Diploma in SAPM

Paper – II Derivatives : Futures, Options and Regulatory Framework

Unit – 1
Derivatives

Introduction
The objective of an investment decision is to get required rate of return with
minimum risk. To achieve this objective, various instruments, practices and
strategies have been devised and developed in the recent past. With the opening
of boundaries for international trade and business, the world trade gained
momentum in the last decade, the world has entered into a new phase of global
integration and liberalisation. The integration of capital markets world-wide has
given rise to increased financial risk with the frequent changes in the interest
rates, currency exchange rate and stock prices. To overcome the risk arising out
of these fluctuating variables and increased dependence of capital markets of one
set of countries to the others, risk management practices have also been reshaped
by inventing such instruments as can mitigate the risk element. These new
popular instruments are known as financial derivatives which, not only reduce
financial risk but also open us new opportunity for high risk takers.

Definition of derivatives

Literal meaning of derivative is that something which is derived. Now question

arises as to what is derived? From what it is derived? Simple one line answer is
that value/price is derived from any underlying asset. The term ‘derivative’
indicates that it has no independent value, i.e., its value is entirely derived from
the value of the underlying asset. The underlying asset can be securities,
commodities, bullion, currency, livestock or anything else.
‘Derivative’ includes–

Security derived from a debt instrument, share, loan whether secured or unsecured,
risk instrument or contract for differences or any other form of security. A contract
which derives its value from the prices, or index of prices of underlying securities.
Basics of Derivatives
Derivative is a contract or a product whose value is derived from value of some other asset
known as underlying. Derivatives are based on wide range of underlying assets. These
include:
 Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
 Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity,
Natural Gas etc.
 Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and
 Financial assets such as Shares, Bonds and Foreign Exchange.

Derivatives Market – History & Evolution

History of Derivatives may be mapped back to the several centuries. Some of the specific
milestones in evolution of Derivatives Market Worldwide are given below:
12th Century- In European trade fairs, sellers signed contracts promising future delivery of the
items they sold.
13th Century- There are many examples of contracts entered into by English Cistercian
Monasteries, who frequently sold their wool up to 20 years in advance, to foreign merchants.
1634-1637 - Tulip Mania in Holland: Fortunes were lost in after a speculative boom in tulip
futures burst.
Late 17th Century - In Japan at Dojima, near Osaka, a futures market in rice was developed to
protect rice producers from bad weather or warfare.
In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on
various commodities.
In 1865, the CBOT went a step further and listed the first ‘exchange traded” derivative
contract in the US. These contracts were called ‘futures contracts”.
In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganised to allow
futures trading. Later its name was changed to Chicago Mercantile Exchange (CME).
In 1972, Chicago Mercantile Exchange introduced International Monetary Market (IMM),
which allowed trading in currency futures.
In 1973, Chicago Board Options Exchange (CBOE) became the first marketplace for trading
listed options.
In 1975, CBOT introduced Treasury bill futures contract. It was the first successful pure
interest rate futures.
In 1977, CBOT introduced T-bond futures contract. In
1982, CME introduced Eurodollar futures contract.
In 1982, Kansas City Board of Trade launched the first stock index futures.
In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock indexes with
the S&P 100® (OEX) and S&P 500® (SPXSM) Indexes.

Indian Derivatives Market

As the initial step towards introduction of derivatives trading in India, SEBI set up a 24–
member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to
develop appropriate regulatory framework for derivatives trading in India. The committee
submitted its report on March 17, 1998 recommending that derivatives should be declared as
‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern
trading of derivatives.
Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof. J. R.
Verma, to recommend measures for risk containment in derivatives market in India. The
committee submitted its report in October 1998. It worked out the operational details of
margining system, methodology for charging initial margins, membership details and net-
worth criterion, deposit requirements and real time monitoring of positions requirements.

In 1999, The Securities Contract Regulation Act (SCRA) was amended to include
“derivatives” within the domain of ‘securities’ and regulatory framework was developed for
governing derivatives trading. In March 2000, government repealed a three-decade- old
notification, which prohibited forward trading in securities.
The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and
NSE to introduce equity derivative segment. To begin with, SEBI approved trading in index
futures contracts based on CNX Nifty and BSE Sensex, which commenced trading in June
2000. Later, trading in Index options commenced in June 2001 and trading in options on
individual stocks commenced in July 2001. Futures contracts on individual stocks started in
November 2001. MCX-SX started trading in all these products (Futures and options on index
SX40 and individual stocks) in February 2013.

Type of Derivatives
1. Commodity Derivatives:
Firstly derivatives originated as a tool for managing risk in commodities
markets. In commodity derivatives, the underlying asset is a commodity. It
can be agricultural commodity like wheat, soybeans, rapeseed, cotton etc.
or precious metals like gold, silver etc.
2. Financial Derivatives :
The term financial derivative denotes a variety of financial instruments
including stocks, bonds, treasury bills, interest rate, foreign currencies
and other hybrid securities. Financial derivatives include futures, forwards,
options, swaps, etc. Futures contracts are the most important form of
derivatives, which are in existence long before the term ‘derivative’ was
coined.

Features of financial derivatives

1. It is a contract: Derivative is defined as the future contract between two

parties. It means there must be a contract-binding on the underlying parties
and the same to be fulfilled in future. The future period may be short or long
depending upon the nature of contract, for example, short term interest rate
futures and long term interest rate futures contract.
2. Derives value from underlying asset: Normally, the derivative
instruments have the value which is derived from the values of other
underlying assets, such as agricultural commodities, metals, financial assets,
intangible assets, etc. Value of derivatives depends upon the value of
underlying instrument and which changes as per the changes in the
underlying assets, and sometimes, it may be nil or zero. Hence, they are
closely related.
3. Specified obligation: In general, the counter parties have specified
obligation under the derivative contract.
4. Direct or exchange traded: The derivatives contracts can be undertaken
directly between the two parties or through the particular exchange like
financial futures contracts.
Example of exchange traded derivatives are Dow Jons, S&P 500, Nikki 225,
NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo
Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
5. Related to notional amount: In general, the financial derivatives are
carried off-balance sheet. The size of the derivative contract depends upon its
notional amount. The notional amount is the amount used to calculate the
 payoff.
6. Delivery of underlying asset not involved: Usually, in derivatives
trading, the taking or making of delivery of underlying assets is not involved,
rather underlying transactions are mostly settled by taking offsetting
positions in the derivatives themselves. There is, therefore, no effective limit
on the quantity of claims, which can be traded in respect of underlying
assets.
7. May be used as deferred delivery: Derivatives are also known as
deferred delivery or deferred payment instrument. It means that it is easier to
take short or long position in derivatives in comparison to other assets or
securities. Further, it is possible to combine them to match specific, i.e., they
are more easily amenable to financial engineering.
8. Secondary market instruments: Derivatives are mostly secondary
market instruments and have little usefulness in mobilizing fresh capital by
the corporate world, however, warrants and convertibles are exception in this
respect.
9. Exposure to risk: Although in the market, the standardized, general and
exchange-traded derivatives are being increasingly evolved, however, still
there are so many privately negotiated customized, over-the-counter (OTC)
traded derivatives are in existence. They expose the trading parties to operational
risk, counter-party risk and legal risk. Further, there may also be uncertainty
about the regulatory status of such derivatives.
10. Off balance sheet item: Finally, the derivative instruments, sometimes,
because of their off-balance sheet nature, can be used to clear up the balance
sheet. For example, a fund manager who is restricted from taking
particular
currency can buy a structured note whose coupon is tied to the performance of a
particular currency pair.

Economic functions of Derivative contracts

Derivative contracts perform a number of economic functions. Important

functions may be outlined as below:-
1. Risk management functions

This is the primary function of derivatives. Derivatives shift the risk from the
buyer of the derivative product to the seller. Thus, derivatives are very effective
risk management tools. Most of the world’s 500 largest companies use derivates
to lower risk.
2. Price discovery function:-

This refers to the ability to achieve and disseminate price information. Without
price information, investors, consumers, and producers cannot make
informed decisions.
They cannot direct their capital to efficient uses. Derivatives are exceptionally
well suited for providing price information. They are the tools that assist everyone
in the market place to determine value. The wider the use of derivatives, the wider
the distribution of price information.
3. Liquidity function

Derivatives contract improve the liquidity of the underlying instruments. They

provide better avenues for raising money. They contribute sustainability to
increasing the depth of the markets. Derivative markets often have greater
liquidity than the spot markets, this higher liquidity is at lest partly due to the
smaller amount of capital required for participation in derivative markets. Since
the capital required is less, more participants will operate in the market. This
leads to increased volume of trade and liquidity.
4. Efficiency function

Derivatives significantly increase market liquidity, as a result, transactional costs

are lowered, the efficiency in doing business is increased, the cost of raising
capital investment is expanded.
5. Portfolio management function

Derivatives help in efficient portfolio management. With a smaller fund at disposal,

better diversification can be achieved. Derivatives provide much wider menu to
portfolio managers who constantly seek better risk return trade off.
6. Economic development function

Bright, creative, well educated people with an entrepreneurial attitude will be

attracted towards the derivative markets. Derivative markets energise other to
create new businesses, new products and new employment opportunities. Derivative
markets help increase savings and investment in the long run.

Products in Derivatives Market

Forwards
It is a contractual agreement between two parties to buy/sell an underlying asset at a
certain future date for a particular price that is pre-decided on the date of contract.
Both the contracting parties are committed and are obliged to honour the transaction
irrespective of price of the underlying asset at the time of delivery. Since forwards are
negotiated between two parties, the terms and conditions of contracts are customized. These
are Over-the-counter (OTC) contracts.
Futures
A futures contract is similar to a forward, except that the deal is made through an organized
and regulated exchange rather than being negotiated directly between two parties. Indeed, we
may say futures are exchange traded forward contracts.
Options
An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying
on or before a stated date and at a stated price. While buyer of option pays the premium and
buys the right, writer/seller of option receives the premium with obligation to sell/ buy the
underlying asset, if the buyer exercises his right.
Swaps
A swap is an agreement made between two parties to exchange cash flows in the future
according to a prearranged formula. Swaps are, broadly speaking, series of forward contracts.
Swaps help market participants manage risk associated with volatile interest rates, currency
exchange rates and commodity prices.

Hedging

Hedging is a technique of managing the risk attached to assets including foreign

exchanges. In short, hedging means covering or eliminating or reducing the risk.
Hedging is done with derivatives.

Market Participants
There are broadly three types of participants in the derivatives market - hedgers, traders (also
called speculators) and arbitrageurs. An individual may play different roles in different market
circumstances.
Hedgers
They face risk associated with the prices of underlying assets and use derivatives to reduce
their risk. Corporations, investing institutions and banks all use derivative products to hedge
or reduce their exposures to market variables such as interest rates, share values, bond prices,
currency exchange rates and commodity prices.
Speculators/Traders
They try to predict the future movements in prices of underlying assets and based on the
view, take positions in derivative contracts. Derivatives are preferred over underlying asset
for trading purpose, as they offer leverage, are less expensive (cost of transaction is generally
lower than that of the underlying) and are faster to execute in size (high volumes market).
Arbitrageurs
Arbitrage is a deal that produces profit by exploiting a price difference in a product in two
different markets. Arbitrage originates when a trader purchases an asset cheaply in one
location and simultaneously arranges to sell it at a higher price in another location. Such
opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these
transactions, thus closing the price gap at different locations.

Difference between Hedging and Speculation

Basis for
Comparison Hedging Speculation
The act of preventing anSpeculation is a process in which the
investment against investor involves in a trading of
Meaning unforeseen price changes isfinancial asset of significant risk, in the
known as hedging. hope of getting profits.
What is it? A means to control priceIt relies on the risk factor, in expectation
risk. of getting returns.
Involves Protection against price Incurring risk to make profits from
changes. price changes.
Operators are Risk averse Risk lovers
Difference between Arbitrage and Speculation

• The aim of both arbitrage and speculation is to make some form of profit
even though the techniques used are quite different to each other.
• Arbitrage traders take lower levels of risk, and benefit from the natural
market inconsistencies by buying at a lower price from one market and selling at
a higher price at another market.
• Speculation is done by trading instruments such as stocks, bonds,
currency, commodities, and derivatives, and a speculator looks to make a profit
through the rising and falling of the prices in these assets.

Difference between Cash Market and Derivative Market

1. Ownership
When you buy shares in the cash market and take delivery, you are the owner of
these shares or you are a shareholder, until you sell the shares. You can never
be a shareholder when you trade in the derivatives segment of the capital
market. This is because you just hold positional stocks, which you have to square-
off at the end of the settlement
2. Holding period
When you buy shares in the cash segment, you can hold the shares for life. This
is not true in the case of the futures market, where you have to settle the contract
within three months at the very maximum. In fact, when you buy shares in the
cash segment they can also be trans-generational, that is they can be transferred
from one generation to the other.
3. Dividends
When you buy shares in the cash segment, you normally take delivery and are a
owner. Hence, you are entitled to dividends that companies pay. No such luck
when you buy any derivatives contract. This is not only true in the case of
dividends, but, also other corporate benefits like rights shares, bonus shares etc.
4. Risk
Both, cash and futures markets pose risk, but the risk in the case of futures can
be higher, because you have to settle the contract within a specified period and
book losses. In the case of shares bought in the cash market, you can hold onto
them for an indefinite period and can hence sell when prices are higher.
5. Investment objective differs
You buy a contract in the derivatives market to hedge risk or to speculate.
Individuals buying shares in the cash market are investors.
6. Lots vs shares
In the derivatives segment you buy a lot, while in the cash segment you buy
shares.
7. Margin money
In the derivatives segment you pay only margin money for example, if you buy 1
lot of Punjab National Bank (4000 shares) you just pay 15 to 20 per cent of the
cost of the 4,000 shares and not the entire amount. That is not true in the case of
cash segment, where you have to pay the entire amount and not only margin.
 PAPER – II

DERIVATIVES : FUTURES, OPTIONS

AND
REGULATORY FRAMEWORK

Unit - I Derivatives

Introduction of Derivatives own material

Definition
Products
Participants
Functions
Types of derivatives
Forward contracts

Unit – II Futures

Introduction
Terms used
Nifty futures and stock futures
Application of futures
Advantages of futures contracts
Margins
Trading
Clearing and Settlement

Unit – III Options

Introduction pg -129
Types of Options:
Call Option, Put Option
Intrinsic and Time value of Money
Profit potential
Options as Geared Instrument and Hedge Instrument – pg 151
Trading
Clearing and Settlement

Unit – IV Regulatory Framework