Tarheel Consultancy Services

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Tarheel Consultancy Services

• Bangalore, Karnataka

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Corporate Training and Consulting
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Course on Futures Options

• For
• XIM -Bhubaneshwar

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For

• PGP-II
• 2004-2006 Batch
• Term-IV 2005

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• Part-I
• An Introduction

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What is a Derivative Security?

• Derivative securities, more appropriately termed
  as derivative contracts, are assets which confer
  the investors who take positions in them with
  certain rights or obligations.

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Why Do We Call Them Derivatives?

• They owe their existence to the presence of a
  market for an underlying asset or portfolio of
  assets, which may be considered as primary
  securities.
• Consequently such contracts are derived from
  these underlying assets, and hence the name.
• Thus if there were to be no market for the
  underlying assets, there would be no derivatives.

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Broad Categories of Derivatives

• Forward Contracts
• Futures Contracts
• Options Contracts
• Swaps

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More Complex Derivatives

• Futures Options Options contracts which are
  written on futures contracts
• Compound options Options contracts which are
  written on options contracts
• Swaptions Options on Swaps

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Definition of a Forward Contract

• A forward contract is an agreement between two
  parties that calls for the delivery of an asset
  on a specified future date at a price that is
  negotiated at the time of entering into the
  contract.

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Forward Contracts (Cont)

• Every forward contract has a buyer and a seller.
• The buyer has an obligation to pay cash and take
  delivery on the future date.
• The seller has an obligation to take the cash and
  make delivery on the future date.

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Definition of a Futures Contract

• A futures contract too is a contract that calls
  for the delivery of an asset on a specified
  future date at a price that is fixed at the
  outset.
• It too imposes an obligation on the buyer to take
  delivery and on the seller to make delivery.
• Thus it is essentially similar to a forward
  contract.

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Forward versus Futures

• Yet there are key differences between the two
  types of contracts.
• A forward contract is an Over-the-Counter or OTC
  contract.
• This means that the terms of the agreement are
  negotiated individually between the buyer and the
  seller.

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Forward vs. Futures (Cont)

• Futures contracts are however traded on organized
  futures exchanges, just the way common stocks are
  traded on stock exchanges.
• The features of such contracts, like the date and
  place of delivery, and the quantity to be
  delivered per contract, are fixed by the exchange.

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Forward vs. Futures (Cont)

• The only job of the potential buyer and seller
  while negotiating a contract, is to ensure that
  they agree on the price at which they wish to
  transact.

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Options

• An options contract gives the buyer the right to
  transact on or before a future date at a price
  that is fixed at the outset.
• It imposes an obligation on the seller of the
  contract to transact as per the agreed upon
  terms, if the buyer of the contract were to
  exercise his right.

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Rights

• What is the difference between a Right and an
  Obligation.
• An Obligation is a binding commitment to perform.
• A Right however, gives the freedom to perform if
  desired.
• It need be exercised only if the holder wishes to
  do so.

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Rights (Cont)

• In a transaction to trade an asset at a future
  date, both parties cannot be given rights.
• For, if it is in the interest of one party to go
  through with the transaction when the time comes,
  it obviously will not be in the interest of the
  other.

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Rights (Cont)

• Consequently while obligations can be imposed on
  both the parties to the contract, like in the
  case of a forward or a futures contract, a right
  can be given to only one of the two parties.
• Hence, while a buyer of an option acquires a
  right, the seller has an obligation to perform
  imposed on him.

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Options (Cont)

• We have said that an option holder acquires a
  right to transact.
• There are two possible transactions from an
  investors standpoint purchases and sales.
• Consequently there are two types of options
  Calls and Puts.

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Options (Cont)

• A Call Option gives the holder the right to
  acquire the asset.
• A Put Option gives the holder the right to sell
  the asset.
• If a call holder were to exercise his right, the
  seller of the call would have to make delivery of
  the asset.

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Options (Cont)

• If the holder of a put were to exercise his
  right, the seller of the put would have to accept
  delivery.
• We have said that an option holder has the right
  to transact on or before a certain specified
  date.
• Certain options permit the holder to exercise his
  right only on a future date.

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Options (Cont)

• These are known as European Options.
• Other types of options permit the holder to
  exercise his right at any point in time on or
  before a specified future date.
• These are known as American Options.

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Longs Shorts

• The buyer of a forward, futures, or options
  contract is known as the Long.
• He is said to have taken a Long Position.
• The seller of a forward, futures, or options
  contract, is known as the Short.
• He is said to have taken a Short Position.
• In the case of options, a Short is also known as
  the option Writer.

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Comparison of Futures/Forwards versus Options
Instrument Nature of Longs Commitment Nature of Shorts Commitment
Forward/Futures Contract Obligation to buy Obligation to sell
Call Options Right to buy Obligation to sell
Put Options Right to sell Obligation to buy
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Swaps

• A swap is a contractual agreement between two
  parties to exchange specified cash flows at
  pre-defined points in time.
• There are two broad categories of swaps
  Interest Rate Swaps and Currency Swaps.

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Interest Rate Swaps

• In the case of these contracts, the cash flows
  being exchanged, represent interest payments on a
  specified principal, which are computed using two
  different parameters.
• For instance one interest payment may be computed
  using a fixed rate of interest, while the other
  may be based on a variable rate such as LIBOR.

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Interest Rate Swaps (Cont)

• There are also swaps where both the interest
  payments are computed using two different
  variable rates For instance one may be based on
  the LIBOR and the other on the Prime Rate of a
  country.
• Obviously a fixed-fixed swap will not make sense.

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Interest Rate Swaps (Cont)

• Since both the interest payments are denominated
  in the same currency, the actual principal is not
  exchanged.
• Consequently the principal is known as a notional
  principal.
• Also, once the interest due from one party to the
  other is calculated, only the difference or the
  net amount is exchanged.

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Currency Swaps

• These are also known as cross-currency swaps.
• In this case the two parties first exchange
  principal amounts denominated in two different
  currencies.
• Each party will then compute interest on the
  amount received by it as per a pre-defined
  yardstick, and exchange it periodically.

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Currency Swaps (Cont)

• At the termination of the swap the principal
  amounts will be swapped back.
• In this case, since the payments being exchanged
  are denominated in two different currencies, we
  can have fixed-floating, floating-floating, as
  well as fixed-fixed swaps.

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Actors in the Market

• There are three broad categories of market
  participants
• Hedgers
• Speculators
• Arbitrageurs

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Hedgers

• These are people who have already acquired a
  position in the spot market prior to entering the
  derivatives market.
• They may have bought the asset underlying the
  derivatives contract, in which case they are said
  to be Long in the spot.

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Hedgers (Cont)

• Or else they may have sold the underlying asset
  in the spot market without owning it, in which
  case they are said to have a Short position in
  the spot market.
• In either case they are exposed to Price Risk.

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Hedgers (Cont)

• Price risk is the risk that the price of the
  asset may move in an unfavourable direction from
  their standpoint.
• What is adverse depends on whether they are long
  or short in the spot market.
• For a long, falling prices represent a negative
  movement.

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Hedgers (Cont)

• For a short, rising prices represent an
  undesirable movement.
• Both longs and shorts can use derivatives to
  minimize, and under certain conditions, even
  eliminate Price Risk.
• This is the purpose of hedging.

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Speculators

• Unlike hedgers who seek to mitigate their
  exposure to risk, speculators consciously take on
  risk.
• They are not however gamblers, in the sense that
  they do not play the market for the sheer thrill
  of it.

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Speculators (Cont)

• They are calculated risk takers, who will take a
  risky position, only if they perceive that the
  expected return is commensurate with the risk.
• A speculator may either be betting that the
  market will rise, or he could be betting that the
  market will fall.

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Hedgers Speculators

• The two categories of investors complement each
  other.
• The market needs both types of players to
  function efficiently.
• Often if a hedger takes a long position, the
  corresponding short position will be taken by a
  speculator and vice versa.

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Arbitrageurs

• These are traders looking to make costless and
  risk-less profits.
• Since derivatives by definition are based on
  markets for an underlying asset, it is but
  obvious that the price of a derivatives contract
  must be related to the price of the asset in the
  spot market.

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Arbitrageurs (Cont)

• Arbitrageurs scan the market constantly for
  discrepancies from the required pricing
  relationships.
• If they see an opportunity for exploiting a
  misaligned price without taking a risk, and after
  accounting for the opportunity cost of funds that
  are required to be deployed, they will seize it
  and exploit it to the hilt.

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Arbitrageurs (Cont)

• Arbitrage activities therefore keep the market
  efficient.
• That is, such activities ensure that prices
  closely conform to their values as predicted by
  economic theory.
• Market participants, like brokerage houses and
  investment banks have an advantage when it comes
  to arbitrage vis a vis individuals.

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Arbitrageurs (Cont)

• Firstly, they do not typically pay commissions
  for they can arrange their own trades.
• Secondly, they have ready access to large amounts
  of capital at a competitive cost.

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Assets Underlying Futures Contracts

• Till about two decades ago most of the action was
  in futures contracts on commodities.
• But nowadays most of the action is in financial
  futures.
• Among commodities, we have contracts on
  agricultural commodities, livestock and meat,
  food and fibre, metals, lumber, and petroleum
  products.

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Food grains Oil seeds

• Corn
• Oats
• Soybeans
• Wheat

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Livestock Meat

• Hogs
• Feeder Cattle
• Live Cattle
• Pork Bellies

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Food Fibre

• Cocoa
• Coffee
• Cotton
• Sugar
• Rice
• Frozen Orange Juice Concentrate

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Metals

• Copper
• Silver
• Gold
• Platinum
• Palladium

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Petroleum Energy Products

• Crude Oil
• Heating Oil
• Gasoline
• Propane
• Electricity

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Financial Futures

• Traditionally we have had three categories of
  financial futures
• Foreign currency futures
• Stock index futures
• Interest rate futures
• The latest entrant is futures contracts on
  individual stocks called single stock futures
  or individual stock futures

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Foreign Currency Futures

• Australian Dollars
• Canadian Dollars
• British Pounds
• Japanese Yen
• Euro

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Major Stock Index Futures

• The DJIA
• SP 500
• Nikkei
• NASDAQ-100

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Interest Rate Futures

• T-bill Futures
• T-note Futures
• T-bond Futures
• Eurodollar Futures
• Federal Funds Futures
• Mexican T-bill (CETES) Futures

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Assets Underlying Options Contracts

• Historically most of the action has been in stock
  options.
• Commodity options do exist but do not trade in
  the same volumes as commodity futures.
• Options on foreign currencies, stock indices, and
  interest rates are also available.

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Major Global Futures Exchanges Trading Volumes
in 2001
EXCHANGE VOLUME in Millions
CME 316.0
CBOT 210.0
NYMEX 85.0
EUREX 435.1
LIFFE 161.5
Tokyo Commodity Ex. 56.5
Korea Stock Ex. 31.5
Singapore Exchange 30.6
BMF 94.2
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Chicago versus Frankfurt

• EUREX is a relatively new exchange.
• However it is a state of the art electronic
  trading platform.
• The Chicago exchanges have traditionally been
  floor based, or what are called open-outcry
  exchanges.
• Competition is now forcing them to embrace
  technological innovations.

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Equity Options Markets Trading Volumes in 2000
EXCHANGE Stock Options Volume in 1,000s Index Options Volume in 1,000s
AMEX 205,716 1,998
CBOE 281,182 47,387
CBOT NT 200
CME NT 5089
ISE 7,716 NT
EUREX 89,238 44,200
OM 30,692 4,167
Korea SE NT 193,829
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Why The Brouhaha?

• Derivatives as a concept have been around for a
  long time.
• In fact there is a hypothesis that such contracts
  originated in India, a few centuries ago.
• But they have gained tremendous visibility only
  over the past two to three decades.

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Why? (Cont)

• The question is, what are the possible
  explanations for this surge in interest.
• Till the 1970s, most of the trading activities
  were confined primarily to commodity futures
  markets.
• However, financial futures have gained a lot of
  importance, and the bulk of the observed trading,
  is in such contracts.

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Why ? (Cont)

• The simple fact is that over the past few
  decades, the exposure to economic risks,
  especially those impacting financial securities,
  has increased manifold for most economic agents.
• Let us take the case of commodities first.
• There was a war in the Middle East in 1973.

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Commodities

• Subsequently, Arab nations began to use crude oil
  prices as a policy instrument.
• This lead to enormous volatility and
  unpredictability in oil prices.
• The result was an enhanced volatility in the
  prices of virtually all commodities.

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Commodities (Cont)

• The is because the transportation costs of all
  commodities is directly correlated with the price
  of crude oil.
• Since commodity prices became volatile,
  instruments for risk management became
  increasingly popular.
• Consequently commodity derivatives got a further
  impetus.

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Exchange Rates

• The Bretton Woods system of fixed exchange rates
  based on a Gold Exchange standard was abandoned
  in the 1970s and currencies began to float freely
  against each other.
• Volatility of exchange rates, and its management,
  lead to the growth of the market for FOREX
  derivatives.

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Interest Rates

• Traditionally, central banks of countries have
  desisted from making frequent changes in the
  structure of interest rates.
• However, beginning with the early 1980s, the
  U.S. Federal Reserve under the chairmanship of
  Paul Volcker began to use money supply as a tool
  for controlling the economy.

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Interest Rates (Cont)

• Interest rates consequently became market
  dependent and volatile.
• This had an impact on all facets of the economy
  since the cost of borrowed funds, namely
  interest, has direct consequences for the bottom
  lines of businesses.
• Hence interest rate derivatives got a fillip.

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LPG

• In the 1980s and 1990s, many economies which had
  remained regulated until then, began to embrace
  an LPG policy Liberalization, Privatization,
  and Globalization.
• With the removal of controls, capital began to
  flow freely across borders.

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LPG (Cont)

• As economies became inter-connected, risks
  generated in one market were easily transmitted
  to other parts of the world.
• Risk management therefore became an issue of
  universal concern, leading to an explosion in
  derivatives trading.

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Deregulation of the Brokerage Industry

• On 1 May 1975, fixed brokerage commissions were
  abolished in the U.S.
• This is called May Day
• Subsequently, brokers and clients were given the
  freedom to negotiate commissions while dealing
  with each other.
• In October 1986, fixed commissions were
  eliminated in London, and in 1999 Japan
  deregulated its brokerage industry.

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Deregulation (Cont)

• Also, from February 1986, the LSE began admitting
  foreign brokerage firms as full members.
• The objective of the entire exercise was to make
  London an attractive international financial
  market, which could effectively compete with
  markets in the U.S.

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Deregulation (Cont)

• London has a tremendous locational advantage in
  the sense that it is located in between markets
  in the U.S. and those in the Far East.
• Hence it is a vital middle link for traders who
  wish to transact round the clock.

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Deregulation (Cont)

• In a deregulated brokerage environment,
  commissions vary substantially from broker to
  broker, and depend on the extent and quality of
  services provided by the firm.
• A full service broker will charge the highest
  commissions, but will offer value-added services
  and advice.

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Deregulation (Cont)

• A deep-discount broker will charge the least but
  will provide only the bare minimum by way of
  service.
• Here is a comparison of fees charged on an
  average by different categories of brokers in the
  U.S.

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Brokerage Rates
Brokerage Type Commission on Stock Options Commissions on Futures
Deep-discount 1 per contract minimum 15 per trade 7 per contract
Discount 29 1.6 of principal 20 per contract
Full Service 50-100 per trade 80-125 per contract
74
IT

• Finally, the key driver behind the derivatives
  revolution has been the rapid growth in the field
  of IT.
• From streamlining back-end operations to
  facilitating arbitrage using stock index futures,
  computers have played a pivotal role.

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Revival of Trading in India

• Financial sector reforms have been an integral
  part of the liberalization process.
• Initially the focus was on streamlining and
  modernizing the cash market for securities.
• Various steps were therefore taken in this
  regard.
• A modern electronic exchange, the NSE was set up
  in 1994.

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India (Cont)

• The National Securities Clearing Corporation
  (NSCCL) was set up to clear and settle trades.
• Dematerialized trading was introduced with the
  setting up of the NSDL.
• The attention then shifted to derivatives, for it
  was felt that that investors in India needed
  access to risk management tools.

77
India (Cont)

• There was however a legal barrier.
• The Securities Contracts Regulation Act, SCRA,
  prohibited trading in derivatives.
• Under this Act forward trading in securities was
  banned in 1969.
• Forward trading on certain agricultural
  commodities however was permitted, although these
  markets have been very thin.

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India (Cont)

• The first step was to repeal this Act.
• The Securities Laws (Amendments) Ordinance was
  promulgated in 1995.
• This ordinance withdrew the prohibition on
  options on securities.
• The next task was to develop a regulatory
  framework to facilitate derivatives trading.

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India (Cont)

• SEBI set up the L.C. Gupta committee in 1996 to
  develop such a framework.
• The committee submitted its report in 1998.
• It recommended that derivatives be declared as
  securities so that the regulatory framework
  applicable for the trading of securities could
  also be extended to include derivatives trading.

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India (Cont)

• Trading in derivatives has its inherent risks
  from the standpoint of non-performance of a party
  with an obligation to perform.
• For this purpose SEBI appointed the
• J.R. Varma Committee to recommend a suitable
  risk management framework.
• This committee submitted its report in 1998.

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India (Cont)

• The SCRA was amended in December 1999 to include
  derivatives within the ambit of securities.
• The Act made it clear that trading in derivatives
  would be legal and valid only if such contracts
  were to be traded on a recognized stock exchange.
• Thus OTC derivatives were ruled out.

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India (Cont)

• In March 2000, the notification prohibiting
  forward trading was rescinded.
• In May 2000 SEBI permitted the NSE and the BSE to
  commence trading in derivatives.
• To begin with trading in index futures was
  allowed.

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India (Cont)

• Thus futures on the SP CNX Nifty and the BSE-30
  (Sensex) were introduced in June 2000.
• Approval for index options and options on stocks
  was subsequently granted.
• Index options were launched in June 2001 and
  stock options in July 2001.
• Finally futures on stocks were launched in
  November 2001.

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Turnover in Crores
Month Index Futures Stock Futures Index Options Stock Options Total
Jun-00 35 - - - 35
Dec-00 237 - - - 237
Jun-01 590 - 196 - 786
Jul-01 1309 - 326 396 2031
Nov-01 2484 2811 455 3010 8760
Mar-02 2185 13989 360 3957 20490
2001-02 21482 51516 3766 25163 101925
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Interest Rate Derivatives

• In July 1999 the RBI permitted banks to enter
  into interest rate swap contracts.
• On 24 June 2003 the Finance Minister launched
  futures trading on the NSE on T-bills and 10 year
  bonds.

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Why Use Derivatives

• Derivatives have many vital economic roles in the
  free market system.
• Firstly, not every one has the same propensity to
  take risks.
• Hedgers consciously seek to avoid risk, while
  speculators consciously take on risk.
• Thus risk re-allocation is made feasible by
  active derivatives markets.

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Why Derivatives? (Cont)

• In a free market economy, prices are everything.
• It is essential that prices accurately convey all
  pertinent information, if decision making in such
  economies is to be optimal.
• How does the system ensure that prices fully
  reflect all relevant information?

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Why Derivatives? (Cont)

• It does so by allowing people to trade.
• An investor whose perception of the value of an
  asset differs from that of others, will seek to
  initiate a trade in the market for the asset.
• If the perception is that the asset is
  undervalued, there will be pressure to buy.

89
Why Derivatives? (Cont)

• On the other hand if there is a perception that
  the asset is overvalued, there will be pressure
  to sell.
• The imbalance on one or the other side of the
  market will ensure that the price eventually
  attains a level where demand is equal to the
  supply.

90
Why Derivatives? (Cont)

• When new information is obtained by investors,
  trades will obviously be induced, for such
  information will invariably have implications for
  asset prices.
• In practice it is easier and cheaper for
  investors to enter derivatives markets as opposed
  to cash or spot markets.

91
Why Derivatives? (Cont)

• This is because, the investor can trade in a
  derivatives market by depositing a relatively
  small performance guarantee or collateral known
  as the margin.
• On the contrary taking a long position in the
  spot market would entail paying the full price of
  the asset.

92
Why Derivatives? (Cont)

• Similarly it is easier to take a short position
  in derivatives than to short sell in the spot
  markets.
• In fact, many assets cannot be sold short in the
  spot market.
• Consequently new information filters into
  derivatives markets very fast.

93
Why Derivatives? (Cont)

• Thus derivatives facilitate Price Discovery.
• Because of the high volumes of transactions in
  such markets, transactions costs tend to be lower
  than in spot markets.
• This in turn fuels even more trading activity.
• Also derivative markets tend to be very liquid.

94
Why Derivatives? (Cont)

• That is, investors who enter these markets,
  usually find that traders who are willing to take
  the opposite side are readily available.
• This enables traders to trade without having to
  induce a transaction by making major price
  concessions.

95
Why Derivatives? (Cont)

• Derivatives improve the overall efficiency of the
  free market system.
• Due to the ease of trading, and the lower
  associated costs, information quickly filters
  into these markets.
• At the same time spot and derivatives prices are
  inextricably linked.

96
Why Derivatives? (Cont)

• Consequently, if there is a perceived
  misalignment of prices, arbitrageurs will move in
  for the kill.
• Their activities will eventually lead to the
  efficiency of spot markets as well.
• Finally derivatives facilitate speculation.
• And speculation is vital for the free market
  system.