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BASICS OF
DERIVATIVES
What are
derivative
instruments?
A derivative is an
instrument whose
value is derived
from the value of
one or more
underlying, which
can be commodities,
precious metals,
currency, bonds,
stocks, stocks
indices, etc. Four
most common examples
of derivative
instruments are
Forwards, Futures,
Options and Swaps.
What are Forward
contracts?
A forward contract
is a customized
contract between two
parties, where
settlement takes
place on a specific
date in future at a
price agreed today.
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The main
features of
forward
contracts are |
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They are
bilateral
contracts and
hence exposed to
counter-party
risk. |
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Each contract is
custom designed,
and hence is
unique in terms
of contract
size, expiration
date and the
asset type and
quality. |
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The contract
price is
generally not
available in
public domain. |
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The contract
has to be
settled by
delivery of the
asset on
expiration date. |
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In case, the
party wishes to
reverse the
contract, it has
to compulsorily
go to the same
counter party,
which being in a
monopoly
situation can
command the
price it wants. |
What are Futures?
Futures are
exchange-traded
contracts to sell or
buy financial
instruments or
physical commodities
for Future delivery
at an agreed price.
There is an
agreement to buy or
sell a specified
quantity of
financial
instrument/
commodity in a
designated Future
month at a price
agreed upon by the
buyer and seller .
Today the contracts
have certain
standardized.
What is the
difference between
Forward contracts
and Futures
contracts?
Futures is a
type of forward
contract.
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1. |
Standardized
Vs Customized
Contract -
Forward contract
is customized
while the future
is standardized.
To be more
specific, the
terms of a
Forward
Contracts are
individually
agreed between
two
counter-parties,
while Futures
being traded on
exchanges have
terms
standardized by
the exchange.
Counter party
risk - In
case of Futures,
after a trade is
confirmed by two
members of
exchange, the
exchange /
clearing house
itself becomes
the
counter-party
(or guarantees)
to every trade.
The credit risk,
which in case of
forward
contracts was on
the
counter-party,
gets transferred
to exchange /
clearing house,
reducing the
risk to almost
nil.
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2. |
Liquidity
- Futures
contracts are
much more liquid
and their price
is much more
transparent due
to
standardization
and market
reporting of
volumes and
price.
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3. |
Squaring
off - A
forward contract
can be reversed
only with the
same
counterparty
with whom it was
entered into. A
Futures contract
can be reversed
with any member
of the exchange. |
What is the
contract
specification for
Index & Stock,
Futures & Options
Click on the
link //http//www.bseindia.com/about/derivati.asp//
SENSEX FUTURES
What is the
underlying for
SENSEX Futures?
The underlying
for the SENSEX
futures is the BSE
Sensitive Index of
30 scrips, popularly
called the SENSEX.
What is the
contract multiplier?
The contract
multiplier is 25.
This means that the
Rupee notional value
of a futures
contract would be 25
times the contracted
value. The following
table gives a few
examples of this
notional value.
|
Contracted Price
of Futures |
Notional Value
in Rs. |
|
13,800 |
3,45,000 |
|
13,900 |
3,47,500 |
|
14,000 |
3,50,000 |
|
14,100 |
3,52,500 |
|
14,150 |
3,53,750 |
What is the
ticker symbol and
trading hours?
The ticker symbol is
BSX. The trading
timings for the
Derivatives Segment
of BSE are from 9:55
a.m. to 3:30 p.m.
What is the
maturity of the
futures contract?
Regulations permit
introduction of
futures upto 12
months maturity.
Initially, however,
futures for the one
month, two months
and three months
maturity have been
introduced. On 9th
June 2000, the three
futures for June,
July and August 2000
were started. These
futures expired on
29th June, 27th July
and 31st August 2000
respectively. This
is because the
expiry date has been
fixed as the last
Thursday of each
month. On the day
after the expiry, a
new future would
come into existence
for three-month
maturity. For
example, on 30th of
June, the September
future came into
existence. This
future expired on
28th of September,
being the last
Thursday of the
month.
What is the tick
size?
The tick size is
minimum price
fluctuation in the
value of a contract.
The tick size is
0.05 inder points.
In Rupee terms, this
translates to
minimum price
fluctuation of
Rs.1.25 (Tick size X
Contract Multiplier
= 0.05 X Rs. 25).
How is the final
settlement price
determined?
The closing value of
Sensex in the cash
market is taken as
the final settlement
price of the futures
contract on the last
trading day of the
contract for
settlement purpose.
What is margin
money?
The aim of margin
money is to minimize
the risk of default
by either
counter-party. The
payment of margin
ensures that the
risk is limited to
the previous day’s
price movement on
each outstanding
position. However,
even this exposure
is offset by the
initial margin
holdings.
Margin money is
like a security
deposit or insurance
against a possible
Future loss of
value.
Are there
different types of
Margin?
Yes, there are
different types of
margin like Initial
Margin, Variation
margin (Mark to
market or M -T- M)
Exposure Margin and
Additional Margin
(if any).
What is the
objective of Initial
margin?
The basic aim of
Initial margin is to
cover the largest
potential loss in
one day. Both buyer
and seller have to
deposit margins. The
initial margin is
deposited before the
opening of the
position in the
Futures transaction.
This margin is
calculated by SPAN
by considering the
worst case scenario.
What is Variation
or Mark-to-Market
Margin?
Variation or mark to
market Margin is the
daily profit or loss
obtained by marking
the members
outstanding position
to the market
(closing price of
the day.)
What are long/
short positions?
In simple terms,
long and short
positions indicate
whether you have a
net purchase
position (long) or
sale position
(short).
Is there a
theoretical way of
pricing Index
Future?
The theoretical way
of pricing any
Future is to factor
in the current price
and holding costs or
cost of carry.
In general, the
Futures Price = Spot
Price + Cost of
Carry.
Cost of carry is the
sum of all costs
incurred if a
similar position is
taken in cash market
and carried to
maturity of the
futures contract
less any revenue
which may result in
this period. The
costs typically
include interest in
case of financial
futures (also
insurance and
storage costs in
case of commodity
futures). The
revenue may be
dividends in case of
index futures.
Apart from the
theoretical value,
the actual value may
vary depending on
demand and supply of
the underlying at
present and
expectations about
the future. These
factors play a much
more important role
in commodities,
specially perishable
commodities than in
financial futures.
In general, the
Futures price is
greater than the
spot price. In
special cases, when
cost of carry is
negative, the
Futures price may be
lower than Spot
prices.
What is the
concept of Basis?
The difference
between Spot price
and Futures price is
known as Basis.
Although the Spot
price and Futures
prices generally
move in line with
each other, the
basis is not the
constant. Generally
basis will decrease
with time. And on
expiry, the basis is
zero as the Futures
price equals Spot
price.
What is Contango?
Under normal market
conditions, Futures
contracts are priced
above the spot
price. This is known
as the Contango
Market.
What is
Backwardation?
It is possible for
the Futures price to
prevail below the
spot price. Such a
situation is known
as Backwardation.
This may happen when
the cost of carry is
negative, or when
the underlying asset
is in short supply
in the cash market
but there is an
expectation of
increased supply in
future - example
agricultural
products.
What are the
profits and losses
in case of a futures
position?
The profits and
losses would depend
upon the difference
between the price at
which the position
is opened and the
price at which it is
closed. Let us take
some examples.
Example 1
Position - Long -
Buy June Sensex
Futures @ 13000
Payoff : Profit - if
the futures price
goes up
Loss - if the
futures price goes
down
Calculation - The
profit or loss would
be equal to twenty
five times the
difference in the
two rates.
If June Sensex
Futures is sold @
13100 there would be
a profit of 100
points which is
equal to Rs. 2,500
(100 X 25).
However if the June
Sensex is sold @
12950 there would be
a loss of 50 points
which is equal to
Rs. 1,250 (50 X 25).
Example 2
Position - Short
Sell June Sensex
Futures @ 13000
Payoff : Profit - if
the futures price
goes down
Loss - if the
futures price goes
up
Calculation - The
profit or loss would
be equal to twenty
five times the
difference in the
two rates.
If June Sensex
Futures is bought @
13200 there would be
a loss of 200 points
which is equal to
Rs. 5,000 (200 X
25).
However if the June
Sensex Futures is
bought @ 12900,
there would be a
profit of 100 points
which is equal to
Rs. 2,500 (100 X
25).
What happens to
the profit or loss
due to daily
settlement?
In case the position
is not closed the
same day, the daily
settlement would
alter the
cash flows depending
on the settlement
price fixed by the
exchange every day.
However the net
total of all the
flows every day
would always be
equal to the profit
or loss calculated
above. Profit or
loss would only
depend upon the
opening and closing
price of the
position,
irrespective of how
the rates have moved
in the intervening
days.
Let us take the
illustration given
in example 1 where a
long position is
opened at 13100 and
closed at 13200
resulting in a
profit of 100 points
or Rs. 2,500. Let us
assume that the
Example 3
Daily closing
settlement price
|
|
Case 1 |
|
Day 1
|
13150 |
|
Day 2
|
13230 |
|
Day 3
|
13210 |
|
Day 4
|
13170 |
|
Position
closed |
13200 |
|
Case 1
|
|
Settlement Price |
Calculation |
Profit / Loss |
|
Position
opened |
13100
(bought) |
|
|
|
|
Day 1 |
|
13150 |
13150 – 13100 |
50 |
|
Day 2 |
|
13230 |
13230 – 13150 |
80 |
|
Day 3 |
|
13210 |
13210 – 13230 |
-20 |
|
Day 4 |
|
13170 |
13170 – 13210 |
-40 |
|
Position
closed |
13200 (sold) |
13200–13170 |
|
30 |
|
Net Profit/
Loss |
|
|
|
100 |
In all the cases the
net result is a
profit of 100
points, which is the
difference between
the closing and
opening price,
irrespective of the
daily settlement
price and different
MTM flows.
How does the Initial
Margin affect the
above profit or
loss?
The initial margin
is only a security
provided by the
client through the
clearing member to
the exchange. It can
be withdrawn in full
after the position
is closed. Therefore
it does not affect
the above
calculation of
profit or loss.
However there would
be a funding cost /
transaction cost in
providing the
security. This cost
must be added to
your total
transaction costs to
arrive at the true
picture. Other items
in transaction costs
would include
brokerage, stamp
duty etc.
What is a spread
position?
A calendar spread is
created by taking
simultaneously two
positions |
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1. |
A long position
in a futures series
expiring in any
calendar month |
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2. |
A short
position in the
same futures as
1 above but for
a series
expiring in any
month other than
the 1 above.
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Examples of Calendar
Spreads |
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1. |
Long June Sensex
Futures Short July
Sensex Futures |
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2. |
Short July Sensex
Futures Long August
Sensex Futures |
A spread position
must be closed by
reversing both the
legs simultaneously.
The reversal of 1
above would be a
sale of June Sensex
Futures while
simultaneously
buying the July
Sensex Futures.
STOCK FUTURES
What are Stock
Futures?
Stock Futures are
financial contracts
where the underlying
asset is an
individual stock.
Stock Future
contract is an
agreement to buy or
sell a specified
quantity of
underlying equity
share for a future
date at a price
agreed upon between
the buyer and
seller. The
contracts have
standardized
specifications like
market lot, expiry
day, unit of price
quotation, tick size
and method of
settlement.
How Stock Futures
are priced?
The theoretical
price of a future
contract is sum of
the current spot
price and cost of
carry. However, the
actual price of
futures contract
very much depends
upon the demand and
supply of the
underlying stock.
Generally, the
futures prices are
higher than the spot
prices of the
underlying stocks.
Futures Price = Spot
Price + Cost of
Carry
Cost of carry is the
interest cost of a
similar position in
cash market and
carried to maturity
of the futures
contract less any
dividend expected
till the expiry of
the contract.
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Example: |
| Spot Price of
Infosys |
= 2000,
Interest Rate = 7%
p.a. |
|
Futures Price of
1 month contract |
=
2000 +
2000*0.07*30/365
= 2000 + 11.51
= 2011.51 |
How are Stock
Futures different
from Stock Options?
In stock options,
the option buyer has
the right and not
the obligation, to
buy or sell the
underlying share. In
case of stock
futures, both the
buyer and seller are
obliged to buy/sell
the underlying
share.
Risk-return profile
is symmetric in case
of single stock
futures whereas in
case of stock
options payoff is
asymmetric.
Also, the price of
stock futures is
affected mainly by
the prices of the
underlying stock
whereas in case of
stock options,
volatility of the
underlying stock
affect the price
along with the
prices of the
underlying stock.
What are the
opportunities
offered by Stock
Futures?
Stock futures offer
a variety of usage
to the investors.
Some of the key
usages are mentioned
below: |
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Investors can
take long term
view on the
underlying stock
using stock
futures. |
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Stock futures
offer high
leverage. This
means that one
can take large
position with
less capital.
For example,
paying 20%
initial margin
one can take
position for 100
i.e. 5 times the
cash outflow. |
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Futures may look
overpriced or
under priced
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