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Derivatives: An Introduction
Derivatives - Introduction
Derivatives are those financial instruments which derive the value from the underlying assets on which they have been created. The underlying asset may be a commodity, a currency, securities(shares and debentures), or index. The most common derivatives are: Option contract Futures contract Forward contracts Index futures swaps
Derivatives are used by different investors with different purpose like hedging, speculation, arbitrage. The trading in these instruments involves a high degree of risk which might lead to a counter party default. For exchange traded derivatives, counter party default risk is negligible because of the rules of exchange. Exchange mainly regulates the following: Decision about the underlying assets in which transactions are to be done Margin requirements Type of derivatives offered Settlement of transactions Lot size
Why Exchange traded Derivatives Are Free From Counter Party Default Risk??
An Exchange Traded Derivatives TransactionOption & Futures is traded Through a member of the exchange called the broker of exchange. Every Broker is required to maintain Security deposit Bank Guarantee Margin Deposit
Call Option vs Put Option : Call option is the option in which the buyer of the option has the right to buy the underlying asset on the exercise date or earlier than this, depending upon the type of contract. American vs European Option: In an american option the buyer of the option can exercise his right on any day until the expiry date.
Expiration of the option : When the buyer of the option doesnt exercise his right to buy/sell the underlying asset(securities),the options transaction simply expire, that is , it remains unexercised. Margin Deposit: In an options contract, the seller of the option has the obligation to honor the contract as soon as the option is exercised by the buyer of the option.
Margin Deposit : In an option contract, the seller of the option has the obligation to honor the contract as soon as the option is exercised by the buyer of the option. Settlement of the Options transaction : the margin deposited is according to the rule of exchange and keeps on changing from time to time. The buyer of the option is not required to deposit margin money as there cannot be any default by buyer of the option.
Illustration: on 3rd June 2011 option with series CE,RIL(250),1000,july is sold by Mr. Avinash at a premium of Rs.12 per shares and spot price of RIL is Rs 980 per share. If initial margin deposit is at 20% of the transaction value, then margin deposit will be as follows: (i) Transaction value Rs 2,50,000(250*1,000) (ii) Initial margin deposit 20% of Rs 2,50,000 i.e. Rs 50,000 to be deposited by the seller of the option by the next day, i.e. 4th June 2011.
Mark-to-Market Margin
Mark-to-market margin is likely daily settlement of the open position in an options contract as if the open position is being squared up. The seller of the options cannot withdraw any amount from the margin deposit account till the option is either squared or settled, or expires on the expiry date.
Illustration: continuing with the previous illustration, if the premium for this option moves as follows: Date premium 6th june 14 7th june 15 8th june 9 9th june 10 10th june 16 13th june 12 Here, the sellers initial margin deposit account will be adjusted for hypothetical loss/profit on daily basis and he will be required to maintain the initial margin deposit at an initial level, i.e. Rs 50,000. if the premium exceeds the initial premium, then it is hypothetical loss for the seller of the option, otherwise it is hypothetical profit. Hypothetical loss is deducted from the margin deposit and hypothetical profit is added to it.
Illustration: (i) Option contract series- CA, RIL (250), Rs 1,010,July here it is CA option on the shares of reliance Industries Limited(RIL) and the lot size is 250 shares. The strike price is Rs 1,010 and expiry month is July. (ii) Option contract series-CE, RIL (250), Rs 1,010, July Here ,it is CE option on the shares of RIL and the lot size is 250 shares. The strike price is Rs 1,010 and expiry month is July. (iii) Option contract series- CA, RIL (250), RS 1,010, July Here, it is CA option on the shares of RIL and the lot size is 250 shares. The strike price is Rs 1,050 and expiry month is July.
Square-up
Square-up means closing down the open interest in a particular product/contract series before the expiry. Illustration : on 1st June, 2011 client X takes a long on twelve lot of put option on Infosys(200) for june Rs 310, and the counter party is Z. on 6th June 2011, client Z buys seven lot of put option on Infosys for June Rs 3100 from client X. On the June 2011 X sells remaining lots to W.
Here, on 1st June 2011, both, clients X and Z have open interest of twelve lot of put option on Infosys for June Rs 3100. The open interest at exchange level is also twelve lot. On 6th June, both the clients have squared-up their position only for seven lots as X is selling the seven lots purchased on 1st June, and Z is buying seven lots sold on 1st june . As a result the open interest for both the parties on 6th June is five lot of put option on Infosys for June Rs 3100. The open interest at exchange level is also five lot. On 8th june, client X has further squared up the remaining five lots resulting into zero open interest for him. However, client W has created an open interest for client X is nil, for client Z five lot, for client W five lot, and the aggregate open interest at exchange level is also five lot.
Strike price: whenever strike price of a call option is less than the current market price, the price change from the option contract will be very high and vice versa. Market trend: market trend are identified as bullish or bearish. In a bullish trend the investors expect the price to rise in the future as a result of which the demand for call option will rise, hence the price of call option also increase. Dividend : payment of dividend or expectation of dividend during the duration of the option has a influence on the price of the option-premium. Interest rate: interest rate affect the opportunity cost of the seller of the call option and the buyer of the put option in both of this situation, the fund get blocked, for which the respective party has to bear the opportunity cost.
Others: apart from the above mentioned factors, the following factors also influence the price of option contract: Inflation Default risk Political risk Government policies Monsoon Demand and supply position Credit and monetary policy
Exotic option
A conventional option contract with certain additional features attached to it is called exotic option. Asian option: it is type of exotic option whose payoff depend on the average price of the underlying asset during some future period preceding the expiry of the option. Barrier option: A Provision in an option contact on account of which option comes into existence only when price of the underlying asset reaches the particular level, it is called option being knock-in. similarly, a provision in the option contract on account of which option ceases to exist as soon as spot price of the underlying asset falls below a particular level, this is called option being knockout.
Bermuda (bermudan) option: it is exotic option which can be exercised during a pre-specified duration during the complete life of the option. It is neither American nor European in nature with respect to the exercise of option rather having benefits of both these. Binary option: an option which provides a fixed pay-off if option happens to be in-the-money otherwise it is zero. It is also called digital option. Chooser option: an exotic option in which buyer of the option has the right to consider it either a call option or put option during a prespecified window period prior to expiry . It is called as you like it option. Knock-in and knock-out option: A Provision in an option contact on account of which option comes into existence only when price of the underlying asset reaches the particular level, it is called option being knock-in. similarly, a provision in the option contract on account of which option ceases to exist as soon as spot price of the underlying asset falls below a particular level, this is called option being knock- out.
Futures Transaction
It is an agreement between two parties to buy or sell the underlying asset for which all the parameters of the transaction are decided on the date of transaction, for settlement on a future date. Both buyer and seller of futures have rights as well as obligations therefore there is no requirement of a premium payment by either of the parties. The product series of a future transaction comprises the underlying asset including lot size and value month. In Indian stock market, only about 250 securities have been specified for futures transaction. As both buyer and seller have the obligation, therefore, both are required to deposit the margin money with the exchange through the respective broker (in indian capital market).
Illustration: For example, on 4th June 2011, a july futures on RIL is specified as follows: RIL (250) July with strike price Rs 1,020, whereas the spot price is Rs 1,000. Here for RIL the lot size is 250 shares. July is the month of expiry. Here the value date is decided by the concerned exchange. Both of these are parts of the product series. The product series is specified by the exchange, and the strike price is decided mutually by the parties for the futures transaction. Here, the strike price is Rs 1,020, which is greater than the spot price. Hence , the futures on RIL for July is at a premium.
Margin : both the parties, that is the buyer and seller of the futures contract are required to deposit the initial margin on the date of contract with the stock exchange ; this is called initial margin. Settlement: majority of the futures transactions are settled by taking or giving the difference in cash on the value date. The cash difference is the difference between strike price and settlement price on the value date. Square up: Square-up means closing down the open interest in a particular product/contract series before the expiry. Position: futures contracts are defined as long on futures and short on futures. Whenever a party purchases a futures contract it is called long on futures and when a party sells the futures contract, it is called short on futures.
Standardized: all the futures transactions are entered on the exchange and different parameters like: underlying assets, lot size, duration and value date, margin, mode of settlement. All these are decided and regulated by the concerned stock exchange. No expiration: in a futures contract, both the parties have rights as well as obligations, therefore, one of the parties will have benefit and the other will have loss on the value date.
If initial margin deposit is at 20% of the transaction value, then the margin deposit will be as follows: 1. Transaction value 2,50,000 ( 250*1,000) 2. Initial margin deposit 20% of 2,50,000 i.e 50,000 to be deposited by Mr. Avinash as well as by Mr. Mohit individually to the respective broker & in turn the brokers of the parties will maintain the margin with the stock exchange.
DATE
SETTLEMENT PRICE
DATE
SETTLEMENT PRICE
6th june
1,010
7th june
1,050
8th june
1,020
9th june
980
10th june
1,000
13th june
970
Forward Transaction
These transactions are for buying and selling an underlying asset, like shares, here, the transaction is done with the settlement taking place on some future date mutually decided by the parties. It is a customized contracts. Transactions are reported to the exchange to give them a validity mark and to provide a coverage for a counter-party risk. These transactions are done on over the counter exchange. Both the parties are required to deposit margin according to the rules of the exchange and both have rights as well as obligations.
FUTURE CONTRACT
FORWARD CONTRACT
Quantity
Minimum quantity & multiples are decided by the exchange in the form of lot size.
Stock exchange fixes the duration & value date. They are traded on the stock exchange. Regulated according to the rule of stock exchange. They are standardized.
nature
margin
INDEX FUTURES : Index Future is a transaction to buy or sell a particular index for which a transaction is entered for settlement on a pre-specidied future date.
INDEX OPTION:
In an index option transaction, the buyer of the option pays the premium to the seller of the option to obtain the right to buy or sell the inderlying index on or before the expiry date.
SWAP
It is a transaction whereby two parties parties exchange either a currency, a loan, or an interest obligation with regard to certain loan. Swap transactions are of following types: Foreign exchange swap Interest rate swap ( plain vanilla swap ) Cross currency swap ( total loan swap )
Foreign Exchange Swap: In this kind of swap transaction, two parties agree to exchange certain money value represented in different currencies at present, With the commitment to do the reverse of this in the future.these are done to hedge the risk arising out of fluctuation in the exchange rate of the currencies.
Interest rate SWAP: In this kind of swap transaction, two parties agree to exchange interest obligation for a certain loan amount. One party pays the interest obligation for loan taken by another Party,and later pays it for the loan taken by the former.
Cross Currency Swap: It is an agreement between two parties, in which they exchange the principal amount of the loan as well as interest obligation. It is done to gain from the comparative advantage of each other. The following mechanism is adopted for this :
Each party will raise a loan according to the objective of another party. Loan amounts are exchanged by both the parties in the beginning of swap. On respective interest due date, both make the payment for interest boligation of each other.
On the maturity date of the loan both exchange the principal amount to be repaid by them. The benefit arising out of the swap transaction Is exchanged according to the mutual agreement.