Introduction to Derivatives Market
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives.
Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vies-versa derivative products based on individual securities is another reason for their growing use.
The following factors have been driving the growth of financial derivatives:
- Increased volatility in asset prices in financial markets,
- Increased integration of national financial markets with the international markets,
- Marked improvement in communication facilities and sharp decline in their costs,
SCOPE OF THE STUDY
The study is limited to “Derivatives with special reference to futures and option in the Indian context and the Networth Stock Broking Ltd., data for this study is from 27-DEC -2007 to 31-JAN- 2008 which represent sample for the study. The study can’t be said as totally perfect. This study is only a humble attempt at evaluating derivatives market in Indian context. The study is not based on the international perspective of derivatives markets, which exists in NASDAQ, CBOT etc.
The Market data that has been used to see whether the Break Even Point (BEP) calculated can be used has an indicator to the investor to maximize the returns on its investment.
OBJECTIVES OF THE STUDY
1. To understand the concept of derivatives in a more appropriate way.
2. To study various trends in derivative market.
3. To understand the scope and growth of derivatives in India.
4. To study the role of derivatives in Indian financial market
5. To study in detail the role of the future and options.
1. Data Collection :
For this study the date collected is of secondary nature,
The data of the Nifty index have been collected from “Economic Times” and internet. The data collected for January contract and the date consist from period 27th December, 2007 to 31st January, 2008.
The analysis consist of the tabulation of the data assessing the profitability positions of the futures buyer and seller and also option holder and the option writer, representing the data with s and making the interpretation using data.
Data collected for analyzing this study is from 27-DEC 2007 to 31-JAN-2008. Time taken to complete this project is 45 days
LIMITATIONS OF THE STUDY
- The study is conducted in short period, due to which the study may not be detailed in all aspect.
- Lack of time on performing the project in detail study.
- Unavailability of software package which will help in calculation
- Lack of software knowledge to determine the correct future estimations.
- The data collected is completely restricted to 31st January, 2008; hence this analysis cannot be taken universal.
INTRODUCTION TO CAPITAL MARKET
Introduction To Indian Capital Market
India’s financial market began its transformation path in the early 1990s. The banking sector witnessed sweeping changes, including the elimination of interest rate controls, reductions in reserve and liquidity requirements and an overhaul in priority sector lending. Persistent efforts by the Reserve Bank of India (RBI) to put in place effective supervision and prudential norms since then have lifted the country closer to global standards.
Around the same time, India’s capital markets also began to stage extensive changes. The Securities and Exchange Board of India (SEBI) was established in 1992 with a mandate to protect investors and improvements into the microstructure of capital markets, while the repeal of the Controller of Capital Issues (CCI) in the same year removed the administrative controls over the pricing of new equity issues. India’s financial markets also began to embrace technology. Competition in the markets increased with the establishment of the National Stock Exchange (NSE) in 1994, leading to a significant rise in the volume of transactions and to the emergence of new important instruments in financial intermediation.
For over a century, India’s capital markets, which consist primarily of debt and equity markets, have increasingly played a significant role in mobilizing funds to meet public and private entities’ financing requirements. The advent of exchange-traded derivative instruments in 2000, such as options and futures, has enabled investors to better hedge their positions and reduce risks.
In total, India’s debt and equity markets were equivalent to 130% of GDP at the end of 2005. This is an impressive stride, coming from just 75% in 1995, suggesting issuers’ growing confidence in market based financing. However, the size of the country’s capital markets relative to the United States’, Malaysia’s and South Korea’s remains low, implying a strong catch-up process for India.
While some form of financial derivatives trading in India dates back to the 1870s, exchange traded derivative instruments started only in 2000. Then, stock index futures, with the Sensex 30 and the S&P CNX Nifty indices as the underlying, began trading at the BSE and NSE. Since their inception, the basket of instruments has expanded and now features individual stock futures, and options for stock index and individual stocks.
NATIONAL STOCK EXCHANGE (NSE)
The National Stock Exchange of India Limited has genesis in the report of the High Powered Study Group on Establishment of New Stock Exchanges, which recommended promotion of a National Stock Exchange by financial institutions (FIs) to provide access to investors from all across the country on an equal footing. Based on the recommendations, NSE was promoted by leading Financial Institutions at the behest of the Government of India and was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country.
On its recognition as a stock exchange under the Securities Contracts (Regulation) Act, 1956 in April 1993, NSE commenced operations in the Wholesale Debt Market (WDM) segment in June 1994. The Capital Market (Equities) segment commenced operations in November 1994 and operations in Derivatives segment commenced in June 2000.
1. NSE’s mission is setting the agenda for change in the securities markets in India. The NSE was set-up with the main objectives of:
2. Establishing a nation-wide trading facility for equities, debt instruments and hybrids,
3. Ensuring equal access to investors all over the country through an appropriate communication network,
4. Providing a fair, efficient and transparent securities market to investors using electronic trading systems,
5. Enabling shorter settlement cycles and book entry settlements systems, and
6. Meeting the current international standards of securities markets.
The standards set by NSE in terms of market practices and technologies have become industry benchmarks and are being emulated by other market participants. NSE is more than a mere market facilitator. It’s that force which is guiding the industry towards new horizons and greater opportunities.
By investing in shares, investors basically buy the ownership right to the company. When the company makes profits, shareholders receive their share of the profits in the form of dividends. In addition, when company performs well and the future expectation from the company is very high, the price of the company’s shares goes up in the market. This allows shareholders to sell shares at a profit, leading to capital gains.
Investors can invest in shares either through primary market offerings or in the secondary market.
The primary market has shown abnormal returns to investors who subscribed for the public issue and were allotted shares.
In a stock exchange a person who wishes to sell his security is called a seller, and a person who is willing to buy the particular stock is called as the buyer. The rate of stock depends on the simple law of demand and supply. If the demand of shares of company x is greater than its supply then its price of its security increases.
In Online Exchange the trading is done on a computer network. The sellers and buyers log on to the network and propose their bids. The system is designed in such ways that at any given instance, the buyers/sellers are bidding at the best prices.
The transaction cycle for purchasing and selling shares online is depicted below:
Role of Clearing House
The clearing house of the exchange interposes itself between the buyer(the long position) and the seller (the short position).this mean clearing house becomes seller to buyer and the buyer to seller. Because the clearing house is obliged to perform on its side of each contract, it is the only party that can hurt if any trader fail to fulfill his obligation. The clearing house protects its interest by imposing margin requirements on traders.
Ever since its inception in 1993, Networth Stock Broking Limited (NSBL) has sought to provide premium financial services and information, so that the power of investment is vested with the client. We equip those who invest with us to make intelligent investment decisions, providing them with the flexibility to either tap into our extensive knowledge and expertise, or make their own decisions. NSBL made its debut in to the financial world by servicing Institutional clients, and proved its high scalability of operations by growing exponentially over a short period of time. Now, powered by a top-notch research team and a network of experts, we provide an array of retail broking services across the globe – spanning India, Middle East, Europe and America. Currently, we are a Depository participant at Central Depository Services India (CDSL) and aim to become one at National Securities Depository (NSDL) by the end of this quarter. Our strong support, technology-driven operations and business units of research, distribution and advisory coalesce to provide you with a one-stop solution to cater to all your broking and investment needs. Our customers have been participating in the booming commodities markets with our membership at Multi Commodity Exchange of India (MCX) and National Commodity & Derivatives Exchange (NCDEX) through Networth Stock.Com Ltd.
NSBL is a member of theNational Stock Exchange of India Ltd (NSE) andthe Bombay Stock Exchange Ltd (BSE)on the Capital Market and Derivatives (Futures & Options) segment. It is also a listed company at theBSE.
• Networth is a listed entity on the BSE since 1994
• The company is professionally managed with experience of over a decade in broking and advisory services
• Networth is a member of BSE, NSE, MCX, NCDEX, AMFI, CDSL
• Current network in Southern and Western India with 107 branches and franchise. Presence in major metros and cities
• Empanelled with prominent domestic Mutual Funds, Insurance Companies, Banks, Financial Institutions and Foreign Financial Institutions.
• Strong experienced professional team
• 20000+ strong and growing client base
• Average daily broking turnover of around INR 1 billion
• AUM with Investment Advisory Services of around INR 3 billion
Products and services Portfolio
v Retail and institutional broking
v Research for institutional and retail clients
v Distribution of financial products
v Corporate finance
v Net trading
v Depository services
v Commodities Broking
• A corporate office and 3 divisional offices in CBD of Mumbai which houses state-of-the-art dealing room, research wing & management and back offices.
• All of 107 branches and franchisees are fully wired and connected to hub at corporate office at Mumbai. Add on branches also will be wired and connected to central hub
• Web enabled connectivity and software in place for net trading.
• 60 operative ID’s for dealing room
• State of the Art accounting and billing system, on line risk management system in place with 100% redundancy back up.
• In house technology back up team to ensure un-interrupted connectivity.
There is nothing more exhilarating, more daring and more rewarding than making the right trade at the right time. Welcome to our Internet trading platform which brings you a world class experience of online trading.
Clicknetworth is a software application suite that offers comprehensive facilities so users can watch Market Prices while they trade. The application is highly integrated which enables the user to place orders in live environment. The user screen is fully customizable by the user to display information based upon his/her own preferences
Networth offers advanced and convenient online trading facility with
N-easy and N-swift which are completely safe and secure.
N-easy: A Powerful and user friendly browser based platform ideally suited for Investors
N-swift: An Advanced EXE based application suite that is ideally suited for Traders
* Clients can trade in NSE – Cash, NSE – F&O and BSE – Cash.
* Single screen order / trade entry as you can add NSE-Cash, Derivative & BSE scripts in the same Market Watch.
* Features such as Lock the Screen, TOP 20 by Most Active Volume, Value, Gainers, Losers, Market Movement and more will help you customise your trading platform according to your specific focus.
* Facility for Online Funds Transfer. Your credit limit increases instantaneously on completion of a successful transfer.
Total holdings with NSBL and NSBL – CDSL DP (POA) can be viewed and delivery sale can also be made.
* Needless to mention other standard features as Real-Time market data, live order status, Real time position updates etc.
REVIEW OF LITERATURE
DEFINATION OF DERIVATIVE
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. There are two types of derivatives that are trades on NSE; namely Futures and Options. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A) defines “equity derivative” to include –
A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security.
A contract, which derives its value from the prices, or index of prices, of underlying securities.The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.
When one buys a cash instrument, for example 100 shares of ABC Inc., the payoff is linear (disregarding the impact of dividends). If we buy the shares at Rs50 and the price appreciates to Rs75, we have made Rs2500 on a mark-to-market basis. If we buy the shares at Rs50 and the price depreciates to Rs25, we have lost Rs2500 on a mark-to-market basis.
Instead of buying the shares in the cash market, we could have bought a 1 month call option on ABC stock with a strike price of Rs50, giving us the right but not the obligation to purchase ABC stock at Rs50 in 1 month’s time. Instead of immediately paying Rs5000 and receiving the stock, we might pay Rs700 today for this right. If ABC goes to Rs75 in 1 month’s time, we can exercise the option, buy the stock at the strike price and sell the stock in the open market, locking in a net profit of Rs1800. If the ABC stock price goes to Rs25, we have only lost the premium of Rs700. If ABC trades as high as Rs100 after we have bought the option but before it expires, we can sell the option in the market for a price of Rs5300.
Classification of Derivatives
Types of Derivatives
The most commonly used derivatives contracts in NSE are ,FUTURES and OPTIONS which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used.
Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price.
Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts.
Options: Options are of two types – calls and puts. Calls give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date.
Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts.
Warrants: Options generally have lives of upto one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.
LEAPS: The acronym LEAPS means Long-Term Equity Anticipation Securities. These are options having a maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.
Participants and Functions
v Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk.
v Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture.
v Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
The derivative market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. The prices of derivatives converge with the prices of the underlying at the expiration of derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite for them. Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled environment of derivatives market. In the absence of an organized derivatives market, speculators trade in the underlying cash markets. Margining, monitoring and surveillance of the activities of various participants become extremely difficult in these kind of mixed markets. Fifth, an important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. They often energize others to create new businesses, new products and new employment opportunities, the benefit of which are immense. Sixth, derivatives markets help increase savings and investment in the long run. Transfer of risk enables market participants to expand their volume of activity. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment.
The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, etc.
Indian Derivatives Market
Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India
CHRONOLOGY OF INSTRUMENTS
Liberalisation process initiated
NSE asked SEBI for permission to trade index futures.
SEBI setup L.C.Gupta Committee to draft a policy framework for index futures.
L.C.Gupta Committee submitted report.
RBI gave permission for OTC forward rate agreements (FRAs) and interest rate swaps.
SIMEX chose Nifty for trading futures and options on an Indian index.
SEBI gave permission to NSE and BSE to do index futures trading.
Trading of BSE Sensex futures commenced at BSE.
Trading of Nifty futures commenced at NSE.
Nifty futures trading commenced at SGX.
Individual Stock Options & Derivatives
A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
There are four major components of a swap price.
v Benchmark price
v Liquidity (availability of counter parties to offset the swap).
v Transaction cost
v Credit risk
Benchmark Price:Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates.
Liquidity: which is function of supply and demand, plays an important role in swaps pricing? This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap.
Transaction cost: Say in case of a bank, which has a floating obligation of 91 days T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference.
Yield on 91 day T. Bill – 9.5%
Cost of fund (e.g.- Repo rate) – 10%
The transaction cost in this case would involve 0.5%
Credit risk: Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating.
Introduction to Futures
Future contract is the simplest of all financial assets. A future contract is just an agreement between two parties to buy and sell an asset at a fixed price in the future. Futures markets were originally designed to solve the problems of forward markets. Future contracts are managed through an organized future exchange Future contracts are a type of derivative security because the value of the contract is derived from an underlying instrument. The exchange specifies standard features of future contract to facilitate liquidity in the futures contracts. The net value of a future contract is zero because future contract represents a zero sum game between a buyer and a seller. Future contracts are standardized to facilitate convenience in trading and price reporting. A futures contract may be offset before maturity by taking opposite position which means that future trading can be closed by entering into equal into an equal and opposite transaction. Future contract must specify at least five terms of the contract and they are:
1) The identity of the underlying commodity or financial instrument.
2) The future contract size.
3) The future maturity date.
4) The delivery or settlement procedure.
5) The future price.
TYPES OF FUTURES
A commodity future is a future contract in a commodity like cocoa, aluminum etc.
A financial future is a futures contract in a financial instrument like Treasury bill, currency or stock index.
Futures contracts are:
v Futures contracts are organized/ standardized contracts, which are traded on the exchanges.
v These contracts, being standardized and traded on the exchanges are very liquid in nature.
v In futures market, clearing corporation/ house provides the settlement guarantee.
v Every futures contract is a forward contract traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
v Are of standard quantity; standard quality (in case of commodities).
Have standard delivery time and place.
What Does Future Trading Apply to Indian Stocks?
Future trading is a type of investments which involves speculating on the prices of securities in the future. Securities traded in future contract can be a stock (Reliance India Limited, TISCO, etc), Stock Index (NSE Nifty Index), commodity (Gold, Silver, Agricultural Products, etc)
Unlike stocks and bonds, when we involve in future trading then we do not buy or own anything but we speculate the future direction of the price in the security we are trading. Suppose we speculate on Stock Index (NSE Nifty index). If we speculate that the future price of Stock Index can go up in the future then we would buy a future contract. If we speculate that the future price of Stock Index can go down then we would sell a future contract.
Futures Trading accounts
A future exchange allows only exchange members to trade on the exchange floor. There are various things to know about future trading accounts. The first thing is that a margin is always required. A margin is the amount of money that we put up to control a future contract.
How to Trade in S&P CNX NIFTY Futures?
Trading on CNX Nifty futures is just like trading in other security. Before buying or selling we use to predict the direction of the market and based on that prediction we buy or sell the index. A profit is made when the closing price on the expiration day is higher than the value at which we had bought the index. If we had predicted a bearish market, and had sold the index then we make a profit.
Trading cycle for S&P CNX Nifty Futures
The trading cycle for S&P CNX Nifty future contracts is 3 months. On the trading day a new contract is introduced. This contract will be introduced for three month duration. As a result there will be 3 contracts available for trading in the market ( i.e., first contract is in near month, second in mid month and third in far month duration)
If Trading in NIFTY Starts from January 2002 then following chart gives us the beginning and expiry date of the contract.
After January 28th, the first trading day will be on January 29th.
To trade futures in NSE, traders have to open an account with a future brokerage firm known as Future Commission Merchant (FCM). FCM records the trades, monitors them and advice t
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