continuous basis. Assumptions of the Cost of Carry model This model of futures pricing works under certain assumptions. The important assumptions are stated below (*): The underlying asset is available in abundance in cash market. Demand and supply in the underlying asset are not seasonal. Holding and maintaining of the underlying asset is easy and feasible. The underlying asset can be sold short. There are no transaction costs. There are no taxes. There are no margin requirements. [*This is not an exhaustive list of the assumptions of the model but is the list of important assumptions] 42 The assumption that the underlying asset is available in abundance in the cash market means that we can buy and/or sell as many units of the underlying assets as we want. This assumption does not work especially when the underlying asset has a seasonal pattern of demand and supply. The prices of seasonal assets (especially commodities) vary drastically in different demand-supply environments. For example, in case of agricultural commodities, when new supplies arrive in the marketplace, prices tend to fall, whereas prices tend to be high just before the arrival of that new supply. When an underlying asset is not storable i.e., the asset is not easy to hold/maintain, then one cannot carry the asset to the future. The Cost of Carry model is not applicable to these types of underlying assets. Similarly, many a time, the underlying may not be sold short. This is true in case of seasonal commodities. Even though this simple model does not discount for transaction cost, taxes, etc., we can always upgrade the formula to reflect the impact of these factors in the model. Margins are not considered while computing the fair value/ synthetic futures value. That is why this model is suitable for pricing forward contracts rather than futures contracts. Thus, no generalized statement can be made with regard to the use of Cost of Carry model for pricing futures contracts. Assumptions of the model and characteristics of underlying asset can help us in deciding whether a specific asset can be priced with the help of this model or not. Further, suitable adjustments are made in the model to fit in the specific requirements of the underlying assets. Convenience Yield Let us touch upon one more concept in futures market called “Convenience Yield”. We need to go back and have a look at the formula for fair price of futures contract. Fair price of futures contract = Spot price + Cost of carry – Inflows As seen earlier inflows may be in the form of dividend (in case of equity) and interest (in case of debt). However, sometimes inflows may also be intangibles. Intangible inflows essentially mean values perceived by the market participants by holding the asset. These values may be in the form of convenience or perceived mental comfort by holding the asset. For instance, in case of a natural disaster like a flood in a particular region, people start storing essential commodities like grains, vegetables and energy products (heating oil), etc. As a human tendency, we store more than what is required for our real consumption during a crisis. If every person behaves in similar way, then suddenly a demand is created 43 for an underlying asset in the cash market. This indirectly increases the price of underlying assets. In such situations people derive convenience, just by holding the asset. This is termed as convenience yield or convenience return. Convenience yield for a commodity is likely to be different for different people, depending on the way they use it or perceive it. Further, it may vary over a period. In fact, convenience is a subjective issue and is very difficult to price. Convenience yield sometimes may dominate the cost of carry, which leads futures to trade at a discount to the cash market. In this case, reverse arbitrage is also not possible because no one lends traders the assets to sell short in the cash market. In such situations, practically, the cash and carry model breaks down and cannot be applied for pricing the underlying assets. Note that the convenience yield mainly arises when there is a scarcity of a commodity (for example, crop failure due to natural calamities) and its inventory is low. Hence, convenience yield is usually observed in case of consumption assets (i.e., commodities) and not in case of financial assets (such as equities, bonds or currencies). Expectations model of futures pricing According to the expectations hypothesis, it is not the relationship between spot and futures prices, but that of expected spot and futures prices, which moves the market, especially in cases when the asset cannot be sold short or cannot be stored. It also argues that futures price is nothing but the expected spot price of an asset in the future. This is why market participants would enter futures contract and they price the futures based upon their estimates of the future spot prices of the underlying assets. According to this model: Futures can trade at a premium or discount to the spot price of underlying asset. Futures price gives market participants an indication of the expected direction of movement of the spot price in the future. For instance, if futures price is higher than spot price of an underlying asset, market participants may expect the spot price to rise in the near future. This expectedly rising market is called “Contango market”. Similarly, if futures price is lower than spot price of an asset, market participants may expect the spot price to fall in future. This expectedly falling market is called “Backwardation market”. 3.8 Price discovery and convergence of cash and futures prices on the expiry It is important to understand what the expectations hypothesis means. For instance, if we say that the May 2023 index futures contract is trading at 18345.50 on May 10, 2023, what does it mean? According to the expectations model of futures pricing, it means that as on May 10, the market expects the spot index to settle at 18345.50 at the closure of 44 the market on last Thursday of May 2023 (i.e., on the last trading day of the contract which is May 25, 2023). The point is that every participant in the market is trying to predict the spot index level at a single point in time i.e., at the closure of the market on last trading day of the contract, which is Thursday in our example. This results in price discovery of spot index at a specific point in time. Thus, the futures prices are essentially expected spot price of the underlying asset, at the maturity of the futures contract. Accordingly, both futures and spot prices converge at the maturity of futures contract, as at that point in time there cannot be any difference between these two prices. This is the reason why all futures contracts on expiry settle at the underlying cash market price. This principle remains the same for all the underlying assets. 3.9 Uses of futures Role of different participants in derivatives markets The participants in the derivatives markets can be categorized as hedgers, speculators and arbitrageurs. Hedgers Corporations, Investing Institutions, banks and governments all use derivative products to hedge or reduce their exposures to market variables such as interest rates, share values, bond prices, currency exchange rates and commodity prices. The classic example is the farmer who sells futures contracts to lock into a price for delivering a crop on a future date. The buyer might be a food