Chapter – 3
THEORETICAL BACKGROUND OF THE STUDY
3. Derivatives markets:
A derivative is a financial contract whose value is” derived from”, or on depends on the price of some underlying assets. Equivalently the value of derivatives changes when there is a change in the price of underlying related asset. In other words, derivatives are contracts whose payoffs depend upon the value of an underlying. It can be a commodity, a stock, a stock index, a currency, a index rate, or factually anything not necessarily an asset. These are designed to shift from one party to another allowing an ever winding array of risk to be traded. This is provides a broad view of four classes of derivative contract: forward, future, options and swaps. These are very similar type of contracts many of them believed that there are only two types of derivatives: options and forwards, while other derivative contracts exist, a careful analysis of their characteristics will reveal that they are mere variations of one or more of these major classes. All derivative instruments have a pre-determined infinite life at end which they expire or are closed out, unusually involve an exchange of payment which is small in comparison with the national principal amount of the transaction. Individuals are many type use derivatives. Speculators who think they know the future direction of price use derivatives to try to profits from their beliefs. They are who accepts the risk the hedger does not want is a speculator. Speculators believe in potential return outweighs the risk. Arbitragers trade derivatives to take advantage of time during which prices are ‘out of sync’: that is, one asset or derivative contract is mispriced relative to another, hedgers face that risk that change in the price will hurt their financial status; they use derivatives to protect, hedge or insure themselves against such harmful movements in prices. Of particular interest is the current indispensability of derivatives for accomplishing many tasks necessary to the successful management of corporations, governments, and large pool of money in general: managing exposure to price risk, lowering interest expense, alerting the structure of assets, liabilities, revenues and cost, reducing taxes and arbitraging price differentials.
We can differentiate derivatives by the structure of markets in which they are trade. Some derivatives are traded on organize exchanges. In particular, there are options and future exchange in existence all over the world. These exchanges allow virtually anyone who meets some set of financial criteria to trade these contracts. Price and trade information are readily available, and at any point in time, the prices at which they can be bought do not appreciably differ from the prices at which they can be sold. Other derivative contracts actively trading in liquid and well established Over-The-counter markets. These markets are open only to large, financially sound corporations, governments, and other institutions.
3.1 Characteristics of derivatives:
Some of the general characteristics of derivatives are;
• Derivatives has one or more underlying assets.
• It requires negligible initial investment compared to other types of financial contracts.
• It should provide for net settlement it means offsetting of initial contract position.
• The derivative instrument relates to the future contracts and settlement of terms between the parties involved, normally called as maturity period in case of forwards contract.
• The parties involved may be obliged to exercise their contracts or offset them or may have rights.
• The contracts are fulfilled or transacted through a recognized exchange through the clearing house or they may be private bi-lateral contracts or over-the-counter contracts.
• The value of derivatives depends on their underlying asset price movements.
3.2 Forward contract:
The forward contract is the most basic derivative contract. A forward contract is an agreement to buy or sell something in the future. The agreement made today to exchange cash for a goods or services at a future date. This differs from a spot transaction, which is the usual way of buying or selling something. In a transaction, one party pays for a good or service, and immediately receives that good or service. This chapter first describes the general concepts of forward contracts. Then, greater details are presented concerning two types of forward contract prevalent in modern business operations and used to manage the financial price risk: forward contract rate agreement (FRA) which is an arrangement to borrow or lend the money at a future date at an agreed upon- interest rate and the forward foreign exchange contract, in which a party agrees to buy or sell an amount of a foreign currency at a future date. When a forward contract created, there must always be two parties: the buyer and the seller.
The buyer:
The buyer of a forward contract agrees to buy something in the future. The buyer is also said to have a long the forward contract.
The seller:
The seller of a forward contract has the obligation or responsibility is to sell something in the future, and is said to have a short position. The terms of contract are agreed upon today, and delivery and payment take place in the future, at what is called either the delivery date, the settlement date, or the maturity date of the contract. The buyer has agreed to take delivery and the seller has agreed to make delivery.
3.3 Future contracts:
Futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today (the futures price) with delivery and payment occurring at a specified future date, the delivery date, making it a derivative product (i.e. a financial product that is derived from an underlying asset). The contracts are negotiated at a futures exchange, which acts as an intermediary between buyer and seller. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be “short”. While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange is to act as intermediary and mitigate the risk of default by either party in the intervening period. For this reason, the futures exchange requires both parties to put up an initial amount of cash (performance bond), the margin. Margins, sometimes set as a percentage of the value of the futures contact needs to be proportionally maintained at all times during the life of the contract to underpin this mitigation because the price of the contract will vary in keeping with supply and demand and will change daily and thus one party or the other will theoretically by making or losing money. To mitigate risk and the possibility of default by either party, the product is marked to market on a daily basis whereby the difference between the prior agreed-upon price and the actual daily futures price is settled on a daily basis. This is sometimes known as the variation margin where the Futures Exchange will draw money out of the losing party's margin account and put it into the other party's thus ensuring that the correct daily loss or profit is reflected in the respective account. If the margin account goes below a certain value set by the Exchange, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (i.e. the original value agreed upon, since any gain or loss has already been previously settled by marking to market). Upon marketing the strike price is often reached and creates lots of income for the "caller."
3.3.1: Features of future contract:
The exchange clearing house is responsible for settling daily gains and losses (marking to market), guaranteeing the transactions and deliveries. A major benefit of organized exchanges is their ability to manage credit risk. Credit risk is the risk that a holder of an unprofitable futures contract will default. An investor is willing to buy or sell in the futures market is required to post an initial margin in the form of cash or government securities, a portion of the full price. In marking-to market, the contract is re valued at the end of each days of trading, and gains or losses are computed. Gains increase the value of the margin account and may be withdrawn. If the margin account drops below a certain level, called the maintenance margin, the holder of the futures contract receives a margin call and is required to restore the account to its initial level. If the holder fails to do so, the contract is closed by the broker. A futures contract obliges its purchaser to buy a given amount of a specified asset at some stated time in the future (known as the delivery date) at the futures price. Similarly, the seller of the contract is obliged to deliver the asset at the futures price. In the futures market less than 2% of the contracts traded involve the actual delivery of the underlying asset. Rather, the buyers of futures contracts usually sell their contracts before the delivery date, thus offsetting („unwinding‟) their positions. Like most assets, the profit or loss on a futures contract is determined by the difference between the selling and buying price. Profits and losses on future contracts are realized daily.
3.3.2Margin:
To reduce the credit risk to the exchange, traders must post a margin or a performance bond, typically 5% -15% of the contract's value. To minimize counterparty risk to traders, trades executed on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each Buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty. Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spread traders who have offsetting contracts balancing the position.
Clearing margin are financial safeguards to ensure that companies or corporations perform on their customers' open futures and options contracts. Clearing margins are different from customer margins that individual buyers and sellers of futures and options contracts are required to deposit with brokers.
3.3.3 Initial margin
Initial margin is the equity required to initiate a futures position. This is a type of performance bond. The maximum exposure is not limited to the amount of the initial margin; however the initial margin requirement is calculated based on the maximum estimated change in contract value within a trading day. Initial margin is set by the exchange. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned. In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referred to as “variation margin”, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the clients account. Some exchanges also use the term “maintenance margin”, which in effect defines by how much the value of the initial margin can reduce before a margin call is made. However, most non-US brokers only use the term “initial margin” and “variation margin”.
3.3.4 Maintenance margin:
Maintenance margin is a set minimum margin per outstanding futures contract that a customer must maintain in their margin account.
3.3.5 Margin-equity ratio
Margin-equity ratio is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he does not want to be subject to margin calls.
3.3.6 Performance bond margin:
Performance bond margin is the amount of money deposited by both a buyer and seller of a futures contract or an options seller to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, but rather it is a security deposit.
3.3.7 Return on margin:
Return on margin (ROM) is often used to judge performance because it represents the gain or loss compared to the exchange’s perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin). The Annualized ROM is equal to (ROM+1) (year/trade-duration)-1.
3.3.8: Pricing:
When the deliverable asset exists in plentiful supply, or may be freely created, then the price of a futures contract is determined via arbitrage arguments. This is typical for stock index futures, Treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest). However, when the deliverable commodity is not in plentiful supply or when it does not yet exist. The futures price cannot be fixed by arbitrage. In this scenario there is only one force setting the price, which is simple supply and demand for the asset in the future, as expressed by supply and demand for the futures contract.
3.3.9: Arbitrage arguments:
Arbitrage arguments ("Rational pricing") apply when the deliverable asset exists in plentiful supply, or may be freely created. Here, the forward price represents the expected future value of the underlying discounted at the risk free rate as any deviation from the theoretical price will afford investors a riskless profit opportunity and should be arbitraged away. We define the forward price to be the strike such that the contract has zero value at the present time. Assuming interest rates are constant the forward price of the futures is equal to the forward price of the forward contract with the same strike and maturity. It is also the same if the underlying asset is uncorrelated with interest rates. Otherwise the difference between the forward price on the futures (futures price) and forward price on the asset is proportional to the covariance between the underlying asset price and interest rates.
3.4 Option:
Option is a contract which gives the buyer (the owner) the right, but not the obligation, to buy or sell an underlying asset or instrument at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfil the transaction – that is to sell or buy – if the buyer (owner) "exercises" the option. The buyer pays a premium to the seller for this right. An option which conveys to the owner the right to buy something at a specific price is referred to as a call; an option which conveys the right of the owner to sell something at a specific price is referred to as a put. In basic terms, the value of an option is commonly decomposed into two parts: The first part is the intrinsic value, which is defined as the difference between the market value of the underlying and the strike price of the given option.
The second part is the time value, which depends on a set of other factors which, through a multi-variable, non-linear interrelationship, reflect the discounted expected value of that difference at expiration. Options are also called as ‘contingent claims’ because their payoffs are contingent on whether they finish in the money or out of the money.
Features of options:
Highly flexible:
Option contract are highly standardized and so they can be traded only in organized exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. There are also privately arranged options which can be traded in Over-The-Counter. These instruments can be made according to the requirements of the writer and user. Thus, it combines the features of “futures” as well as “forward” contracts.
Down Payment:
The option holder must pay a certain amount called as “premium” for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted from the total payoff in calculating the net payoff due to the option holder.
Settlements:
No money or commodity or share is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.
Non – Linearity:
Unlike futures and forward, an option contract does not possess the property of linearity. It means that the option holder’s profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract.
No Obligation to Buy or Sell:
In call option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise his right at any time during the currency of the contract. But, in some cases, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.
3.5 Swaps:
Characteristics of a swap there is a mystique which surrounds swap contracts due to lack of knowledge or available information. By explaining the basics of swaps, including how they work and what their purpose is, I hope this will help to clarify them. A swap is an agreement between two parties to exchange a series of future cash flows. Swaps are financial instruments that fall under the general umbrella of financial derivatives. Other types of derivatives are forward agreements, futures and options (calls and puts). Most swaps are over-the-counter instruments; this means that they are customized to the requirements of the counterparties to the swap. A swap can be viewed as the exchange of one loan for another. A standard loan will have interest and principal repayment terms and the interest is based on either a fixed or floating rate. The three most common types of swaps are interest rate swaps, currency swaps and equity swaps.
REGULATIONS FOR DERIVATIVES TRADING:
In India, following are the major regulations for trading of derivatives. They are;
1. Any exchange fulfilling the eligibility criteria as prescribed in the L.C.Gupta committee report may apply to SEBI for grant of recognition under Section 4 of the SC(R)A,1956 to start trading in derivatives. The derivatives exchange/segment should have a separate governing council and representation of trading/clearing members shall be limited to a maximum of 40% of the total members of the governing council. The exchange should regulate the sales practices of its members and will get prior approval of SEBI before start of trading in any derivative contract.
2. The exchange shall have minimum 50 members.
3. The member of an existing segment of the exchange will not automatically become the members of derivative segment. The members of the derivative segment need to fulfil the eligibility conditions as laid down by the L.C. Gupta committee.
4. The clearing and settlement of derivatives trades should be through a Securities and Exchange Board of India approved clearing corporations or houses.
5. Derivative brokers or dealers and clearing members are required to seek registration from SEBI. This is in addition to their registration as brokers of existing stock exchanges. The minimum net worth for clearing members of the derivatives clearing corporation/house shall be Rs.300 lakh. The net worth of the member shall be computed as follows:
Capital + Free reserves –non-allowable assets
Non allowable assets includes fixed assets, pledged securities, Member’s card, Non-allowable securities (unlisted securities), bad deliveries, doubtful debts and advances, prepaid expenses, intangible assets, 30% marketable securities.
6. The minimum contract value should not be less than Rs.2 lakh. Exchanges should also submit details of the future contract they propose to introduce.
7. The initial margin requirement, exposure limits linked to capital adequacy and margin demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange from time to time.
8. The L.C.Gupta committee report requires strict enforcement of ‘Know your customer’ rules and requires that every client shall be registered with the derivatives broker. The derivative segment members are also required to make their clients aware of the risk involved in derivatives trading by issuing to the client the Risk Disclosure Document and get a copy of the same duly signed by the client.