SYNOPSIS of

DERIVATIVES-FUTURES & OPTIONS

8/31/2014

By: Ashwini guggalla –LLM 1yr

Roll.No.17
INTRODUCTION:
DERIVATIVE IS

A product whose value is derived from the value of one or more basic variables, called bases
(underlying asset, index or reference rate), in a contractual manner. The underlying asset can be
equity, forex commodity or any other asset.

History

• The Bombay Cotton trade association started future Trading in 1875

• In 1952 the government banned cash settlement and Option Trading
• In 1995 a Prohibition of trading options was lifted
• In 1999, the Securities Contract (Regulation) Act of 1956 was amended and derivatives
could be Declared “securities”
• SEBI allowed futures and options in equity shares in june,2000.
• NSE & BSE started trading in futures on Nifty and SENSEX in June,2001.

TYPES OF DERIVATIVES

➢ Exchange traded Derivatives

➢ Over the counter Derivatives

Exchange traded derivatives, as the name signifies are traded through organized exchanges
around the world. These instruments can be bought and sold through these exchanges, just
like the stock market. Some of the common exchange traded derivative instruments are
futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the
exchanges. They are not standardized and have varied features. Some of the popular OTC
instruments are forwards, swaps, swaptions​ etc​.

Market players of derivatives:

I. Hedgers – Transfer of Risk component of their portfolio

II. Speculators – Intentionally taking the risk from the Hedgers in pursuit of profit
III. Arbitrageurs – Operating in different markets Simultaneously, in pursuit of profit and
eliminate mis-pricing

FUTURES​

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined
time. If you buy a futures contract, it means that you promise to pay the price of the asset at a
specified time. If you sell a future, you effectively make a promise to transfer the asset to the buyer
of the future at a specified price at a particular time.
Some of the most popular assets on which futures contracts are available are equity stocks, indices,
commodities and currency.

Types of futures:

Futures comprise of three principle types

● Interest rate Futures

● Currency futures
● Stock Futures

Interest rate futures​ c on specific types of financial instruments, whose prices are dependent on
interest rates.

Currency futures​ are based on internationally significant currencies.

Stock Futures​ are based on individual stocks index futures draw on internationally recognised
stock exchange indices.

OPTIONS​

An Option is a contract that gives its owner the right(but not obligation)to buy or to sell an
underlying asset on or before a given date at a fixed price. This fixed price is called as Exercise
price, it also called as Strike price

An option can be a 'call' option or a 'put' option.

A call option gives the buyer of option the right (but not obligation) to buy the asset at a given
price.
A 'put' option gives the buyer of the option the right (but not obligation) to sell the asset at the
'strike price' to the buyer. Here the buyer has the right to sell and the seller has the obligation to
buy.

European option: an option that can be exercised on the specific date.

American option: An option that can be exercised on any date up to the expiry date.

So in any options contract, the right to exercise the option is vested with the buyer of the contract.
The seller of the contract has only the obligation and no right. As the seller of the contract bears the
obligation, he is paid a price called as 'premium'. Therefore the price that is paid for buying an
option contract is called as premium.

Parties of the option Contract:

• Option writer and seller

 • Option owner and holder

In the Money option​: when it is advantageous to exercise it.

Out of the money option​: when it is disadvantageous to exercise it.

At The Money option​: The option holder does not lose or gain if he exercise option or not.

Trading Strategies Of Option:

Various trading strategies used by option traders as follows

➢ Straddles and strangles

➢ Strip and strap
➢ Butterfly with reference to options
➢ Condor spread
➢ Bull spread and bear spread
➢ Calendar spread

Option valuation:

o The value of option at the time of its maturity

o The value of the option at the time of its writing

DISTINCTION BETWEEN FUTURES AND OPTIONS

FUTURES OPTIONS
A) Both the buyer and seller are obliged to In options the buyer enjoys the right and
buy/sell the underlying asset. not the obligation, to buy or sell the
underlying asset.

B) Unlimited upside & downside for both Limited downside (to the extent of
buyer and seller. premium paid) for buyer and unlimited
upside. For seller (writer) of the option,
profits are limited whereas losses can be
unlimited.

C) Futures contracts prices are affected Prices of options are however, affected by
mainly by the prices of the underlying a)prices of the underlying asset, b)time
asset remaining for expiry of the contract and
c)volatility of the underlying asset
D) No premium paid by any party Premium is paid by the buyer to the seller
at the inception of the contract

Laws of Derivatives In INDIA

 ❖ Forward Contracts Regulation Act,1952

This act regulates in the transactions of the commodity futures in India.

This Act very clearly prohibits options in goods. By the provisions of section 19, such
agreements are prohibited.

The act declares the following contracts to be illegal:

a. Forward Contracts in the permitted commodities, i.e., commodities notified under

Section 15 of the Act, which are entered into other than: (a) between the members of the
recognized Association or (b) through or (c) with any such members.
b. Forward contracts in prohibited commodities, i.e., commodities notified under section 17
of the Act.
c. Forward Contracts in contravention of the provisions contained in the Bye-laws of the
Exchange, which attract section 15 (3) of the Act.
d. Forward Contracts in the commodities in which such contracts have been prohibited.

❖ The securities contracts regulation Act,1956

Section 18A talks about the Contracts in derivatives​:

Notwithstanding anything contained in any other law for the time being in force, contracts in
derivative shall be legal and valid if such contracts are—
● (a) traded on a recognized stock exchange;
● (b) Settled on the clearing house of the recognized stock exchange, in accordance with
the rules and bye-laws of such stock exchange.

❖ Foreign Exchange Management (foreign exchange Derivative contracts)

Regulation,2000

Regulation 2 (v) of Foreign Exchange Management (Foreign Exchange Derivative Contracts)

Regulations, 2000 defined "Foreign Exchange Derivative Contract" as follows:

'Foreign exchange derivative contract' means a financial transaction or an arrangement in

whatever form and by whatever name called, whose value is derived from price movement in one
or more underlying assets, and includes,

(a) a transaction which involves at least one foreign currency other than currency of Nepal or
Bhutan, or

(b) a transaction which involves at least one interest rate applicable to a foreign currency not being
a currency of Nepal or Bhutan, or

(c) a forward contract, but does not include foreign exchange transaction for Cash or Tom or Spot
deliveries.
 ❖ Reserve Bank of India,1934

RBI issued Comprehensive guidelines on derivatives in 2007 to regulate the transactions of interest
rate derivatives, foreign currency derivatives and the credit derivatives in a better way

Advantages & Disadvantages:

Feature Advantage Disadvantage

Cost Options are an inexpensive way to As a form of insurance, an option

gain access to the underlying contract may expire worthless. This risk
investment without having to buy increases the greater the extent to which
stock the option is out of the money and the
shorter the time until expiration.

Leverage Options enable investors to stump up Investors should realize that options\'
less money and obtain additional leverage can impact performance on the
gain. down side as well.

Marketability Option terms trade on an exchange Regulatory intervention can prevent

and as such are standardized. exercise which may not be desirable.

Hedging Options may be used to limit losses. The investor may end up being
incorrect as to the direction and timing
of a stock\'s price and may implement a
less than perfect hedge.

Bibliography:

1. The security and exchange board of India Act, 1992. Guide line.

2. ​http://www.sebi.gov.in

3. ​http://www.nseindia.com

4. ​http://www.rediff/money/derivatives

5. ​http://www.derivativeindia.com
6. ​http://www.icai.org/publications.html

7. Forward Contracts Regulation Act, 1952

8.​ ​The Securities Contracts Regulation Act, 1956

9. Foreign Exchange Management (foreign exchange Derivative contracts) Regulation, 2000

10.​ ​Reserve Bank of India, 1934