Financial Derivatives Final (1)

7/31/2019 Financial Derivatives Final (1)

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FINANCIAL DERIVATIVES

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common underlying assets include stocks, bonds, commodities, currencies, interest rates and

market indexes. Most derivatives are characterized by high leverage.

According to the Securities Contract Regulation Act, (1956) the term derivative

includes:

i. 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;

ii. a contract which derives its value from the prices, or index of prices, of underlyingsecurities.

Derivatives are securities under the Securities Contract (Regulation) Act and hence the

trading of derivatives is governed by the regulatory framework under the Securities

Contract (Regulation) Act.

INDEX PRODUCTS DERIVATIVE ON INTEREST RATE GOI SECURITIES,

SECURITY PRODUCTS BONDS,

T-BILLS.


REAL ESTATE FOREX

EQUITY DEBT

INDEX OPTIONS INDEX FUTURES

STOCK OPTIONS STOCK FUTURES


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Indian Derivative contracts can be traded either on Exchange or Over-the-counter (OTC)market:

Exchange: Derivatives traded on the regulated exchanges are highly standardized. Options

and Futures are standardized. In other words, the parties to the contracts do not decide the

terms of futures/option contracts; but they merely accept terms of contract standardized by

exchange. Exchange-traded derivatives offer the maximum protection to the investors because

of the various regulatory measures offered by SEBI to provide for fairness and transparency

in trading. Stock Exchange is one important constituent ofcapital market. Stock Exchange is

an organized market for the purchase and sale of industrial and financial security. It is

convenient place where trading in securities is conducted in systematic manner i.e. as per

certain rules and regulations. It performs various functions and offers useful services to

investors and borrowing companies. It is an investment intermediary and facilitates economic

and industrial development of a country.

Stock exchange is an organized market for buying and selling corporate and other

securities. Here, securities are purchased and sold out as per certain well-defined rules and

regulations. It provides a convenient and secured mechanism or platform for transactions in

different securities. Such securities include shares and debentures issued by public companies

which are duly listed at the stock exchange and bonds and debentures issued by government,

public corporations and municipal and port trust bodies.

Stock exchanges are indispensable for the smooth and orderly functioning of corporate sector

in a free market economy. A stock exchange need not be treated as a place for speculation or a

gambling den. It should act as a place for safe and profitable investment, for this, effective

control on the working of stock exchange is necessary. This will avoid misuse of this platform

for excessive speculation, scams and other undesirable and anti-social activities.

Over-the counter: OTC is an alternative trading platform linked to the network of dealers

who does not physically meet but instead communicate through a network of phones and

computers. The buyers and sellers to suite their requirements can customize the contracts

traded in these market. Encompass tailored financial derivatives such as swaps, swaptions,

caps and collars that are traded in the offices of the worlds leading financial institutions.
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These contracts are customized. In other words, the terms of OTC contracts are individually

agreed upon two counter-parties

The main difference between the above two is on account of counterparty risk and liquidity.

Whereas exchange traded instruments do not have any counter party risk, it is present in OTC

instruments. Further, in exchange-traded instruments, one can exit any time at the prevailing

rate, since these instruments are regularly quoted in the exchange market. Liquidity is not

available in OTC instruments. These contracts can be terminated only to the disadvantage of

the holder.

FEATURES OF DERIVATIVES

Price discovery: The futures and options market serve an all important functions of price

discovery. The individuals with better information and judgment participate in these markets

to take advantage of such information. When some new information arrives, perhaps some

good news about the economy, for instance, the action of speculators quickly feed their

information into the derivatives market causing changes in the price of derivatives. These

markets are usually the first one to react because the transaction cost is much lower in these

markets than in the spot market. Therefore, these markets indicate what is likely to happen

and thus assist in better discovery.

Transfer risks: The derivatives market helps to transfer risks from those who have them but

may not like them, to those who have an appetite for them. An investor having large exposure

to equity may transfer his risk of downside in his portfolio due to volatility in markets, to

another market participant, by using various hedging strategies available in the derivatives

market.

Leverage: Derivatives market requires the trader to pay a small fraction of the value of the

total contract as margin. The trader is able to take position in equity or index with a relativelylower capital as compared to the spot market. He is able to control the total value of the

contract with a relatively small amount of margin. Leverage enables the trader to make a large

profit or loss with a comparatively small amount of capital employment.


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Low transaction cost and better surveillance: Derivatives market involves the lowest

possible transaction cost due to the large number of participants and the traders volume as

compared to the cash market. Retail investor is attracted to the derivatives market due to the

low transaction cost which in turn increases their margin. What is noteworthy is that

notwithstanding, a small set of scripts and surveillance and reporting requirements the

derivatives volume have surpassed cash market volumes within such a short time. Derivatives

have a number of advantages such as hassle free settlement, lower transaction cost, flexibility

in terms of various permutations and combination of trading strategies etc.

Maximize returns and minimize risks: The primary objectives of any investor are to

maximize returns and minimize risks. Derivatives are contracts that originated from the need

to minimize risk.

Increased savings and investment: Derivatives markets help increase savings and

investment in the end. Transfer of the risk enables market participants to expand their

volumes of activity.

RISKS IN DERIVATIVES MARKET

There are different types of risks associated with the derivative instruments are as

follows:

1) Credit risk: These are the usual risks associated with the counterparty default and whichmust be assessed as a part of any financial transaction. However, in India the two major

stock exchanges that offer equity derivative products have settlement/Trade guarantee

funds that address the risk.

2) Financial risks: The financial risk is the function of the companys capital structure orfinancial leverage. The company may fall on financial grounds, if its capital structure

tends to make earnings unstable. Financial leverage is the percent change in net earningsfor given results from the use of debt financing in the capital structure. If company uses a

large amount of debt, then it has contracted to pay a relatively large fixed amount for its

sources of capital. When the operating profits falls, the company will have to pay a large

interest payment and thus the net profit will fall even more.


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3) Market risk: The market risk means the variability in the rate of return caused by themarket up swings or market down swings. It is caused by the investors reactions to

tangible as well as intangible events in market. Most investors are quick to note about the

security markets that returns on securities tend to move together. That is, on a good day,

the fact that some stocks in the market are rising seems to fuel enthusiasm, and other

stock tends to rise also. On the other hand, when some stock begins to fall, other will also

tend to fall as a mood of pessimism pervades the market. When a relatively small

increase in the market usually accompanies a relatively larger increase in the price of

stock, the stock has a high degree of market.

4) Liquidity risk: Liquidity risk arises from the inability to convert an investment quicklyinto cash. It refers to the ease with which a stock may be sold. If a stock is highly liquid,

it can be sold very quickly at a price which is more or less equal to its previous market

price. In a security market, liquidity risk is function of the marketability of the security.

When an investor wants to sell a stock he is concerned with its liquidity. On the other

hand, when an investor wants to buy a stock, he is interested in its availability. A stock

may be regarded as not easily available, if purchaser has to wait for quite some time to

buy it at a price which is more or less equal to its previous price. Thus, the lower

marketability of stock give a degree of liquidity risk that makes the price of stock a bit

uncertain.

5) Systematic risk: The fluctuations in an investments return attributable to changes inbroad economic social or political factors which may influence the return on investment

as a systematic risk. It is that portion of total risk of security which is caused by the

influence of certain economic-wide factors like money supply, inflation, level of

government spending etc. It is undiversifiable risk and investors cannot avoid the risk

arising from the above factors.

6) Unsystematic risk: Unsystematic risk is the variation in returns due to factors related tothe individual firm or security. It is that portion of total risk which arises from factors

specific to particular firm such as plant breakdown, labor strikes, sources of materials etc.

It is possible to reduce unsystematic risk by adding more securities to the investors

portfolio. All risky securities have some degree of unsystematic risk but combining

securities into diversified portfolios reduces unsystematic risk from the portfolio.


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Therefore, unsystematic risk is often referred to as diversified risk. The sum of

systematic and unsystematic risks is equal to the total risk of the security.

7) Default risk: It is the risk of issuer of investment going bankrupt. An investor whopurchases shares or debentures will have to face the possibility of default and bankruptcy

of the company. In the case of fixed income securities such as debenture or fixed deposits

of companies, the investor make take the care to see that the credit rating given to the

company, so that the risk can be minimized.

8) Strategic risk : These risks arise from activities such as Entrepreneurial behavior oftraders in financial institutions, Misreading client requests, Costs getting out of control,

Trading with inappropriate counterparties.

9) Legal risk:Legal risk is the risk that contracts are not legally enforceable or documentedcorrectly. Legal risks should be limited and managed through policies developed by the

institutions legal counsel (typically in consultation with officers in the risk management

process) that have been approved by the institutions senior management and board of

directors. At a minimum, there should be guidelines and processes in place to ensure then

force ability of counterparty agreements.

Prior to engaging in derivatives transactions, an institution should reasonably satisfy

itself that its counterparties have the legal and necessary regulatory authority to engage

in those transactions. In addition to determining the authority of a counter party to enter

into a derivatives transaction, an institution should also reasonably satisfy itself that the

terms of any contract governing its derivatives activities with a counterparty are legally

sound.

HISTORY OF FINANCIAL DERIVATIVES MARKET

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

computer sand 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.


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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 for buyers and sellers to negotiate forward contracts. In1865, the CBOT

went one step further and listed the first exchange traded derivatives contract in the US.

These contracts were called futures contracts. 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 1970s 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. In1973, 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 Euro-Dollar 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.

TYPES OF DERIVATIVE CONTRACTS

The most commonly used derivatives contracts are forwards, futures and options, which we

shall discuss in detail later. Here we take a brief look at various derivatives contracts that have

come to be used.

Forwards: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today's pre-agreed price.


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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. Futures contracts are special types of forward

contracts in the sense that the former are standardized exchange-traded contracts.

Options: 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 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.

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 betweenthe parties in the same currency.

Currency swaps: These entail swapping both principal and interest between theparties, with the cash flows in one direction being in a different currency than those in

the opposite direction.

Warrants: Options generally have lives of upto one year, the majority of options traded on

options exchanges having a maximum maturity of nine months. Longer-dated options are

called warrants and are generally traded over-the-counter.

Swaptions: Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls

and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver

swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay

fixed and receive floating.


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DERIVATIVES INTRODUCTION IN INDIA

The first step towards introduction of derivative trading in India was the promulgation

of the Securities Law Ordinance, 1995, which withdrew the prohibition on the option in

securities.

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 market in

India, submitted its report on March 17, 1998. The committee recommended that the

derivatives should be declared as securities so that regulatory framework applicable to

trade of the securities could also govern trading of derivatives.

SEBI also set up a group in June 1998 under the chairmanship of Prof. J.R.Varma, to

recommend measures for risk containment in a derivatives market in India. The report, which

was submitted in October 1998, work out the operational details of margining system,

methodology for charging initial margins, broker net worth, deposit requirement and real-time

monitoring requirements.

The Securities Contract Regulation Act (SCRA) was amended in December 1999 to shall

be legal and valid only if such contracts are traded on a recognized stock exchange precluding

OTC derivatives. The government also rescinded in March 2000, the three-decade old

notification, which prohibited forward trading in securities. Derivatives trading commenced in

India in June 2000 after SEBI granted the final approval to this effect in May 2000. SEBI

permitted the derivative segment of two stock exchanges- NSE and BSE, and their clearing

house to commence trading and settlement in approved derivatives contract. Include

derivatives within the ambit of securities and act made it clear that derivatives

SEBI approved trading in index futures contract based on S&P CNX Nifty and BSE-30

(Sensex) index. This was followed by approval for trading in option based on these two

indices and options on individual securities. The trading in index options commenced in June

2001 and the trading in options on individual securities commenced in July 2001.Futures

contracts on individual stocks were launched in November 2001.


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Products available for trading on Derivatives segment

Products on Derivative Segment Date of launch

S & P CNX Nifty Futures 12-June-2000

S & P CNX Nifty Options 4-June-01

Single Stock Options 2-July-01

Single Stock Futures 9-Nov-01

Interest Rate Futures 24-June-03

CNX IT Futures & Options 29-Aug-03

Bank Nifty Futures & Options 13-June-05

CNX Nifty Junior Futures & Options 1-June-07

CNX 100 Futures & Options 1-June-07

Nifty Midcap 50 Futures & Options 5-Oct-07

Mini Nifty Futures & Options on S&P CNX Nifty 1-Jan-08

Long Term Options on S&P CNX Nifty 3-March-08

S&P CNX Defty Futures & Options 10-Dec-08

(source: Derivatives market by Laila Ahmed Patel)

PARTICIPANTS IN DERIVATIVE MARKETS

Hedgers: Hedgers are those traders who wish to eliminate price risk associated with the

underlying security being traded. The objective of these kinds of traders is to safeguard their

existing positions by reducing the risk. They are not in the derivatives market to make profits.

Apart from equity markets, hedging is common in the foreign exchange markets where

fluctuations in the exchange rate have to be taken care of in foreign currency transactions.

For example, an importer has to pay US $ to buy goods and rupee is expected to fall to Rs.

50/$ from Rs. 48/$, then the importer can minimize his losses by paying a currency futures at

Rs. 49/$.

Speculators: While hedgers might be adept at managing the risks, there are parties who are

adept at managing and even making money out of such exogenous risk. Using their own

capital and that of their clients, some individuals and organization may accept such risks in


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the expectation of the return. But unlike investing in business with its risks, speculators have

no clear interest in the underlying activity itself. For the possibility of a reward, they are

willing to accept certain risks. They are traders with a view and objective of making profits.

These are people who take long or short position and assume risk to profit from fluctuations

in prices. They are willing to take risks and they bet upon whether the markets would go up or

come down. Speculators may be either day traders or position traders. The former speculate

on the price movements during one trading day, while the latter attempt to gain keep their

position for longer time period to gain from price fluctuations. For example, an investor

expected that the stock price of Coal India Ltd will go upto Rs 500 in a month and he buys a

1 month futures of Coal India Ltd at Rs. 350 and make profits.

Arbitrageurs: The Institute of Chartered Accountant of India, the word ARBITRAGE has

been defined as follows:

Simultaneous purchase of securities in one market where the price there of is low and sale

thereof in another market, where the price thereof is comparatively higher. These are done

when the same securities are being quoted at different prices in the two markets, with a view

to make profit and carried on with conceived intention to derive advantagefro0m difference in

prices of securities prevailing in the two different markets

Riskless profit making is the prime goal of arbitrageurs. It is useful for the people who buy or

sell to make money on price differentials in different markets.

For example BHEL is quoting Rs. 2078 in the Equity market, and Rs. 2082 in Futures market.

Since there is price difference in both the markets and at the end of expiry the price converges

to one, one can buy BHEL in equity market and sell in futures market to earn a risk-free profit

of Rs. 4.


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FORWARD CONTRACTS

INTRODUCTION

A contract that obligates one counter party to buy and the other to sell a specific

underlying asset at a specific price, amount and date in the future is known as a forward

contract. Forward contracts are the important type of forward-based derivatives. They are the

simplest derivatives. There is a separate forward market for multitude of underlying,

including currencies and interest rates. The change in the value of a forward contract is

roughly proportional to the change in the value of its underlying asset. These contracts create

credit exposures. As the value of the contract is conveyed only at the maturity, the parties are

exposed to the risk of default during the life of the contract. Forward contracts are customized

with the terms and conditions tailored to fit the particular business, financial or risk

management objectives of the counter parties. Negotiations often take place with respect to

contract size, delivery grade, delivery locations, and delivery date and credit terms.

DEFINITION

A forward contract can be defined as an agreement between two parties, a buyer and a

seller, that calls for the delivery of an asset at a future date with a price agreed today. It is a

personalized contract between parties. The forward market is a general term use to describe

the in formal market through which these contracts are entered into .Standardized forward

contracts are known as futures contracts and are traded on futures exchanges. Often, the buyer

of the contract is called long and seller of the contract is called short.

The salient features of forward contracts are as given below:

i. They are bilateral contracts and hence exposed to counter party risk.ii. Each contract is custom designed, and hence is unique in terms of contract size,

expiration date, and the asset type and quality.

iii. The contract price is generally not available in public domain.iv. On the expiration date, the contract has to be settled by delivery of asset.


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v. If the counter party wishes to reverse the contract, it has to compulsorily go to thesame counter-party, which often results in high price charged.

CLASSIFICATION OF FORWARD CONTRACTS

Forward contracts in India are broadly governed by the Forward Contracts (regulation) Act,

1952. According to this act, forward contracts are of the following three major categories.

a) Hedge contracts: These are freely transferable contracts which do not requirespecification of a particular lot size, quality or delivery standards for the underlying

assets. Most of these are necessary to be settled through delivery of underlying assets.

b) Transferable specific delivery forward contracts: Apart from being freelytransferable between parties concerned, these forward contracts refer to a specific and

predetermined lot size and variety of the underlying asset. It is compulsory for

delivery of the underlying assets to take place at the expiration of contract.

c) Non-Transferable Specific Delivery Forward Contract : These contracts arenormally exempted from the provision of regulation under Forward Contract Act,

1952 but the Central Government reserves the right to bring them back under the Act

when it feels necessary. These contracts which cannot be transferred to another party.

These contracts, the consignment lot size, and quality of underlying asset are required

to be settled at expiration through delivery of the assets.

ADVANTAGES AND DISADVANTAGES OF FORWARDS

Advantages

Forward contracts can be used to hedge or lock-in the price of purchase or sale of anfinancial asset on the future commitment date.

On forward contracts, generally, margins are not paid and there is also no upfrontpremium. So, it does not involve initial cost.

Since forwards are tailor made, price risk exposure can be hedged up to 100% whichmay not be possible in futures and options.


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Disadvantages

Counter party risk is very much present in forward contracts since there is noperformance guarantee. On due date, the possibility of counterpartys failure to perform

his obligation creates another risk exposure.

Forward contracts do not allow the investor to derive any gain from favorable pricemovement or to unwind the transaction once the contract is made. At the most, the

contract can be cancelled on the terms agreed upon by the counterparty.

Since forwards are not exchange-traded, they have no liquidity. Further, it is difficult toget counter party on ones term.

One of the counterparties of these contracts is generally a bank or a trader who squaresup their position by entering into reverse contracts. These transactions do not take place

simultaneously, so these parties normally keep large bid-ask spread to avoid any loss

due to price fluctuations. This increases the cost of hedging.

TYPES OF FINANCIAL FORWARD CONTRACTS:

Currency Forward Contracts: Currency forward markets development over the years can

be attributed to relaxation of government controls over exchange rates of most of the

currencies. Currency forwards contracts are mostly used by banks and companies to manageforeign exchange risk. For example, Microsoft its European subsidiary to send it 12 million

Euros in period of 3months. On receiving the Euros form the subsidiary, Microsoft will

convert them into dollars. Thus, Microsoft is essentially long on Euros,as it has to sell Euros.

At the same time it is short on dollars as it has to buy the dollars. In such a situation, a

currency forward contract proves useful because it enables Microsoft to lock-in the exchange

rate at which it can sell Euros and buy dollars in 3 months. This can be done if Microsoft goes

short on forwards. This implies than Microsoft will go short on euro and long on dollar. This

arrangement will offset its otherwise long-euro, short-dollar position. In other words,

Microsoft requires a forward contract to sell Euros and buy dollars.

Equity Forward Contracts : Equity forward can be defined as a contract calling for the

purchase of an individual stock, a stock portfolio or a stock index on a forward date.


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a) Forward Contract On Individual StockA portfolio can consist of small number of stocks or sometimes stocks that have been over a

number of years. For example, lets us consider a stock XYZ. The client has heavily invested

in this stock and her portfolio is not diversified. The client informs her portfolio manager of

her requirement of $2 million in cash in a period of 6 months. This amount is raised by selling

16000 shares at the current price of $125 per share. Thus, the risk exposure is related to the

market value of $2 million of stock. It is better not to sell the stock any earlier than is

required. The portfolio manager feels that forward contracts to sell the stock XYZ in 6months

will serve the purpose. Hence, the manager contacts a forward contract dealer and obtains a

quote of $128.13 per share. This implies that the portfolio manager will enter into a contract

with the dealer to sell the stock at $128.13. Let us assume that the shares will be delivered

when the actual sale is made. Further, lets us assume that the client has some flexibility in the

required amount. So the contract is signed for the sale of 15000 shares at 128.13 per share.

This will raise an amount of $1,998,828. However, if the contract expires, the stock could be

sold for any price. The client may either gain or lose on the transaction. Even if the stock

price rises above $128.13 during the 6 months, the client must and should deliver the stock for

$128.13. Conversely, if the price falls, still the client will get $128.13 per share.

b) Interest rate forwardsAn Interest Rate Forward contact is commonly known as a Forward Rate Agreement or FRA.

In finance, a forward rate agreement (FRA) is a forward contract, an over-the-counter contract

between parties that determines the rate of interest, or the currency exchange rate, to be paid

or received on an obligation beginning at a future start date. The contract will determine the

rates to be used along with the termination date and notional value. On this type of agreement,

it is only the differential that is paid on the notional amount of the contract. It is paid on the

effective date. The reference rate is fixed one or two days before the effective date, dependent

on the market convention for the particular currency. FRAs are over-the counter derivatives.

A FRA differs from a swap in that a payment is only made once at maturity. Many banks and

large corporations will use FRAs to hedge future interest or exchange rate exposure. The

buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of
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falling interest rates. Other parties that use Forward Rate Agreements are speculators purely

looking to make bets on future directional changes in interest rates.

In other words, a forward rate agreement (FRA) is a tailor-made, over-the-counter financial

futures contract on short-term deposits. A FRA transaction is a contract between two parties

to exchange payments on a deposit, called the Notional amount, to be determined on the basis

of a short-term interest rate, referred to as the Reference rate, over a predetermined time

period at a future date. FRA transactions are entered as a hedge against interest rate changes.

The buyer of the contract locks in the interest rate in an effort to protect against an interest

rate increase, while the seller protects against a possible interest rate decline. At maturity, no

funds exchange hands; rather, the difference between the contracted interest rate and the

market rate is exchanged. The buyer of the contract is paid if the reference rate is above thecontracted rate, and the buyer pays to the seller if the reference rate is below the contracted

rate. A company that seeks to hedge against a possible increase in interest rates would

purchase FRAs, whereas a company that seeks an interest hedge against a possible decline of

the rates would sell FRAs.

FORWARDS AS A ZERO-SUM-GAME

In essence, a forward transaction typically involves a contract, most often with a bank,under which both the buyer of the contract and the seller of the contract are obligated to

execute a transaction at a specified price on a pre-specified date. This means that the seller is

obligated to deliver a specified asset to the buyer on a specified date in future, and the buyer

is obligated to pay the seller a specified price upon the delivery. This specified price is

known as forward price

At the inception of the contract, the contract value is zero in the eyes of both buyer and the

seller. But the value of the underlying asset changes throughout the life of the contract, and as

such there is change in the value of the contract vise versa the buyer and the seller. The value

changes for the benefit of one party and at the expense of the other. This property of the

forward contract makes it as zero-sum-game for the buyer and seller.


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FUTURES & OPTIONS (F&O)

In the recent decade financial markets have been marked by excessive volatility and are

associated with various risks, therefore derivative instruments have become increasingly

important in the field of finance. While futures and options are now actively traded on may

exchanges, forward contracts are popular in OTC markets. Fortunately, efficient-minded

entrepreneurs discovered that standardized agreements can facilitate transactions in a much

quicker manner than a privately negotiated forward contract, and thus, the futures and

options contract were born.

FUTURE CONTRACTS

Futures were designed to solve the limitations that existed the forward markets. A future

contract is a very similar to a forward contract in all respect excepting the fact that it is a

completely standardized one. It is always traded on organized exchange.

A futures contract is a standardized agreement between two parties that commits one to

sell and the other to buy stipulated quantity and grade of a currency, security, index or other

specified item at a set price on or before a given date in future, requires the daily settlement of

all gains and losses as long as the contract remains open; and for contracts remaining open

until trading terminates, provides either for delivery or a final cash payment (cash settlement).

To facilitate liquidity, exchange specified standard features for the contract:

Quantity and quality of the underlying. Date and month of delivery. Units of price quotation and minimum price change. Location and mode of settlement. Futures can be offset prior to maturity.

Example: Investor A is bullish about TCS Company and buys ten-one month TCS futures

contracts at Rs. 3,00,000. On the last Thursday of the month, TCS closes at Rs. 270. At Rs.

3,00,000 per futures contract, it costs him Rs. 300 per unit of futures, i.e. 3,00,000/(10 x 100).

On expiration day the spot and futures converge. He makes a loss of Rs. 30,000.


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The mechanics of future trading are straightforward: both buyers and sellers deposit

fundstraditionally called margin but more correctly characterized as a performance bond or

good faith deposit depositwith a brokerage firm. This amount is typically a small

percentage less than 20 percentof the total value of the item underlying the contract.

Features of Futures:

Organized Exchanges: Unlike forward contracts which are traded in an over- the- counter

market, futures are traded on organized exchanges with a designated physical location where

trading takes place. This provides a ready, liquid market which futures can be bought and sold

at any time like in a stock market.

Standardization: In the case of forward contracts the amount of commodities to be delivered

and the maturity date are negotiated between the buyer and seller and can be tailor made to

buyers requirement. In a futures contract both these are standardized by the exchange on

which the contract is traded.

Clearing House: The exchange acts a clearinghouse to all contracts struck on the trading

floor. For instance a contract is struck between capital A and B. upon entering into the records

of the exchange, this is immediately replaced by two contracts, one between A and the

clearing house and another between B and the clearing house. In other words the exchange

interposes itself in every contract and deal, where it is a buyer to seller, and seller to buyer.

The advantage of this is that A and B do not have to undertake any exercise to investigate

each others credit worthiness. It also guarantees financial integrity of the market. The

enforces the delivery for the delivery of contracts held for until maturity and protects itself

from default risk by imposing margin requirements on traders and enforcing this through a

system called marking to market.

Margins: In order to avoid unhealthy competition among clearing members in reducing

margins to attract customers, a mandatory minimum margins are obtained by the members

from the customers. Such a stop insures the market against serious liquidity crises arising out

of possible defaults by the clearing members. The members collect margins from their clients

has may be stipulated by the stock exchanges from time to time and pass the margins to the


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clearing house on the net basis i.e. at a stipulated percentage of the net purchase and sale

position.

Secondary market: Futures are dealt in organized exchanges for e.g. NSE F&O, BSE F&O

and as such they have secondary market too. Futures contracts enable investors to use various

tactics that can prove profitable while trading. One can resort to arbitrage, hedging and

speculation depending on ones objectives.

While hedging safeguards against risks due to price variation, arbitrage results in the risk-

free profit and speculation aims at generating very large profits or losses. However, a futures

contract is an obligation and, consequently, the investor must fulfill it even if the asset price

on the settlement date is not favorable for him.

FUTURES V/S FORWARDS

1. MeaningA futures contract is a contractual agreement

between two parties to buy or sell a

standardized quantity and quality of asset on a

specific future date on a futures exchange.

A Forward contract refers to an agreement

between two parties to exchange an agreed

quantity of an asset for cash at a certain date

in future at a predetermined price specified in

that agreement. A forward contract is nottraded on the exchange.

2. Trading placeA futures contract is traded on the centralized

trading platform of an exchange.

A forward contract is traded in an OTC

market.

3. TransparencyThe contract price of a futures contract is

transparent as it is available on the centralized

trading screen of the exchange.

The contract price of a forward contract is

not transparent, as it is not publicly disclosed.

4. SettlementIn a future contract, valuation of open

position is calculated as on a daily basis and

mark-to-market (MTM) margin requirement

In a forward contract, valuation of open

position is not calculated on a daily basis and

there is no requirement of MTM on daily


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exists. basis since the settlement of contract is only

on the maturity date of contract.

5. LiquidityA futures contract is more liquid as it is traded

on the exchange.

A forward contract is less liquid due to its

customized nature.

6. Counterparty riskIn futures contract, the exchange clearing

house provides trade guarantee. Therefore,

counterparty risk is almost eliminated.

In forward contracts, counterparty risk is

high due to the customized nature of the

transaction.

7. RegulationsA regulatory authority and the exchangeregulate a futures contract.

A forward contract is not regulated by anyexchange.

8. Price discoveryEfficient, as markets are centralized and all

buyers and sellers come to a common

platform to discover the price.

Not efficient, as markets are scattered.

Stock index Futures:

Stock index futures are most popular financial futures, which have been used to hedge or

manage systematic risk by the investors of the stock market. They are called hedgers, who

own portfolio of securities and are exposed to systematic risk. Stock index is the apt hedging

asset since, the rise or fall due to systematic risk is accurately shown in the stock index. Stock

index futures contract is an agreement to buy or sell a specified amount of an underlying stock

traded on a regulated futures exchange for a specified price at a specified time in future. Stock

index futures will require lower capital adequacy and margin requirement as compared to

margins on carry forward of individual scrips. The brokerage cost on index futures will be

much lower. Savings in cost is possible through reduced bid-ask spreads where stocks are

traded in packaged forms.

The impact cost will be much lower in case of stock index futures as opposed to dealing

in individual scripts. The market is conditioned to think in terms of the index and therefore,


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would refer trade in stock index futures. Further the chances of manipulation are much lesser.

The stock index futures are expected to be extremely liquid, given the speculative nature of

our markets and overwhelming retail participation expected to be fairly high. In the near

future stock index futures will definitely see incredible volumes in India. It will be a

blockbuster product and is pitched to become the most liquid contract in the world in terms of

contracts traded. The advantage to the equity or cash market is in the fact that they would

become less volatile as most of the speculative activity would shift to stock index futures. The

stock index futures market should ideally have more depth, volumes and act as a stabilizing

factor for the cash market. However, it is too early to base any conclusions on the volume are

to form any firm trend. The difference between stock index futures and most other financial

futures contracts is that settlement is made at the value of the index at maturity of the contract.

Example:

If BSE Sensex is at 6800 and each point in the index equals to Rs.30, a contract struck at this

level could work Rs.204000 (6800x30). If at the expiration of the contract, the BSE Sensex is

at 6850, a cash settlement of Rs.1500 is required (6850-6800) x30).

Stock Futures:

With the purchase of futures on a security, the holder essentially makes a legally binding

promise or obligation to buy the underlying security at same 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 share holder. A futures contract represents a promise to

transact at same point in the future. In this light, a promise to sell security is just as easy to

make as a promise to buy security. Selling security futures without previously owing them

simply obligates the trader to sell a certain amount of the underlying security at same point in

the future. It can be done just as easily as buying futures, which obligates the trader to buy a

certain amount of the underlying security at some point in future.

Example:

If the current price of the ACC share is Rs.170 per share. We believe that in one month it will

touch Rs.200 and we buy ACC shares. If the price really increases to Rs.200,we made a profit

of Rs.30 i.e. a return of 18%.If we buy ACC futures instead, we get the same position as ACC


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in the cash market, but we have to pay the margin not the entire amount. In the above example

if the margin is 20%, we would pay only Rs.34 initially to enter into the futures contract. If

ACC share goes up to Rs.200 as expected, we still earn Rs.30 as profit.

Currency futures

A currency future, also FX future or foreign exchange future, is a futures contract to

exchange one currency for another at a specified date in the future at a price (exchange rate)

that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the

currencies is the US dollar. The price of a future is then in terms of US dollars per unit of

other currency. This can be different from the standard way of quoting in the spot foreign

exchange markets. The trade unit of each contract is then a certain amount of other currency,

for instance 125,000. Most contracts have physical delivery, so for those held at the end of

the last trading day, actual payments are made in each currency. However, most contracts are

closed out before that. Investors can close out the contract at any time prior to the contract's

delivery date.

Investors use these futures contracts to hedge against foreign exchange risk. If an investor

will receive a cash flow denominated in a foreign currency on some future date, that investor

can lock in the current exchange rate by entering into an offsetting currency futures position

that expires on the date of the cash flow.

For example, A is a US-based investor who will receive 1,000,000 on December 1. The

current exchange rate implied by the futures is $1.2/. He can lock in this exchange rate by

selling 1,000,000 worth of futures contracts expiring on December 1. That way, He is

guaranteed an exchange rate of $1.2/ regardless of exchange rate fluctuations in the

meantime.

Interest Rate Futures

An interest rate future is a financial derivative (a futures contract) with an interest-bearing

instrument as the underlying asset. Examples include Treasury-bill futures, Treasury-bond

futures and Eurodollarfutures. Interest rate futures are used to hedge against the risk of that

interest rates will move in an adverse direction, causing a cost to the company.
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For example, borrowers face the risk of interest rates rising. Futures use the inverse

relationship between interest rates and bond prices to hedge against the risk of rising interest

rates. A borrower will enter to sell a future today. Then if interest rates rise in the future, the

value of the future will fall (as it is linked to the underlying asset, bond prices), and hence a

profit can be made when closing out of the future (i.e. buying the future).

Treasury futures are contracts sold on the Globex market for March, June, September and

December contracts. As pressure to raise interest rates rises, futures contracts will reflect that

speculation as a decline in price. Price and yield will always be in an inversely correlated

relationship.

OPTIONS CONTRACT

In finance, an option is a contract whereby one party (the holder or buyer) has the right

but not the obligation to exercise a feature of the contract (the option) on or before a future

date (the exercise date or expiry). The other party (the writer or seller) has the obligation to

honor the specified feature of the contract. Since the option gives the buyer a right and the

seller an obligation, the buyer has received something of value. The amount the buyer pays

the seller for the option is called the option premium.

Most often the term option refers to a type of derivative which gives the holder of

option the right but not the obligation to purchase (a call option) or sell (a put option) a

specified amount of a security within a specified time span.

Definition

An option is a contract that gives the buyer the right, but not the obligation, to buy or sell

an underlying asset at a specific price on or before a certain date. An option, just like a stock

or bond, is a security. It is also a binding contract with strictly defined terms and properties.

For example, Anand is bullish about the Index. Spot Nifty stands at 2200. He decides to buy

one three-month Nifty call option contract with a strike of 2260 at a premium of Rs. 15 per


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call. Three months later, the index closes at 2295. His pay off position- each call option earns

him Rs.1000.

Types of option

There are two basic types of optionscall option and put option.

i. Call option: A call option gives the holder the right but not the obligation to buy anasset by a certain date for a certain price.

ii. Put option: A Put option gives the holder the right but not the obligation to sell an assetby a certain date for a certain price.

The price of options decided between the buyers and sellers on trading screens of theexchange in a transparent manner. The investors can see the best five orders by price and

quantity. The investor can place a market limit order, stop loss order, etc. the investor can

modify or delete his pending orders. The whole process is similar to that of trading in shares.

In simple words, a call option gives the holder the right to buy an asset at a certain price

within or at the end of a specific period of time. Calls are similar to having a long position on

a stock. Buyers of call hope that the stock will increase substantially before the option expires.

Similarly, a put option gives the holder the right to sell an asset at a certain price within or

at the end of a specific period of time. Puts are similar to having a short position on a short

position on a stock. Buyers of the put option hope that the stock will decrease substantially

before the option expires.

An investor with a long expiry call or put position may exercise that contract at any time

before the contract expires, up to and including the Friday (in the Indian stock market) before

its expiration. To do so, the investor must notify his brokerage firm of intent to exercise in a

manner, and by the deadline specified by that particular firm.

Any investor with an open short position in a call or put option may nullify the obligations

inherent in that short (or written) contract by making an offsetting closing purchase

transaction of a similar option (same series) in the marketplace. This transaction must be


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made before the assignment is received, regardless of whether you have been notified by your

brokerage firm to this effect or not.

Categories of Options

There are three main categories of options: European, American and Bermudan.

The distinction between American and European options has nothing to do with its

geographical location. European options can be exercised only at the expiration time whereas

American option can be exercised at any moment prior to maturity (expiration). A third form

of exercise, which is occasionally used with OTC options, is Bermudan exercise. A Bermudan

was chosen perhaps because Bermuda is half way between America and Europe.

There are hundreds of different types of options which differ in their payoff structures,

path-dependence, and payoff trigger and termination conditions. Pricing some of these options

represent a complex mathematical problem.

Advantages and Disadvantages of Options

Advantages:

An investor can gain leverage in a stock without committing to a trade. Option premiums are significantly cheaper on a per-share basis than the full price of the

underlying stock.

Risk is limited to the option premium (except when writing options for a security that isnot already owned).

Options allow investors to protect their positions against price fluctuations

Disadvantages:

The costs of trading options (including both commissions and the bid/ask spread) issignificantly higher on a percentage basis than trading the underlying stock, and these

costs can drastically eat into any profits.

Options are very complex and require a great deal of observation and maintenance.


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The time-sensitive nature of options leads to the result that most options expire worthless.Making money by trading options is extremely difficult, and the average investor will fail.

Some option positions, such as writing uncovered options, are accompanied by unlimitedrisk.

Option Components

An option for a given stock has three main components: an expiration date, a strike price

and a premium. The expiration date tells the month in which the option will expire. Options

expire one day after the third Friday of the expiration month. The strike price is the price at

which the holder is allowed to buy or sell the underlying stock at a later date. The premium is

amount that the holder must pay for the right to exercise the option. Because the holder

acquires the right to trade 100 shares, the total cost of the option, if exercised, is 100 times the

premium.

In order to relate them to the price of the underlying stock at any given time, options are

classified as in-the-money, out-of-the-money or at-the-money. A call option is in-the-money

when the stock price is above the strike price and out-of-the-money when the stock price is

below the strike price. For put options, the reverse is true. When the stock price and strike

price are equal, both types of options are considered at-the-money.

Of course, when calculating profit and loss, the premium, as well as taxes and commissions

must be factored in. Therefore, an option must be far enough in-the-money to cover these

costs in order to be profitable.

Valuing and Pricing Options

The price of an option is primarily affected by:

The difference between the stock price and the strike price The time remaining for the option to be exercised The volatility of the underlying stock


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Affecting the premium to a lesser degree are factors such as interest rates, market

conditions, and the dividend rate of the underlying stock.

Because the value of an option decreases as its expiration date approaches and becomes

worthless after that date, options are considered "wasting assets". The total value consists of

intrinsic value, which is simply how far in-the-money an option is, and time value, which is

the difference between the price paid and the intrinsic value

In general, premiums should increase as the volatility of the underlying stock increases

because the greater fluctuation makes the right to buy in the future at the current price more

valuable. Volatility can be historical or implied. Historical volatility is based on the past

performance of the stock. Implied volatility is a reflection of the way options are being priced

in general.

Options Clearing Corporation (OCC)

Founded in 1973, the Options Clearing Corporation is the largest equity derivatives

clearing organization in the world. The OCC's mission and values statement states, "OCC is a

customer-driven clearing organization that delivers world-class risk management, clearance

and settlement services at a reasonable cost; and provide value-added solutions that support

and grow the markets we serve."

An organization that acts as both the issuer and guarantor for option and futures contracts.

The Options Clearing Corporation operates under the jurisdiction of the U.S. Securities and

Exchange Commission (SEC). Under its SEC jurisdiction, the OCC clears transactions for put

and call options, stock indexes, foreign currencies, interest rate composites and single-stock

futures. The OCC substantially reduces the credit risk aspect of trading options, as the OCC

requires that every buyer and every seller have a clearing member and that both sides of the

transaction are matched. It also has the authority to make margin calls on firms during the

trading day. The OCC has a AAA credit rating from Standard & Poors Corporation.

As a registered Derivatives Clearing Organization (DCO) regulated by the CFTC, the OCC

provides clearing and settlement services for transactions in futures products, as well as


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options on futures. For securities lending transactions, the OCC offers central counterparty

clearing and settlement services.

A clearing member dominated board of directors oversees the Options Clearing

Corporation. Most of its revenues are received from clearing fees charged to its members;

volume discounts on fees are available. Exchanges and markets that OCC serves include

BATS Options Exchange; C2 options Exchange, Inc; Chicago board Options Exchange, Inc;

International Securities Exchange, NASDAQ OMX BX, Inc; NASDAQ OMX PHLX, Nasdaq

Stock Market; NYSE Amex Options; and NYSE Arca Options.

Moneyness of Options

Intrinsic Value and Time Value

The option premium is broken down into two components: the intrinsic value and the

speculative ortime value. The intrinsic value is an easy calculation - the market price of an

option minus the strike price - and it represents the profit that the holder of the option would

enjoy if he or she exercised the option, took delivery of the underlying asset and sold it in the

current marketplace. The time value is calculated by subtracting the intrinsic value of the

option from the option premium

In-The-Money Options

For example, let's say it's September and Pat is long (owns) a Google (Nasdaq:GOOG)

December 400 call option. The option has a current premium of 28 and GOOG is currently

trading at 420. The intrinsic value of the option would be 20 (market price of 420 - strike

price of 400 = 20). Therefore, the option premium of 28 is comprised of $20 of intrinsic value

and $8 of time value (option premium of 28 - intrinsic value of 20 = 8).

Pat's option is in the money. An in-the-money option is an option that has intrinsic value.

With regard to a call option, it is an option with a strike price below the current market price.

It would make the most financial sense for Pat to sell her call option, as then she would get $8

more per share than she would by taking delivery of the shares (calling them away) and

selling them in the open market.
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Out-Of-The-Money Options

Returning to the example, if Pat were long a December 400 GOOGput option with a

current premium of 5, and if GOOG had a current market price of 420, she would not have

any intrinsic value (the entire premium would be considered time value), and the option

would be out of the money. An out-of-the-money put option is an option with a strike price

that is lower than the current market price.

The intrinsic value of a put option is determined by subtracting the market value from the

strike price (strike price of 400 - market value of 420 = -20). Intuitively, it looks as if the

intrinsic value is negative, but in this scenario the intrinsic value can never be negative; the

lowest it can ever be is zero.

At-The-Money Options

A third scenario would be if the current market price of GOOG was 400. In that case, both

the call and put options would be at the money, and the intrinsic value of both would be zero,

as immediate exercise of either option would not result in any profit. However, that doesn't

mean that the options have no value - they could still have time value.

Uses of options

One can combine options and other derivatives in a process known as financial

engineering to control the risk in a given transaction. The risk taken on can be anywhere from

zero to infinite, depending on the combination of derivative features used. By using

derivatives one party transfers (buys or sells) risk to or from another. When using options for

insurance, the option-holder reduces the risk he bears by paying the option seller a premium

to assume it.

Because one can use options to assume risk, one can purchase options to create leverage.The payoff to purchasing an option can be much greater than by purchasing the underlying

instrument directly. For example buying an at-the-money call option for 2 monetary units per

share for a total of 200 units on a security priced at 20 units, will lead to a 100% return on

premium if the option is exercised when the underlying securitys price has risen by 2 units,

whereas buying the security directly for 20 units per share would have led to a 10% return.
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The greater leverage comes at the cost of greater risk of losing 100% of the option premium if

the underlying security does not rise in price.

Employee stock options are also widely used as a compensation vehicle for employees

and, particular, senior executives of publicly traded corporations. However, employees stock

options use is being curbed thanks in part to a decision by the Financial Accounting Standards

Board (FASB) requiring that stock option grants are recorded on the income statement as an

expense. Previously, options granted with fair market value exercise prices were not

considered to have a cost to the company. This was significant factor in their ascendancy as a

compensation tool.

Stock Options

Stock Options are contracts that grant the holder the right to buy or sell a specific stock at

a specific price before the contract expires. A stock option is a contract which conveys to its

holder the right, but not the obligation, to buy or sell shares of the underlying security at a

specified price on or before a given date. After this given date, the option ceases to exist. The

seller of an Option is, in turn, obligated to sell (or buy) the shares to (or from) the buyer of the

Option at the specified price upon the buyer's request.

Options are currently traded on the following U.S. exchanges: The American Stock

Exchange, Inc. (AMEX), the Chicago Board Options Exchange, Inc. (CBOE), the New

York Stock Exchange, Inc. (NYSE), the Pacific Stock Exchange, Inc. (PSE), and the

Philadelphia Stock Exchange, Inc. (PHLX). Like trading in stocks, option trading is

regulated by the Securities and Exchange Commission (SEC).The purpose of this publication

is to provide an introductory understanding of stock options and how they can be used.

Options are also traded on indexes (AMEX, CBOE, NYSE, PHLX, PSE), on U.S. Treasury

securities (CBOE), and on foreign currencies(PHLX); information on these option products is

not included in this document but can be obtained by contacting the appropriate exchange.

These exchanges which trade options seek to provide competitive, liquid, and orderly markets

for the purchase and sale of standardized options.


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Index Options

A financial derivative that gives the holder the right, but not the obligation, to buy or sell a

basket of stocks, such as the S&P 500, at an agreed-upon price and before a certain date. An

index option is similar to other options contracts, the difference being the underlying

instruments are indexes. Options contracts, including index options, allow investors to profit

from an expected market move or to reduce the risk of holding the underlying instrument

Index options provide diversification as investors are exposed to a large number of

securities in one trading instrument. The degree of exposure varies with the particular index

option. Popular index options include S&P 500 Index Options (SPX), Dow Jones Industrial

Average Index Options (DJX) and Nasdaq-100 Index Options (NDX). Index options are

typically cash settled.

Currency Option

A contract that grants the holder the right, but not the obligation, to buy or sell currency at

a specified exchange rate during a specified period of time. For this right, a premium is paid

to the broker, which will vary depending on the number of contracts purchased. Currency

options are one of the best ways for corporations or individuals to hedge against adverse

movements in exchange rates.

Investors can hedge against foreign currency risk by purchasing a currency option put or

call. For example, assume that an investor believes that the USD/EUR rate is going to

increase from 0.80 to 0.90 (meaning that it will become more expensive for a European

investor to buy U.S dollars). In this case, the investor would want to buy a call option on

USD/EUR so that he or she could stand to gain from an increase in the exchange rate (or

the USD rise).

Bond option

In finance, a bond option is an option to buy or sell abond at a certain price on or before the

option expiry date. These instruments are typically traded OTC.
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A Europeanbond option is an option to buy or sell a bond at a certain date in future for apredetermined price.

An Americanbond option is an option to buy or sell a bond on or before a certain datein future for a predetermined price.

Generally, one buys a call option on the bond if one believes that interest rates will fall,

causing an increase in bond prices. Likewise, one buys theput option if one believes that the

opposite will be the case. One result of trading in a bond option, is that the price of the

underlying bond is "locked in" for the term of the contract, thereby reducing the credit risk

associated with fluctuations in the bond price.

Interest Rate Options

An investment tool whose payoff depends on the future level of interest rates. Interest rate

options are both exchange traded and over-the-counter instruments. An Interest rate is similar

to an equity option. There are two types, Calls and Puts. Calls give the bearer the right, but

not the obligation, to benefit off a rise in interest rates. A put gives the bearer the right, but not

the obligation, to profit off a decrease in interest rates.

All of these options are cash settled. A quantity of bonds does not have to be delivered,

but the differences between the interest rates are settled using a scale of 100, much like equity

options are. Interest Rate options, however, differ from equity options in that excise in the

European style. This allows the option to be excised only on a specified date and not at any

point leading up to it. Speculating on interest rates, or on any investment, is a risky strategy.

Interest rate options should only be used by sophisticated investors with a high tolerance for

risk. Interest rate options from exchanges in the United States are offered on Treasury bond

futures, Treasury note futures and Eurodollar futures. An investor taking a long position in

interest rate call options believes that interest rates will rise, while an investor taking a

position in interest rate put options believes that interest rates will fall.
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TRADING OF DERIVATIVES CONTRACTS

Futures and Options Trading System

The futures & options trading system of NSE, called NEAT-F&O trading system, provides a

fully automated screen-based trading for Index futures & options and Stock futures & options

on a nationwide basis as well as an online monitoring and surveillance mechanism. It supports

an order driven market and provides complete transparency of trading operations. It is similar

to that of trading of equities in the cash market segment. The software for the F&O market

has been developed to facilitate efficient and transparent trading in futures and options

instruments. Keeping in view the familiarity of trading members with the current capital

market trading system, modifications have been performed in the existing capital market

trading system so as to make it suitable for trading futures and options.

Market Timings

Trading on the derivatives segment takes place on all days of the week (except Saturdays and

Sundays and holidays cleared by the Exchange in advance). The market timings of the

derivatives segment are: Normal Market / Exercise Market Open time : 09:55 hours Normal

market close : 15:30 hours Set up cut of time for Position limit/Collateral value : till

15:30hrsTrade modification end time / Exercise Market : 16:15 hours

Trading Locations

Till the advent of NSE, an investor wanting to transact in a security not traded on the

nearest exchange had to route orders through a series of correspondent brokers to the

appropriate exchange. This resulted in a great deal of uncertainty and high transaction costs.

One of the objectives of NSE was to provide a nationwide trading facility and to enableinvestors spread all over the country to have an equal access to NSE.NSE has made it possible

for an investor to access the same market and order book, irrespective of location, at the same

price and at the same cost. NSE uses sophisticated telecommunication technology through

which members can trade remotely from their offices located in any part of the country. NSE

trading terminals (F&O segment) are present in various cities and towns all over India.


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Entities in the trading system

Trading members: Trading members are members of NSE. They can trade either on theirown account or on behalf of their clients including participants. The exchange assigns a

trading member ID to each trading member. Each trading member can have more than one

user. The number of users allowed for each trading member is notified by the exchange

from time to time. Each user of a trading member must be registered with the exchange

and is assigned an unique user ID. The unique trading member ID functions as a reference

for all orders/trades of different users. This ID is common for all users of a particular

trading member. It is the responsibility of the trading member to maintain adequate

control over persons having access to the firms User IDs.

Clearing members: Clearing members are members of NSCCL. They carry out riskmanagement activities and confirmation/inquiry of trades through the trading system.

Professional clearing members: A professional clearing member is a clearing member whois not a trading member. Typically, banks and custodians become professional clearing

members and clear and settle for their trading members.

Participants: A participant is a client of trading members like financial institutions. Theseclients may trade through multiple trading members but settle through a single clearing

member.

Basis of trading

The NEAT F&O system supports an order driven market, wherein orders match

automatically. Order matching is essentially on the basis of security, its price, time and

quantity. All quantity fields are in units and price in rupees. The exchange notifies the regularlot size and tick size for each of the contracts traded on this segment from time to time. When

any order enters the trading system, it is an active order. It tries to find a match on the other

side of the book. If it finds a match, a trade is generated. If it does not find a match, the order

becomes passive and goes and sits in the respective outstanding order book in the system.


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Corporate hierarchy

In the F&O trading software, a trading member has the facility of defining a hierarchy

amongst users of the system.

Corporate manager: The term is assigned to a user placed at the highest level in a trading

firm. Such a user can perform all the functions such as order and trade related activities of all

users, view net position of all dealers and at all clients level, can receive end of day

consolidated trade and order reports dealer wise for all branches of the trading member firm

and also all dealers of the firm. Only a corporate manager can sign off any user and also

define exposure limits for the branches of the firm and its dealers.

Branch manager: This term is assigned to a user who is placed under the corporate manager.

Such a user can perform and view order and trade related activities for all dealers under that

branch.

Dealer: Dealers are users at the bottom of the hierarchy. A Dealer can perform view order

and trade related activities only for one and does not have access to information on other

dealers under either the same branch or other branches.

Admin: Another user type, Admin is provided to every trading member along with the

corporate manager user. This user type facilitates the trading members and the clearing

members to receive and capture on a real-time basis all the trades, exercise requests and give

up requests of all the users under him. The clearing members can receive and capture all the

above information on a real time basis for the member sand participants linked to him. All this

information is written to comma separated files which can be accessed by any other program

on a real time basis in a read only mode.

This however does not affect the online data capture process. Besides this the admin users can

take online backup, view and upload net position, view previous trades.


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- Cli: Cli means that the trading member enters the orders on behalf of a client.

The Trader Workstation

The Market Watch Window

The following windows are displayed on the trader workstation screen:

Title bar

Ticker window of futures and options market

Ticker window of underlying (capital) market

Toolbar

Market watch window

Inquiry window

Snap quote

Order/trade window

System message window

The market watch window is the third window from the top of the screen which is always

visible to the user. The purpose of market watch is to allow continuous monitoring of

contracts or securities that are of specific interest to the user. It displays trading information

for contracts selected by the user. The user also gets a broadcast of all the cash market

securities on the screen. This function also will be available if the user selects the relevant

securities for display on the market watch screen. Display of trading information related to

cash market securities will be on Read only format, i.e. the dealer can only view the

information on cash market but, cannot trade in them through the system. This is the main

window from the dealers perspective.


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Eligibility criteria of stocks

The stock is chosen from amongst the top 500 stocks in terms of average daily market

capitalization and average daily traded value in the previous six months on a rolling basis.

The stocks median quarter-sigma order size over the last six months should be not less than

Rs. 5 lakhs. For this purpose, a stocks quarter-sigma order size should mean the order size (in

value terms) required to cause a change in the stock price equal to one-quarter of a standard

deviation.

The market wide position limit in the stock should not be less than Rs.100 crores. The

market wide position limit (number of shares) is valued taking the closing prices of stocks in

the underlying cash market on the date of expiry of contract in the month. The market wide

position limit of open position (in terms of the number of underlying stock) on futures and

option contracts on a particular underlying stock shall be 20% of the number of shares held by

non-promoters in the relevant underlying security i.e. .free-float holding.

Eligibility criteria of indices

The exchange may consider introducing derivative contracts on an index if the stocks

contributing to 80% weightage of the index are individually eligible for derivative trading.

However, no single ineligible stocks in the index should have a weightage of more than 5% in

the index. The above criteria is applied every month, if the index fails to meet the eligibility

criteria for three months consecutively, then no fresh month contract would be issued on that

index, However, the existing unexpired contacts will be permitted to trade till expiry and new

strike scan also be introduced in the existing contracts.


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CLEARING & SETTLEMENT

National Securities Clearing Corporation Limited (NSCCL) is the clearing and settlement

agency for all deals executed on the Derivatives (Futures & Options) segment. NSCCL acts as

legal counter-party to all deals on NSE's F&O segment and guarantee settlement .A Clearing

Member (CM) of NSCCL has the responsibility of clearing and settlement of all deals

executed by Trading Members(TM) on NSE, who clear and settle such deals through them.

Clearing Members

A Clearing Member (CM) of NSCCL has the responsibility of clearing and settlement of all

deals executed by Trading Members(TM) on NSE, who clear and settle such deals through

them. primarily, the CM performs the following functions:

1. Clearing: Computing obligations of all his TM's i.e. determining positions to settle.2. Settlement: Performing actual settlement. Only funds settlement is allowed at present

in Index as well as Stock futures and options contracts.

3. Risk Management: Setting position limits based on up front deposits / margins foreach TM and monitoring positions on a continuous basis

Clearing Member Eligibility Norms

Net worth of at least Rs.300 lakhs. The net worth requirement for a CM who clears andsettles only deals executed by him is Rs. 100 lakhs.

Deposit of Rs. 50 lakhs to NSCCL which forms the Base Minimum Capital (BMC) of theCM.

Additional incremental deposits of Rs.10 lakhs to NSCCL for each additional TM in casethe CM undertakes to clear and settle deals for other TMs.


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Clearing BanksNSCCL has empanelled 13clearing banks namely Axis Bank Ltd., Bank of India, Canara

Bank, Citibank N.A, HDFC Bank, Hongkong & Shanghai Banking Corporation Ltd., ICICI

Bank, IDBI Bank, IndusInd Bank, Kotak Mahindra Bank, Standard Chartered Bank, State

Bank of India and Union Bank of India. Every Clearing Member is required to maintain and

operate a clearing account with any one of the empanelled clearing banks at the designated

clearing bank branches. The clearing account is to be used exclusively for clearing &

settlement operations.

Settlement Mechanism

Daily Mark-to-Market Settlement

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