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.

The main features of forward contracts are
	They are bilateral contracts and hence exposed to counter-party risk.
	Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.
	The contract price is generally not available in public domain.
	The contract has to be settled by delivery of the asset on expiration date.
	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?

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.

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

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.

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.

 
 


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:
	Investors can take long term view on the underlying stock using stock futures.
	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.
	Futures may look overpriced or under priced