Financial Derivatives

MBA
(DISTANCE MODE)
DBA 1754 FINANCIAL DERIVATIVES
IV SEMESTER COURSE MATERIAL
Centre for Distance Education

Anna University Chennai Chennai 600 025
Author Dr. J. Dr. J. Gopu

Assistant Professor Department of Management Studies BSA Crescent Engineering College Chennai - 600 048
Reviewer Ms. Yasmeen Haider Ms. Yasmeen

Senior Lecturer Department of Management Studies BSA Crescent Engineering College Chennai - 600 048
Editorial Board Dr.T.V.Geetha .T.V Dr.T.V.Geetha

Professor Department of Computer Science and Engineering Anna University Chennai Chennai - 600 025
Dr.H.Peeru .H.Peer Dr.H.P eer u Mohamed

Professor Department of Management Studies Anna University Chennai Chennai - 600 025
Dr.C Chellappan .C. Dr.C. Chella ppan

Dr.A.K .A.Kannan Dr.A.K annan

Copyrights Reserved (For Private Circulation only) ii
iii
ACKNOWLEDGEMENT
The author has drawn inputs from several sources for the preparation of this course material, to meet the requirements of the syllabus. The author gratefully acknowledges the following sources: N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006. www.nseindia.com www.theponytail.com http://www.emecklai.com http://www.geocities.com www.indiainfoline.com http://sasmit.blogspot.com
Inspite of at most care taken to prepare the list of references any omission in the list is only accidental and not purposeful.
Dr. J. Gopu Author
DBA 1754 FINANCIAL DERIVATIVES
UNIT I - INTRODUCTION Financial derivatives an introduction; Futures market and contracting; Forward market pricing and trading mechanism; Futures pricing theories and characteristics. UNIT II - REGULATIONS Financial derivatives market in India; Regulation of financial derivatives in India. UNIT III - STRATEGIES Hedging strategy using futures; Stock index futures; Short-term interest rate futures; Long-term interest rate futures; Foreign currency futures; Foreign currency forwards. UNIT IV - OPTIONS Options basics; Option pricing models; trading with options; Hedging with options; currency options; Financial Swaps and Options; Swap markets. UNIT V - ACCOUNTING Accounting treatment of derivative transactions; Management of derivatives exposure; Advanced financial derivatives; Credit derivatives. REFERENCES 1. N.D.Vohra and B.R.Bagri, Futures and Options II Edition; Tata McGraw Hill Ltd. 2. S.L.Gupta, Financial derivatives, theory, concepts and problems, Prentice Hall India, 2006.
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CONTENTS
UNIT I CHAPTER I FINANCIAL DERIVATIES AN INTRODUCTION
1.1 1.2 1.3 INTRODUCTION THE SIGNIFICANCE OF DERIVATIVES TYPES OF DERIVATIVES 1.3.1 Forward Contracts 1.3.2 Future Contracts 1.3.3 Options Contracts 1.3.4 Swap FUTURES MARKET AND CONTRACTING 1.4.1 Contract Specifications 1.4.2 Trading Parameters FORWARDS VS FUTURES DIFFERENCES BETWEEN FORWARDS AND FUTURES CONTRACTS FUTURES PRICES AND FUTURE SPOT PRICES 1 3 3 3 4 4 4 4 5 5 7 8
1.4
1.5 1.6 1.7
UNIT II CHAPTER I FINANCIAL DERIVATIVES MARKET IN INDIA

2.1.1 2.1.2 2.1.3 2.1.4 Introduction Derivatives Market in India Development of exchange-traded derivatives The need for a derivatives market 11 11 16 16
CHAPTER II REGULATIONS OF FINANCIAL DERIVATIVES IN INDIA

2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 2.2.6 Introduction Regulations by National Stock Exchange Black-Scholes Option Price calculation model Payment of Margins Violations Market Wide Position Limits for derivative contracts on underlying stocks 2.2.7 Price Scan Range
ix
18 18 26 27 27 28 29
2.2.8 Position Limits 2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives
29 30
UNIT III CHAPTER I HEDGING STRATEGIES USING INDEX FUTURES

3.1.1 Introduction 3.1.2 S&P CNX Nifty 3.1.3 Trading in Nifty 3.1.4 S&P CNX Nifty Futures 3.1.5 CNX Nifty Junior Futures 3.1.6 Cnxit Futures 3.1.7 CNX 100 Futures 3.1.8 BANK Nifty Futures 3.1.9 Nifty Midcap 50 Futures 3.1.10 Futures on Individual Securities 35 35 36 36 41 43 44 46 48 50
CHAPTER II INTEREST RATE FUTURES

3.2.1 3.2.2 3.2.3 3.2.4 3.2.5 3.2.6 3.2.7 3.2.8 3.2.9 Introduction Security descriptor Underlying Instrument Trading cycle Expiry day Product Characteristics Trading Parameters Clearing and Settlement Interest Rate Derivatives - Risk Containment 54 54 54 55 55 55 55 57 59
CHAPTER III CUURENCY FUTURES

3.3.1 Introduction 3.3.2 To Hedge or Not to Hedge? 3.3.3 Uncorrelated risks 3.3.4 Expected returns are zero 3.3.5 a) How long is the long-run? 3.3.5 b) Risk-return trade-off 3.3.6 Instruments for Hedging Currency Risk 3.3.7 Exchange-Traded Currency Futures 3.3.8 Accessible to All Market Participants
x
61 61 61 62 62 62 62 63 63
3.3.9 Illustrating the Use of Currency Futures 3.3.10 Summary
64 65
UNIT IV CHAPTER I OPTION MARKET

4.1.1 Introduction 4.1.2 The main characteristics of a option contract 4.1.3 The market participants 4.1.4 Mini Option contracts on S&P CNX Nifty index 4.1.5 CNXIT Options 4.1.6 CNX 100 Options 4.1.7 BANKNIFTY OPTIONS 4.1.8 NIFTY MIDCAP 50 OPTIONS 4.1.9 Options on Individual Securities 67 67 68 69 69 73 76 79 82
CHAPTER II FINANCIAL SWAPS MARKET

4.2.1 4.2.2 4.2.3 4.2.4 4.2.5 4.2.6 4.2.7 4.2.8 4.2.9 4.2.10 4.2.11 4.2.12 4.2.13 4.2.14 4.2.15 4.2.16 4.2.17 4.2.18 4.2.19 4.2.20 Introduction There are Three Basic Motivations for Swaps: Firms use Swaps to Reduce Financing Costs Parallel Loans Back-to-Back Loans Drawbacks of parallel and back to back loans Swap Banks Types of Swaps Swaptions, Caps, Floor and Collars Motivation for Swaps Closing Thoughts Interest Rate Swaps Currency Swaps Flexibility Exposure Hedging Swaps Identifying the risk of the swaps portfolio Constructing the Hedge Portfolio Why will the Dealer only Partially Hedge the Swaps Portfolio? Floating Rate Cash Flow Management 96 96 96 96 97 97 98 98 99 99 99 100 101 102 105 103 104 104 105 105
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4.2.21 4.2.22 4.2.23 4.2.24 4.2.25 4.2.26
Mismatches in the Timing of Short-Term Cash Flows. Mmismatches in the Type of Index used to Hedge. Interest Rate Swaps Valuation of swaps Equity Swaps Equity swaps make the index trading strategy even easier.
105 105 106 106 107 107
UNIT V CHAPTER I ACCOUNTING TREATMENT FOR DERIVATIVE TRANSACTIONS

5.1.1 5.1.2 5.1.3 5.1.4 5.1.5 5.1.6 5.1.7 5.1.8 5.1.9 5.1.10 5.1.11 5.1.12 5.1.13 5.1.14 Introduction Getting Ready Hedge Accounting Embedded Derivatives Recent Announcement Fair value hedges are accounted for as follows: Cash flow hedges are accounted for as follows: New Accounting Rules for Derivatives and Hedging Activity Fair Value Hedges Cash Flow Hedges Hedges for Net Investment in Foreign Operations Derivatives and Income Statement Volatility Increased Derivatives Disclosure Derivatives Management Systems 111 111 112 113 113 114 114 115 115 116 116 117 117 117
CHAPTER II CREDIT DERIVATIVES

5.2.1 5.2.2 5.2.3 5.2.4 Introduction Credit Swaps management. Credit Default Swaps Options on Credit Risky Bonds 122 122 123 124
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FINANCIAL DERIVATIVES
UNIT I
NOTES
INTRODUCTION
CHAPTER I
FINANCIAL DERIVATIES AN INTRODUCTION
1.1 INTRODUCTION In finance, a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using American dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into euros. Derivative is any financial instrument, whose payoffs depend in a direct way on the value of an underlying variable at a time in the future. This underlying variable is also called the underlying asset, or just the underlying. Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives]. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.
1 ANNA UNIVERSITY CHENNAI
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Derivative contracts in general and options in particular are not novel securities. It has been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his account of the operation of the Amsterdam Exchange, describes traded contracts that exhibit striking similarities to the modern traded options. Nevertheless, the modern treatment of derivative contracts has its roots in the inspired work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous mathematical representation of an asset price evolution through time. Bachelier used the concepts of random walk in order to model the fluctuations of the stock prices, and developed a mathematical model in order to evaluate the price of options on bond futures. Although the above model was incomplete and based on assumptions that are virtually unacceptable in recent studies, its importance lies on the novelty of its ideas, both from an economists and a mathematicians point of view. Unfortunately, this work was not developed further, despite the publication of the Einstein paper on Brownian motion in 1905, which would shed light on the properties of the model and perhaps highlight its misspecifications. The above treatment of security prices was long forgotten until the 70s, when Professor Samuelson and his co-workers at MIT rediscovered Bacheliers work and questioned its underlying assumptions. By construction, the payoff of a call option on the expiration day will depend on the price of the underlying asset on that day, relative to the options exercise price. Common reasoning declares that therefore, the price of the call option today has to depend on the probability of the stock price exceeding the exercise price. One could then argue that a mathematical model that can satisfactory explain the underlying assets price is sufficient in order to price the call option today, just by constructing the probabilistic model of the price on the expiration day. Professors Black, Merton and Scholes recognized that the above reasoning is incorrect: Since todays price incorporates the probabilistic model of the future behavior of the asset price, the option can (and has to) be priced relative to todays price alone. They realized that a levered position, using the stock and the riskless bond that replicates the payoff of the option is feasible, and therefore the option can be priced using no-arbitrage restrictions. Equivalently, they observed that the true probability distribution for the stock price return can be transformed into one which has an expected value equal to the risk free rate, the so called risk adjusted or risk neutral distribution; the pricing of the derivative can be carried out using the risk neutral distribution when expectations are taken. The classic papers produced by this work, namely Black and Scholes (1973) and Merton (1976), triggered an avalanche of papers on option pricing, and resulted in the 1997 Nobel Prize in economics for the pioneers of contingent claims pricing. Even today, nearly thirty years after its publication, the original Black and Scholes paper is one of the most heavily cited in finance?
ANNA UNIVERSITY CHENNAI
1.2 THE SIGNIFICANCE OF DERIVATIVES Every candidate underlying asset will have a value that is affected by a variety of factors, therefore inheriting risk. Derivative contracts, due to the leverage that they offer may seem to multiply the exposure to such risks. However, derivatives are rarely used in isolation. By forming portfolios utilizing a variety of derivatives and underlying assets, one can substantially reduce her risk exposure, when an appropriate strategy is considered. Derivative contracts provide an easy and straightforward way to both reduce risk hedging, and to bear extra risk -speculating. As noted above, in any market conditions every security bears some risk. Using active derivative management involves isolating the factors that serve as the sources of risk, and attacking them in turn. In general, derivatives can be used to hedge risks; reflect a view on the future behavior of the market, speculate; lock in an arbitrage profit; change the nature of a liability; change the nature of an investment;
NOTES
1.3 TYPES OF DERIVATIVES Derivative contracts have several variants. The most common variants are forwards, futures, options and swap. 1.3.1 Forward Contracts A forward contract is an agreement between two parties a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments, are very common in everyone life. For example, an apartment lease is a forward commitment. By signing a one-year lease, the tenant agrees to purchase the service use of the apartment each month for the next twelve months at a predetermined rate. Like-wise, the landlord agrees to provide the service each month for the next twelve months at the agreed-upon rate. Now suppose that six months later the tenant finds a better apartment and decides to move out. The forward commitment remains in effect, and the only way the tenant can get out of the contract is to sublease the apartment. Because there is usually a market for subleases, the lease is even more like a futures contract than a forward contract. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract.
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1.3.2 Future Contracts A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts, however, futures contracts trade on organized exchanges, called future markets. For example, the buyer of a future contact, who has the obligation to buy the good at the later date, can sell the contact in the future market, which relieves him or her of the obligation to purchase the good. Likewise, the seller of the futures contract, who is obligated to sell the good at the later date, can buy the contact back in the future market, relieving him or her of the obligation to sell the good. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits. 1.3.3 Options Contracts 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. 1.3.4 Swap 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. The two commonly used swaps are interest rate swaps and currency swaps. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction. 1.4 FUTURES MARKET AND CONTRACTING This contract is an agreement to buy or sell an asset at a certain time in the future for a certain price. Futures are traded in exchanges and the delivery price is always such that todays value of the contract is zero. Therefore in principle, one can always engage into future without the need of an initial capital: the speculators heaven A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures contracts are based on the popular market benchmark S & P CNX Nifty index.
NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. 1.4.1 Contract Specifications Security descriptor The security descriptor for the S&P CNX Nifty futures contracts is: Market type Instrument Type Underlying Expiry date : : : : N UTIDX NIFTY Date of contract expiry
NOTES
Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is S&P CNX Nifty Expiry date identifies the date of expiry of the contract Underlying Instrument The underlying index is S&P CNX Nifty. Trading cycle S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. Expiry day S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 1.4.2 Trading Parameters Contract size The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. Price steps The price step in respect of S&P CNX Nifty futures contracts is Re.0.05.
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Base Prices Base price of S&P CNX Nifty futures contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. Price bands There are no day minimum/maximum price ranges applicable for S&P CNX Nifty futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. Quantity freeze Orders which may come to the exchange as Quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order The forward contract
The forward contract is an over-the-counter [OTC] agreement between two parties, to buy or sell an asset at a certain time in the future for a certain price. The party that has agreed to buy has a long position. The party that has agreed to sell has a short position.
Usually, the delivery price is such that the initial value of the contract is zero. The contract is settled at maturity. For example, a long forward position with delivery price will K have the payoffs shown in figure
NOTES
Forward contract payoffs 1.5 FORWARDS VS FUTURES It can be shown that when interest rates are constant and the same for all maturities, then the futures and forward prices are the same. If the interest rates are stochastic, this relationship does not hold. Whether the forward price is lower than the futures price or higher will depend on the correlation of the underlying asset with the interest rates. This situation arises from the daily settlement procedure that takes place in the futures market. Remember that there is no secondary market for the forward contracts. Suppose that the interest rates and the underlying asset are negatively correlated. That is to say that on average, when the interest rates fall the price of the underlying asset increases, something that is true in the stock markets. Consider an investor that holds a long futures position. When the asset price increases, because of the marking-the-market procedure, the investor is making an immediate gain the basis increases. This extra gain will be invested at an interest rate which is lower than average, due to the negative correlation. In a similar fashion, when the price of the underlying falls, the immediate loss will have to be financed at a rate which is above the average. Forwards are not subject to daily settlements, and therefore not affected by the spot-interest correlation. This makes forward contracts more attractive; in an efficient market when the spot-interest correlation is negative we expect forward prices to be higher than the futures ones. Obviously the inverse will also hold, that is to say when the spot-interest correlation is positive we expect forward prices to be lower than the futures ones. These differences have only a theoretical value, in practice these differences are ignored. Usually the maturity of futures contracts is quite short, and the spot-interest correlation is not that high in absolute terms to imply significant differences. Therefore handbooks and practitioners make the assumption that futures and forwards have the same price, even when interest rates are uncertain. Of course one has to be careful when dealing with longer maturity futures, since then the differences might become quite significant.
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In the remaining of these notes we will use the same notation F(t, r) for both forwards and futures, recognizing the pitfalls. Although similar in nature, these two instruments exhibit some fundamental differences in the organization and the contract characteristics. 1.6 DIFFERENCES BETWEEN FORWARDS AND FUTURES CONTRACTS
Forwards Primary market Secondary market Contracts Delivery Collateral Credit risk Dealers None Negotiated Contracts expire None Depends on parties Futures Organized Exchange the Primary market Standardized Rare delivery Initial margin, mark-themarket None [Clearing House] Wide variety
Market participants Large firms
In the example a futures contract was not available for the investor to hedge against the interest rate risk. One can now see that she could alternative go to some investment company seeking for a forward contract that would suit her needs. 1.7 FUTURES PRICES AND FUTURE SPOT PRICES One very important question that one can ask is: Is the futures price an unbiased estimator of the future spot price? The answer is no in general. Remember the relation between risk and return as stated by the CAPM: there are two types of risk in the economy, namely the systematic and the nonsystematic risk. The nonsystematic risk can be eliminated by holding a well diversified portfolio, which is perfectly correlated with the market. The systematic risk cannot be eliminated, since it is the risk of the portfolio that is inherited from the market as a whole and it cannot be diversified away. The CAPM formula dictates that rp r = (r M r) p We have already seen that a futures contract, when seen as a riskless investment will grow in value with the risk free rate of return. Example 10 (Futures risk) Suppose that an investor takes a long futures position. She puts the present value of the futures position into a risk free investment, to meet the requirements when the contract matures, in order to buy the asset on the delivery date.
The cash flows of the speculator are

F ( t , ) e S ( )
r ( t)
NOTES
at time t , and at time .
The present value of this investment is
F(t, ) e r(t ) + Et [S()] e r1 (t )

where Et is the conditional expectations operator, and r1 is the discount rate appropriate for the investment meaning the expected return required from investors in order to compensate for the risks that are beard. The fact that the present value of all investment opportunities is equal to zero will give
F(t, ) = Et [S()]e (rr1) ( t ) .

It is straightforward to observe that the relationship of the futures with the expected spot price will depend on the relationship between the two returns, which in turn depends on the correlation of the investment with the market due to the CAPM. Example 11 (cont. Futures risk) Consider the case that ST is positively correlated with the market as is the usual case. Then, from the definition of I = var (rm) it is implied that I is positive. The CAPM dictates that an investment with positive will have required return higher than the risk free rate. This in turn will give F(t,r) < Et [S(r)].The inverse will also hold: If STis negatively correlated with the market, then F(t,r) > Et [S(r)].. What is the case where the futures price is an unbiased estimator of the future spot price? This happens only when the investment is not correlated with the market, or equivalently when the investment does not exhibit systematic risk. If fact in this cases the above feature is more of an accident: it is not the case that the futures price became an unbiased estimator, it is more that the asset price happens to grow at the risk free rate of return. Summary Usually, derivatives are contracts to buy or sell the underlying asset at a future time, with the price, quantity and other specifications defined today. Contracts can be binding for both parties or for one party only, with the other party reserving the option to exercise or not. If the underlying asset is not traded, for example if the underlying is an index, some kind of cash settlement has to take place. Derivatives are traded in organized exchanges as well as over the counter [OTC derivatives]. Examples of derivatives include forwards, futures, options, caps, floors, swaps, collars, and many others.
cov (r1 , rM )
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Derivative contracts in general and options in particular are not novel securities. It has been nearly 25 centuries since the above abstract appeared in Aristotles Politics, describing the purchase of a call option on oil-presses. More recently, De La Vega (1688), in his account of the operation of the Amsterdam Exchange, describes traded contracts that exhibit striking similarities to the modern traded options. Nevertheless, the modern treatment of derivative contracts has its roots in the inspired work of the Frenchman Louis Bachelier in 1900. This was the first attempt of a rigorous mathematical representation of an asset price evolution through time. Bachelier used the concepts of random walk in order to model the fluctuations of the stock prices, and developed a mathematical model in order to evaluate the price of options on bond futures. Although the above model was incomplete and based on assumptions that are virtually unacceptable in recent studies, its importance lies on the novelty of its ideas, both from an economists and a mathematicians point of view. Unfortunately, this work was not developed further, despite the publication of the Einstein paper on Brownian motion in 1905, which would shed light on the properties of the model and perhaps highlight its misspecifications. Questions 1. What do you mean by Derivatives? Explain its importance 2. Discuss the various types of Derivatives 3. Explain the differences between Forwards and Futures contracts 4. Define Option contract 5. Is the futures price an unbiased estimator of the future spot price? Explain
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UNIT II
NOTES
REGULATIONS
CHAPTER - I
FINANCIAL DERIVATIVES MARKET IN INDIA
2.1.1 Introduction Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities. Derivatives include a wide assortment of financial contracts, including forwards, futures, swaps, and options. The International Monetary Fund defines derivatives as financial instruments that are linked to a specific financial instrument or indicator or commodity and through which specific financial risks can be traded in financial markets in their own right. The value of financial derivatives derives from the price of an underlying item, such as asset or index. Unlike debt securities, no principal is advanced to be repaid and no investment income accrues. While some derivatives instruments may have very complex structures, all of them can be divided into basic building blocks of options, forward contracts or some combination thereof. Derivatives allow financial institutions and other participants to identify, isolate and manage separately the market risks in financial instruments and commodities for the purpose of hedging, speculating, arbitraging price differences and adjusting portfolio risks. 2.1.2 Derivatives Market in India Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr. L.C. Gupta on 18th November 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI was given more powers and it starts regulating the stock exchanges in a professional manner by gradually introducing reforms in trading.
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Derivatives trading commenced in India in June 2000 after SEBI granted the final approval in May 2000. SEBI permitted the derivative segments of two stock exchanges, viz NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivative contracts. Introduction of derivatives was made in a phase manner allowing investors and traders sufficient time to get used to the new financial instruments. Index futures on CNX Nifty and BSE Sensex were introduced during 2000. The trading in index options commenced in June 2001 and trading in options on individual securities commenced in July 2001. Futures contracts on individual stock were launched in November 2001. In June 2003, SEBI/RBI approved the trading in interest rate derivatives instruments and NSE introduced trading in futures contract on June 24, 2003 on 91 day Notional T-bills. Derivatives contracts are traded and settled in accordance with the rules, bylaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. The emergence of the market for derivatives products, most notable forwards, futures, options and swaps 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 can be subject to 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, derivatives products generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivatives products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Factors generally attributed as the major driving force behind growth of financial derivatives are: i. Increased Volatility in asset prices in financial markets, ii. Increased integration of national financial markets with the international markets, iii. Marked improvement in communication facilities and sharp decline in their costs, iv. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and v. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as transaction costs as compared to individual financial assets Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex,
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equity, etc), bases or reference rates. 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. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. Development of exchange-traded derivatives has probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. The need for a derivatives market. The derivatives market performs a number of economic functions: i. They help in transferring risks from risk averse people to risk oriented people ii. They help in the discovery of future as well as current prices iii. They catalyze entrepreneurial activity iv. They increase the volume traded in markets because of participation of risk averse people in greater numbers v. They increase savings and investment in the long run The participants in a derivatives market Hedgers use futures or options markets to reduce or eliminate the risk associated with price of an asset. Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. 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. Types of Derivatives Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at todays 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. 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.
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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. 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. The two commonly used swaps are : Interest rate swaps: These entail swapping only the interest related cash flows between the parties in the same currency. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating. Factors driving the growth of financial derivatives a. Increased volatility in asset prices in financial markets, b. Increased integration of national financial markets with the international markets, c. Marked improvement in communication facilities and sharp decline in their costs, d. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and d. Innovations in the derivatives markets, which optimally combine the risks and returns over a large number of financial assets leading to higher returns, reduced risk as well as transactions costs as compared to individual financial assets. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on Nov. 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and
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notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continue to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.
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Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. Calls on Satyam fall, while puts rise when Satyam falls intra-day. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-toone impact on the option premiums. Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses. With commodity futures, delivery is best effected using
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warehouse receipts (which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998 Exchange-traded vs. OTC (Over The Counter) derivatives markets The OTC derivatives markets have witnessed rather sharp growth over the last few years, which has accompanied the modernization of commercial and investment banking and globalisation of financial activities. The recent developments in information technology have contributed to a great extent to these developments. While both exchange-traded and OTC derivative contracts offer many benefits, the former have rigid structures compared to the latter. It has been widely discussed that the highly leveraged institutions and their OTC derivative positions were the main cause of turbulence in financial markets in 1998. These episodes of turbulence revealed the risks posed to market stability originating in features of OTC derivative instruments and markets. The OTC derivatives markets have the following features compared to exchange-traded derivatives: 1. The management of counter-party (credit) risk is decentralized and located within individual institutions, 2. There are no formal centralized limits on individual positions, leverage, or margining, 3. There are no formal rules for risk and burden-sharing, 4. There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance. 2.1.3 Development of exchange-traded derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and May well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for pre-arranging a buyer or seller for a stock of commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. 2.1.4 The need for a derivatives market The derivatives market performs a number of economic functions: They help in transferring risks from risk adverse people to risk oriented people They help in the discovery of future as well as current prices
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They catalyze entrepreneurial activity They increase the volume traded in markets because of participation of risk adverse people in greater numbers They increase savings and investment in the long run
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Summary Derivatives are financial contracts whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rates, exchange rates, commodities, and equities Derivatives markets have had a slow start in India. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendments) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. 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. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset Commodity Derivatives Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. Questions The derivatives market performs a number of economic functions, Discuss What is the feature of OTC derivatives markets? Explain the development of Derivatives Market in India What are the factors generally attributed as the major driving force behind growth of financial derivatives in India? What do you understand by Swaps?
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CHAPTER II
REGULATIONS OF FINANCIAL DERIVATIVES IN INDIA
2.2.1 Introduction The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the threedecade old notification, which prohibited forward trading in securities. 2.2.2 Regulations by National Stock Exchange 2.2.2.1 Minimum Base Capital A Clearing Member (CM) is required to meet with the Base Minimum Capital (BMC) requirements prescribed by NSCCL before activation. The CM has also to ensure that BMC is maintained in accordance with the requirements of NSCCL at all points of time, after activation. Every CM is required to maintain BMC of Rs.50 lakhs with NSCCL in the following manner: 1. Rs.25 lakhs in the form of cash. 2. Rs.25 lakhs in any one form or combination of the below forms:
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i.
Cash
ii. Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL iii. Bank Guarantee in favour of NSCCL from approved banks in the specified format. iv. Approved securities in demat form deposited with approved Custodians. In addition to the above MBC requirements, every CM is required to maintain BMC of Rs.10 lakhs, in respect of every trading member(TM) whose deals such CM undertakes to clear and settle, in the following manner: 1. Rs.2 lakhs in the form of cash. 2. Rs.8 lakhs in a one form or combination of the following: Cash Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL Bank Guarantee in favour of NSCCL from approved banks in the specified format. Approved securities in demat form deposited with approved Custodians.
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Any failure on the part of a CM to meet with the BMC requirements at any point of time, will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and would attract disciplinary action inter-alia including, withdrawal of trading facility and/ore clearing facility, closing out of outstanding positions etc. 2.2.2.2 Additional Base Capital Clearing members may provide additional margin/collateral deposit (additional base capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are receivable from NSCCL, over and above their minimum deposit requirements, towards initial margin and/ or other obligations. Clearing members may submit such deposits in any one form or combination of the following forms: Cash Fixed Deposit Receipts (FDRs) issued by approved banks and deposited with approved Custodians or NSCCL Bank Guarantee in favour of NSCCL from approved banks in the specified format. Approved securities in demat form deposited with approved custodians
2.2.2.3 Effective Deposits / Liquid Networth Effective deposits All collateral deposits made by CMs are segregated into cash component and noncash component.
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For Additional Base Capital, cash component means cash, bank guarantee, fixed deposit receipts, T-bills and dated government securities. Non-cash component shall mean all other forms of collateral deposits like deposit of approved demat securities. At least 50% of the Effective Deposits should be in the form of cash. 2.2.2.4 Liquid Networth Liquid Networth is computed by reducing the initial margin payable at any point in time from the effective deposits. The Liquid Networth maintained by CMs at any point in time should not be less than Rs.50 lakhs (referred to as Minimum Liquid Net Worth). 2.2.2.5 Margins NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN (Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a portfolio based system 2.2.2.6 Initial Margin NSCCL collects initial margin up-front for all the open positions of a CM based on the margins computed by NSCCL - SPAN. A CM is in turn required to collect the initial margin from the TMs and his respective clients. Similarly, a TM should collect upfront margins from his clients. Initial margin requirements are based on 99% value at risk over a one day time horizon. However, in the case of futures contracts (on index or individual securities), where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two-day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage is as per the recommendations of SEBI from time to time. 2.2.2.7 Initial margin requirement for a member For client positions - shall be netted at the level of individual client and grossed across all clients, at the Trading/ Clearing Member level, without any setoffs between clients. For proprietary positions - shall be netted at Trading/ Clearing Member level without any setoffs between client and proprietary positions. For the purpose of SPAN Margin, various parameters are specified from time to time.
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In case a trading member wishes to take additional trading positions his CM is required to provide Additional Base Capital (ABC) to NSCCL. ABC can be provided by the members in the form of Cash Bank Guarantee, Fixed Deposit Receipts and approved securities. 2.2.2.8 Premium Margin In addition to Initial Margin, Premium Margin would be charged to members. The premium margin is the client wise margin amount payable for the day and will be required to be paid by the buyer till the premium settlement is complete. 2.2.2.9 Assignment Margin Assignment Margin is levied on a CM in addition to SPAN margin and Premium Margin. It is required to be paid on assigned positions of CMs towards Interim and Final Exercise Settlement obligations for option contracts on individual securities, till such obligations are fulfilled. The margin is charged on the Net Exercise Settlement Value payable by a Clearing Member towards Interim and Final Exercise Settlement and is deductible from the effective deposits of the Clearing Member available towards margins. Assignment margin is released to the CMs for exercise settlement pay-in. 2.2.2.10 Margin Reports The following margin reports are downloaded to members on a daily basis: 1. Margin Statement of Clearing Members : MG-09 2. Margin Statement of Trading Member/ Custodial Participant : MG-10 3. Margin Payable Statement of Clearing Member : MG-11 4. Detail Margin File of Clearing Members : MG - 12 5. Client Level Margin File of Trading Members : MG-13 Details of Margin Reports 2.2.2.11 NSCCL SPAN The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity risk. Because SPAN is used to determine performance bond requirements (margin requirements), its overriding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day.
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In standard pricing models, three factors most directly affect the value of an option at a given point in time: 1. Underlying market price 2. Volatility (variability) of underlying instrument 3. Time to expiration As these factors change, so too will the value of futures and options maintained within a portfolio. SPAN constructs scenarios of probable changes in underlying prices and volatilities in order to identify the largest loss a portfolio might suffer from one day to the next. It then sets the margin requirement at a level sufficient to cover this one-day loss. i. Mechanics of SPAN ii. Risk Arrays iii. Composite Delta iv. Calendar spread or Intra commodity or Inter month Risk Charge v. Short option Minimum Charge vi. Net Buy Premium (only for option contracts) vii. Computation of Initial Margin Overall Portfolio Margin Requirement viii. Black Scholes Option Price calculation model. 2.2.2.12 Mechanics of SPAN The complex calculations (e.g. the pricing of options) in SPAN are executed by the Clearing Corporation. The results of these calculations are called Risk arrays. Risk arrays, and other necessary data inputs for margin calculation are then provided to members in a file called the SPAN Risk Parameter file. This file will be provided to members on a daily basis. Members can apply the data contained in the Risk parameter files, to their specific portfolios of futures and options contracts, to determine their SPAN margin requirements. Hence members need not execute complex option pricing calculations, which would be performed by NSCCL. SPAN has the ability to estimate risk for combined futures and options portfolios, and re-value the same under various scenarios of changing market conditions. 2.2.2.13 Risk Arrays The SPAN risk array represents how a specific derivative instrument (for example, an option on NIFTY index at a specific strike price) will gain or lose value, from the current point in time to a specific point in time in the near future (typically it calculates risk over a one day period called the look ahead time), for a specific set of market conditions which may occur over this time duration.
The specific set of market conditions evaluated, are called the risk scenarios, and these are defined in terms of : 1. how much the price of the underlying instrument is expected to change over one trading day, and 2. how much the volatility of that underlying price is expected to change over one trading day. The results of the calculation for each risk scenario i.e. the amount by which the futures and options contracts will gain or lose value over the look-ahead time under that risk scenario - is called the risk array value for that scenario. The set of risk array values for each futures and options contract under the full set of risk scenarios, constitutes the Risk Array for that contract. In the Risk Array, losses are represented as positive values, and gains as negative values. Risk array values are typically represented in the currency (Indian Rupees) in which the futures or options contract is denominated. SPAN further uses a standardized definition of the risk scenarios, defined in terms of i. the underlying price scan range or probable price change over a one day period, ii. and the underlying price volatility scan range or probable volatility change of the underlying over a one day period. These two values are often simply referred to as the price scan range and the volatility scan range. There are sixteen risk scenarios in the standard definition. These scenarios are listed as under: a. Underlying unchanged; volatility up b. Underlying unchanged; volatility down c. Underlying up by 1/3 of price scanning range; volatility up d. Underlying up by 1/3 of price scanning range; volatility down e. Underlying down by 1/3 of price scanning range; volatility up f. Underlying down by 1/3 of price scanning range; volatility down g. Underlying up by 2/3 of price scanning range; volatility up h. Underlying up by 2/3 of price scanning range; volatility down i. Underlying down by 2/3 of price scanning range; volatility up j. Underlying down by 2/3 of price scanning range; volatility down k. Underlying up by 3/3 of price scanning range; volatility up l. Underlying up by 3/3 of price scanning range; volatility down m. Underlying down by 3/3 of price scanning range; volatility up n. Underlying down by 3/3 of price scanning range; volatility down
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NOTES
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o. Underlying up extreme move, double the price scanning range (cover 35% of loss) p. Underlying down extreme move, double the price scanning range (cover 35% of loss) SPAN uses the risk arrays to scan probable underlying market price changes and probable volatility changes for all contracts in a portfolio, in order to determine value gains and losses at the portfolio level. This is the single most important calculation executed by the system. As shown above in the sixteen standard risk scenarios, SPAN starts at the last underlying market settlement price and scans up and down three even intervals of price changes (price scan range). At each price scan point, the program also scans up and down a range of probable volatility from the underlying markets current volatility (volatility scan range). SPAN calculates the probable premium value at each price scan point for volatility up and volatility down scenario. It then compares this probable premium value to the theoretical premium value (based on last closing value of the underlying) to determine profit or loss. Deep-out-of-the-money short options positions pose a special risk identification problem. As they move towards expiration, they may not be significantly exposed to normal price moves in the underlying. However, unusually large underlying price changes may cause these options to move into-the-money, thus creating large losses to the holders of short option positions. In order to account for this possibility, two of the standard risk scenarios in the Risk Array (sr. no. 15 and 16) reflect an extreme underlying price movement, currently defined as double the maximum price scan range for a given underlying. However, because price changes of these magnitudes are rare, the system only covers 35% of the resulting losses. After SPAN has scanned the 16 different scenarios of underlying market price and volatility changes, it selects the largest loss from among these 16 observations. This largest reasonable loss is the Scanning Risk Charge for the portfolio - in other words, for all futures and options contracts. 2.2.2.14 Composite Delta SPAN uses delta information to form spreads between futures and options contracts. Delta values measure the manner in which a futures or options value will change in relation to changes in the value of the underlying instrument. Futures deltas are always 1.0; options deltas range from -1.0 to +1.0. Moreover, options deltas are dynamic: a change in value of the underlying instrument will affect not only the options price, but also its delta.
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In the interest of simplicity, SPAN employs only one delta value per contract, called the Composite Delta. It is the weighted average of the deltas associated with each underlying price scan point. The weights associated with each price scan point are based upon the probability of the associated price movement, with more likely price changes receiving higher weights and less likely price changes receiving lower weights. Please note that Composite Delta for an options contract is an estimate of the contracts delta after the lookahead - in other words, after one trading day has passed. 2.2.2.15 Calendar Spread or Intra-commodity or Inter-month Risk Charge As SPAN scans futures prices within a single underlying instrument, it assumes that price moves correlate perfectly across contract months. Since price moves across contract months do not generally exhibit perfect correlation, SPAN adds an Calendar Spread Charge (also called the Inter-month Spread Charge) to the Scanning Risk Charge associated with each futures and options contract. To put it in a different way, the Calendar Spread Charge covers the calendar (inter-month etc.) basis risk that may exist for portfolios containing futures and options with different expirations. For each futures and options contract, SPAN identifies the delta associated each futures and option position, for a contract month. It then forms spreads using these deltas across contract months. For each spread formed, SPAN assesses a specific charge per spread which constitutes the Calendar Spread Charge. The margin for calendar spread shall be calculated on the basis of delta of the portfolio in each month. Thus a portfolio consisting of a near month option with a delta of 100 and a far month option with a delta of 100 would bear a spread charge equivalent to the calendar spread charge for a portfolio which is long 100 near month futures contract and short 100 far month futures contract. A calendar spread would be treated as a naked position in the far month contract three trading days before the near month contract expires. 2.2.2.16 Short Option Minimum Charge Short options positions in extremely deep-out-of-the-money strikes may appear to have little or no risk across the entire scanning range. However, in the event that underlying market conditions change sufficiently, these options may move into-the-money, thereby generating large losses for the short positions in these options. To cover the risks associated with deep-out-of-the-money short options positions, SPAN assesses a minimum margin for each short option position in the portfolio called the Short Option Minimum charge, which is set by the NSCCL. The Short Option Minimum charge serves as a minimum charge towards margin requirements for each short position in an option contract.
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For example, suppose that the Short Option Minimum charge is Rs. 50 per short position. A portfolio containing 20 short options will have a margin requirement of at least Rs. 1,000, even if the scanning risk charge plus the inter month spread charge on the position is only Rs. 500. 2.2.2.17 Net Buy Premium (only for option contracts) In the above scenario only sell positions are margined and offsetting benefits for buy positions are given to the extent of long positions in the portfolio by computing the net option value. To cover the one day risk on long option positions (for which premium shall be payable on T+1 day), net buy premium to the extent of the net long options position value is deducted from the Liquid Networth of the member on a real time basis. This would be applicable only for trades done on a given day. The Net Buy Premium margin shall be released towards the Liquid Networth of the member on T+1 day after the completion of pay-in towards premium settlement. 2.2.2.18 Computation of Initial Margin - Overall Portfolio Margin Requirement The total margin requirements for a member for a portfolio of futures and options contract would be computed as follows: i. SPAN will add up the Scanning Risk Charges and the Intracommodity Spread Charges.
ii. SPAN will compares this figure (as per i above) to the Short Option Minimum charge iii. It will select the larger of the two values between (i) and (ii) iv. Total SPAN Margin requirement is equal to SPAN Risk Requirement (as per above), less the net option value, which is mark to market value of difference in long option positions and short option positions. v. Initial Margin requirement = Total SPAN Margin Requirement + Net Buy Premium 2.2.3 Black-Scholes Option Price calculation model The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t)
26
d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean =0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. SPAN is a registered trademark of the Chicago Mercantile Exchange, used herein under License. The Chicago Mercantile Exchange assumes no liability in connection with the use of SPAN by any person or entity. 2.2.4 Payment of Margins The initial margin is payable upfront by Clearing Members. Initial margins can be paid by members in the form of Cash, Guarantee, Fixed Deposit Receipts and approved securities Non-fulfillment of either the whole or part of the margin obligations will be treated as a violation of the Rules, Bye-Laws and Regulations of NSCCL and will attract penal charges at 0.7 percent per day of the amount not paid throughout the period of nonpayment. In addition NSCCL may at its discretion and without any further notice to the clearing member, initiate other disciplinary action, inter-alia including, withdrawal of trading facilities and/ or clearing facility, close out of outstanding positions, imposing penalties, collecting appropriate deposits, invoking bank guarantees/ fixed deposit receipts, etc. 2.2.5 Violations PRISM (Parallel Risk Management System) is the real-time position monitoring and risk management system for the Futures and Options market segment at NSCCL. The risk of each trading and clearing member is monitored on a real-time basis and alerts/ disablement messages are generated if the member crosses the set limits.
27
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Initial Margin Violation Exposure Limit Violation Trading Memberwise Position Limit Violation Client Level Position Limit Violation Market Wide Position Limit Violation Violation arising out of misutilisation of trading member/constituent collaterals and/ or deposits Violation of Exercised Positions
Clearing members, who have violated any requirement and / or limits, may submit a written request to NSCCL to either reduce their open position or, bring in additional cash deposit by way of cash or bank guarantee or FDR or securities. A penalty of Rs. 5000/- is levied for each violation and is debited to the clearing account of clearing member on the next business day. In respect of violation on more than one occasion on the same day, penalty in case of second and subsequent violation during the day will be increased by Rs.5000/- for each such instance. (For example in case of second violation for the day the penalty leviable will be Rs.10000/-, Rs.15000 for third instance and so on). The penalty is charged to the clearing member irrespective of whether the clearing member brings in margin deposits subsequently. Where the penalty levied on a clearing member/ trading member relates to a violation of Client-wise Position Limit, the clearing member/ trading member may in turn, recover such amount of penalty from the concerned clients who committed the violation 2.2.6 Market Wide Position Limits for derivative contracts on underlying stocks At the end of each day the Exchange shall test whether the market wide open interest for any scrip exceeds 95% of the market wide position limit for that scrip. If so, the Exchange shall take note of open position of all client/ TMs as at the end of that day in that scrip, and from next day onwards the client/ TMs shall trade only to decrease their positions through offsetting positions till the normal trading in the scrip is resumed. The normal trading in the scrip shall be resumed only after the open outstanding position comes down to 80% or below of the market wide position limit. A facility is available on the trading system to display an alert once the open interest in the futures and options contract in a security exceeds 60% of the market wide position limits specified for such security. Such alerts are presently displayed at time intervals of 10 minutes.
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At the end of each day during which the ban on fresh positions is in force for any scrip, when any member or client has increased his existing positions or has created a new position in that scrip the client/ TMs shall be subject to a penalty of 1% of the value of increased position subject to a minimum of Rs.5000 and maximum of Rs.1, 00,000. The positions, for this purpose, will be valued at the underlying close price. The penalty shall be recovered from the clearing member affiliated with such trading members/clients on a T+1 day basis along with pay-in. The amount of penalty shall be informed to the clearing member at the end of the day. 2.2.7 Price Scan Range To compute worst scenario loss on a portfolio, the price scan range for option on individual securities and futures on individual securities would also be linked to liquidity, measured in terms of impact cost for an order size of Rs 5 lakh calculated on the basis of order book snapshots in the previous six months. Accordingly if the mean value of the impact cost exceeds 1%, the price scanning range would be scaled up by square root of three. This would be in addition to the requirement on account of look ahead period as may be applicable. The mean impact cost as stipulated by SEBI is calculated on the 15th of each month on a rolling basis considering the order book snap shots of previous six months. If the mean impact cost of a security moves from less than or equal to 1% to more than 1%, the price scan range in such underlying shall be scaled by square root of three and scaling shall be dropped when the impact cost drops to 1% or less. Such changes shall be applicable on all existing open position from the third working day from the 15th of each month. The detail of impact cost on the list of underlyings on which derivative contracts are available and the methodology of computation of the same are available at our website. 2.2.8 Position Limits Clearing Members are subject to the following exposure / position limits in addition to initial margins requirements i. Exposure Limits ii. Trading Member wise Position Limit iii. Client Level Position Limit iv. Market Wide Position Limits (for Derivative Contracts on Underlying Stocks) v. Collateral limit for Trading Members
NOTES
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2.2.9 Scheme for FIIs and MFs trading in Exchange traded derivatives 2.2.9.1 Position Limits The position limits for FII, Mutual Funds , FII sub-accounts & MF schemes shall be as under: 2.2.9.2 At the level of the FII and MF i. FII & MF Position limits in Index options contracts:
FII and MF position limit in all index options contracts on a particular underlying index shall be Rs.500 crores or 15 % of the total open interest of the market in index options, whichever is higher. This limit would be applicable on open positions in all options contracts on a particular underlying index. ii. FII & MF Position limits in Index futures contracts:
FII and MF position limit in all index futures contracts on a particular underlying index shall be Rs.500 crores or 15 % of the total open interest of the market in index futures, whichever is higher. This limit would be applicable on open positions in all futures contracts on a particular underlying index. In addition to the above, FIIs & MFs shall take exposure in equity index derivatives subject to the following limits: Short positions in index derivatives (short futures, short calls and long puts) not exceeding (in notional value) the FIIs / MFs holding of stocks. Long positions in index derivatives (long futures, long calls and short puts) not exceeding (in notional value) the FIIs / MFs holding of cash, government securities, T-Bills and similar instruments. In this regard, if the open positions of an FII / MF exceeds the limits as stated in item no a or b, such surplus would be deemed to comprise of short and long positions in the same proportion of the total open positions individually. Such short and long positions in excess of the said limits shall be compared with the FIIs / MFs holding in stocks, cash etc as stated above. iii. Stock Futures & Options For stocks having applicable market-wise position limit (MWPL) of Rs. 500 crores or more, the combined futures and options position limit shall be 20% of applicable MWPL or Rs. 300 crores, whichever is lower and within which stock futures position cannot exceed 10% of applicable MWPL or Rs. 150 crores, whichever is lower.
30
For stocks having applicable market-wise position limit (MWPL) less than Rs. 500 crores, the combined futures and options position limit would be 20% of applicable MWPL and futures position cannot exceed 20% of applicable MWPL or Rs. 50 crore which ever is lower.
NOTES
2.2.9. 3 At the level of the sub-account a) Index Futures & Options A disclosure is requirement from any person or persons acting in concert who together own 15% or more of the open interest of all futures and options contracts on a particular underlying index on the Exchange. A failure to do so shall be treated as a violation and shall attract appropriate penal and disciplinary action in accordance with the Rules, Bye-Laws and Regulations of NSE/NSCCL. b) Stock Futures & Options
The gross open position across all futures and options contracts on a particular underlying security, of a sub-account of an FII, should not exceed the higher of : i. 1% of the free float market capitalisation (in terms of number of shares) or ii. 5% of the open interest in the derivative contracts on a particular underlying stock (in terms of number of contracts). These position limits shall be applicable on the combined position in all futures and options contracts on an underlying security on the Exchange. c) Procedures
The Clearing Corporation would monitor the FII position limits at the end of each trading day. For this purpose, the following procedure is prescribed: FIIs intending to trade in the F&O segment of the Exchange shall be required to notify the following details of the Clearing Member/s, who shall clear and settle their trades in the F&O segment, to Clearing Corporation. 1. Name of FII 2. SEBI Registration Number 3. Name of sub-account/s of FII (if any) 4. Name of the Clearing Member/s. A unique code will be allotted by Clearing Corporation to each such FII prior to commencement of trading by them. This will be utilized by Clearing Corporation for the purpose of monitoring position limits at the level of the FII. For e.g. If the name of FII is say XYZ and it has 2 sub accounts viz. scheme 1 and 2, the FII code allotted by NSCCL may be XYZ (comprising 12 characters). Each FII/ sub-account of the FII, as the case may be, intending to trade in the F&O segment of the Exchange, shall further be required to obtain a unique Custodial Participant (CP) code allotted from the Clearing Corporation, through their Clearing Member. CP
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code normally comprises of 12 alphanumeric characters. Clearing Corporation will allot CP codes to each such FII/ sub-account of the FII. he Clearing Member/s of the FII/ subaccount of the FII, are required to furnish the following details to Clearing Corporation, to obtain CP codes: a) Name of FII b) Unique code allotted to the FII by NSCCL (as detailed in 2 above) c) Name of sub-account/s of FII d) CP code/s allotted to the FII/ sub account/s of the FII, in the Capital Market segment of Clearing Corporation Eg. In the example given in 2 above the CP codes allotted by NSCCL may be ABCDEFGH0001 and ABCDEFGH0002. FIIs/ sub accounts of FIIs which have been allotted a unique CP code by Clearing Corporation shall only be permitted to trade on the Exchange. The FII/ sub-account of FII shall ensure that all orders placed by them on the Exchange carry the relevant CP code allotted by Clearing Corporation as specified in point 3 above, in the relevant field in NEATFO. Clearing Member/s of the FII shall submit the details of all the trades confirmed by FII to Clearing Corporation, by the end of each trading day, as per the mechanism specified. Clearing Corporation will monitor the open positions of the FII/ sub-account of the FII for each underlying security and index on which futures and option contracts are traded on the Exchange, against the position limits specified at the level of FII/ sub-accounts of FII respectively, at the end of each trading day. The cumulative FII position may be disclosed to the market on a T + 1 basis, before the commencement of trading on the next day. In the event of an FII breaching the position limits on any underlying, Clearing Corporation will advise the Exchange to withdraw the facility granted to such FII to take any fresh positions in any derivative contracts. Such FII will be required to reduce their open position in such underlying, in accordance with the mechanism provided by Clearing Corporation from time to time. The facility withdrawn may be reinstated upon due compliance of the position limits. It shall also be obligatory on FIIs to report any breach of position limits by them / their sub-account/s, to Clearing Corporation and ensure that such sub-account/s does not take any fresh positions in any derivative contracts in such underlying. The sub-account of FII shall be required to reduce open position in such underlying, in accordance with the mechanism specified by Clearing Corporation. Only upon due compliance of the position limits, the sub-accounts may permitted to take further positions.
d) Computation of Position Limits The position limits would be computed on a gross basis at the level of a FII and on a net basis at the level of sub-accounts and proprietary positions. The open position for all derivative contracts would be valued as the open interest multiplied with the closing price of the respective underlying in the cash market. E) Client Margin Reporting Clearing Members (CMs) and Trading Members (TMs) are required to collect upfront initial margins from all their Trading Members/ Constituents. CMs are required to compulsorily report, on a daily basis, details in respect of such margin amount due and collected, from the TMs/ Constituents clearing and settling through them, with respect to the trades executed/ open positions of the TMs/ Constituents, which the CMs have paid to NSCCL, for the purpose of meeting margin requirements. Similarly, TMs are required to report on a daily basis details in respect of such margin amount due and collected from the constituents clearing and settling through them, with respect to the trades executed/ open positions of the constituents, which the trading members have paid to the CMs, and on which the CMs have allowed initial margin limit to the TMs. f) Due date for Margin Reporting
NOTES
The cut off day upto which a member may report client margin details to NSCCL is referred to as the sign off date. It shall be 2 working days after the trade day. g) Non submission of Client Margin Reporting Files
A penalty of Rs.200/- is charged to the members for each day of wrong reporting/ partial reporting or non reporting of client margin in the prescribed format as specified above, beyond 2 working days from the trade day. h) Short reporting of margins in Client Margin Reporting Files
The following penalty shall be levied in case of short reporting by trading/clearing member per instance. The amount of penalty shall vary as per the percentage of short reporting done by members as indicated below :
Percentage of short reporting (In terms of Value) < 1% > 1% but less than or equal to 20% >20 Penalty per instance Nil Reprimand Letter Rs. 1000 or 0.10% of the shortage amount whichever is higher subject to a maximum of Rs. 1,00,000/33 ANNA UNIVERSITY CHENNAI
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Summary The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. Clearing members may provide additional margin/collateral deposit (additional base capital) to NSCCL and/or may wish to retain deposits and/or such amounts which are receivable from NSCCL, over and above their minimum deposit requirements, towards initial margin and/ or other obligations. NSCCL has developed a comprehensive risk containment mechanism for the Futures & Options segment. The most critical component of a risk containment mechanism for NSCCL is the online position monitoring and margining system. The actual margining and position monitoring is done on-line, on an intra-day basis. NSCCL uses the SPAN (Standard Portfolio Analysis of Risk) system for the purpose of margining, which is a portfolio based system The objective of SPAN is to identify overall risk in a portfolio of futures and options contracts for each member. The system treats futures and options contracts uniformly, while at the same time recognizing the unique exposures associated with options portfolios like extremely deep out-of-the-money short positions, inter-month risk and inter-commodity risk. Because SPAN is used to determine performance bond requirements (margin requirements), its overriding objective is to determine the largest loss that a portfolio might reasonably be expected to suffer from one day to the next day PRISM (Parallel Risk Management System) is the real-time position monitoring and risk management system for the Futures and Options market segment at NSCCL. The risk of each trading and clearing member is monitored on a real-time basis and alerts/ disablement messages are generated if the member crosses the set limits. Questions (a) Explain the NSE Regulation over Minimum Base Capital of Clearing Member (b) What is the initial margin of Members for Derivative Trading? (c) Explain the Mechanics of SPAN (d) What is meant by Price Scan Range? (e) What do you mean by Client Margin Reporting? (f) How does the Clearing Corporation monitor the FII position limits at the end of each trading day?
UNIT III
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STRATEGIES
CHAPTER I
HEDGING STRATEGIES USING INDEX FUTURES
3.1.1 Introduction If a company knows that it has to sell a particular asset at a particular time in the future, it can hedge by taking a short position, therefore locking in the price of delivery. This is called a short hedge. Similarly, a company that knows that it will need an asset in the future can take a long hedge, thus locking in the price of purchase. It is very important to note that hedging does not necessarily improve the financial outcome, it just reduces the uncertainty. In practice, hedging is not perfect, the basis risk arises due to a number of reasons: The asset being hedged might be different that the one underlying the futures contract, i.e. using a 30y T-bill to hedge a 10y T-note; The hedger might be uncertain about the exact time that the delivery has to take place, i.e. a new oil ring that is expected to start extracting next summer, without knowing exactly when; and
3.1.2 S&P CNX Nifty S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. S&P CNX Nifty is owned and managed by India Index Services and Products Ltd. (IISL), hich is a joint venture between NSE and CRISIL. IISL is Indias first specialised company focused upon the index as a core product. IISL has a Marketing and licensing agreement with Standard & Poors (S&P), who are world leaders in index services. The traded value for the last six months of all Nifty stocks is approximately 48.15% of the traded value of all stocks on the NSE Nifty stocks represent about 59.32% of the total market capitalization as on June 30, 2008.
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Impact cost f the S&P CNX Nifty for a portfolio size of Rs.2 crore is 0.14% S&P CNX Nifty is professionally maintained and is ideal for derivatives trading 3.1.3 Trading in Nifty The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with index futures on June 12, 2000. The futures contracts on NSE are based on S&P CNX Nifty. The Exchange later introduced trading on index options based on Nifty on June 4, 2001. The turnover in the derivatives segment has shown considerable growth in the last year, with NSE turnover accounting for 60% of the total turnover in the year 2000-2001. Further details on index based derivatives are available under the Derivatives (F&O) section of the website. 3.1.4 S&P CNX Nifty Futures A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures contracts are based on the popular market benchmark S&P CNX Nifty index. (Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. 3.1.4.1 Eligibility Criteria for selection of Securities and Indices The eligibility of a stock / index for trading in Derivatives segment is based upon the criteria laid down by SEBI through various circulars issued from time to time. A) Eligibility criteria of stocks The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis. The stocks median quarter-sigma order size over the last six months shall be not less than Rs. 0.10 million (Rs. 1 lac). For this purpose, a stocks quarter-sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. The market wide position limit in the stock shall not be less than Rs. 500 million (Rs. 50 crores). The market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in
36
the month. The market wide position limit of open position (in terms of the number of underlying stock) on futures and option contracts on a particular underlying stock shall be 20% of the number of shares held by non-promoters in the relevant underlying security i.e. free-float holding. B) Continued Eligibility For an existing stock to become ineligible, the criteria for market wide position limit shall be relaxed upto 10% of the criteria applicable for the stock to become eligible for derivatives trading. To be dropped out of Derivatives segment, the stock will have to fail the relaxed criteria for 3 consecutive months. If an existing security fails to meet the eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that security. However, the existing unexpired contracts may be permitted to trade till expiry and new strikes may also be introduced in the existing contract months. C) Re-introduction of dropped stocks A stock which is dropped from derivatives trading may become eligible once again. In such instances, the stock is required to fulfill the eligibility criteria for three consecutive months to be re-introduced for derivatives trading. D) Eligibility criteria of Indices Futures & Options contracts on an index can be introduced only if 80% of the index constituents are individually eligible for derivatives trading. However, no single ineligible stock in the index shall have a weightage of more than 5% in the index. The index on which futures and options contracts are permitted shall be required to comply with the eligibility criteria on a continuous basis. SEBI has subsequently modified the above criteria, vide its clarification issued to the Exchange The Exchange may consider introducing derivative contracts on an index if the stocks contributing to 80% weightage of the index are individually eligible for derivative trading. However, no single ineligible stocks in the index shall have a weightage of more than 5% in the index. The above criteria is applied every month, if the index fails to meet the eligibility criteria for three months consecutively, then no fresh month contract shall be issued on that index, However, the existing unexpired contacts shall be permitted to trade till expiry and new strikes may also be introduced in the existing contracts.
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3.1.4.2 The following procedure is adopted for calculating the Quarter Sigma Order Size a) The applicable VAR (Value at Risk) is calculated for each security based on the J.R. Varma Committee guidelines. (The formula suggested by J. R. Varma for computation of VAR for margin calculation is statistically known as Exponentially weighted moving average (EWMA) method. In comparison to the traditional method, EWMA has the advantage of giving more weight to the recent price movements and less weight to the historical price movements.) b) Such computed VAR is a value (like 0.03), which is also called standard deviation or Sigma. (The meaning of this figure is that the security has the probability to move 3% to the lower side or 3% to the upper side on the next trading day from the current closing price of the security). c) Such arrived at standard deviation (one sigma), is multiplied by 0.25 to arrive at the quarter sigma. (For example, if one sigma is 0.09, then quarter sigma is 0.09 * 0.25 = 0.0225) a) From the order snapshots (taken four times a day from NSEs Capital Market Segment order book) the average of best buy price and best sell price is computed which is called the average price. b) The quarter sigma is then multiplied with the average price to arrive at quarter sigma price. The following example explains the same : a) Based on the order snapshot, the value of the order (order size in Rs.), which will move the price of the security by quarter sigma price in buy and sell side is computed. The value of such order size is called Quarter Sigma order size. (Based on the above example, it will be required to compute the value of the order (Rs.) to move the stock price to Rs. 306.00 in the buy side and Rs. 307.40 on the sell side. That is Buy side = average price quarter sigma price and Sell side = average price + quarter sigma price). Such an exercise is carried out for four order snapshots per day for all stocks for the previous six months period b) From the above determined quarter sigma order size (Rs.) for each order book snap shot for each security, the median of the order sizes (Rs.) for buy side and sell side separately, are computed for all the order snapshots taken together for the last six months. c) The average of the median order sizes for buy and sell side are taken as the median quarter sigma order size for the security. d) The securities whose median quarter sigma order size is equal to or greater than Rs. 0.1 million (Rs. 1 Lac) qualify for inclusion in the F&O segment. Futures & Options contracts may be introduced on new securities which meet the above mentioned eligibility criteria, subject to approval by SEBI.
38
New securities being introduced in the F&O segment are based on the eligibility criteria which take into consideration average daily market capitalization, average daily traded value, the market wide position limit in the security, the quarter sigma values and as approved by SEBI. The average daily market capitalisation and the average daily traded value would be computed on the 15th of each month, on a rolling basis, to arrive at the list of top 500 securities. Similarly, the quarter sigma order size in a stock would also be calculated on the 15th of each month, on a rolling basis, considering the order book snapshots of securities in the previous six months and the market wide position limit (number of shares) shall be valued taking the closing prices of stocks in the underlying cash market on the date of expiry of contract in the month. The number of eligible securities may vary from month to month depending upon the changes in quarter sigma order sizes, average daily market capitalisation & average daily traded value calculated every month on a rolling basis for the past six months and the market wide position limit in that security. Consequently, the procedure for introducing and dropping securities on which option and future contracts are traded will be as stipulated by SEBI. 3.1.4.3 Selection criteria for mini derivative contracts: Mini derivative contracts (Futures and options) shall be made available for trading on such indices/securities as specified by SEBI from time to time. 3.1.4.4 Eligibility criteria for long term option contracts SEBI has specifically permitted introduction of option contracts with longer tenure on S&P CNX Nifty index. 3.1.4.5 Selection criteria for unlisted companies For unlisted companies coming out with initial public offering, if the net public offer is Rs. 500 crs. or more, then the Exchange may consider introducing stock options and stock futures on such stocks at the time of its listing in the cash market. 3.1.4.6 Contract Specifications Security descriptor The security descriptor for the S&P CNX Nifty futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : NIFTY Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is S&P CNX Nifty Expiry date identifies the date of expiry of the contract 3.1.4.7 Underlying Instrument The underlying index is S&P CNX NIFTY.
NOTES
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3.1.4.8 Trading cycle S&P CNX Nifty futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. 3.1.4.9 Expiry day S&P CNX Nifty futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.4.10 Trading Parameters a) Contract size
The value of the futures contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of S&P CNX Nifty futures contracts is Re.0.05. c) Base Prices
Base price of S&P CNX Nifty futures contracts on the first day of trading would be theoretical futures price. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands
There are no day minimum/maximum price ranges applicable for S&P CNX Nifty futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. e) Quantity freeze
Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error
in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. f) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
NOTES
3.1.5 CNX Nifty Junior Futures A futures contract is a forward contract, which is traded on an Exchange. JUNIOR futures contracts would be based on the CNX Nifty Junior index. (Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. 3.1.5.1 Security descriptor The security descriptor for the CNX Nifty Junior futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : JUNIOR Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is CNX Nifty Junior Expiry date identifies the date of expiry of the contract 3.1.5.2 Underlying Instrument The underlying index is CNX NIFTY JUNIOR 3.1.5.3 Trading cycle JUNIOR futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively.
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3.1.5.4 Expiry day JUNIOR futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.5.5 Trading Parameters a) Contract size
The value of the futures contracts on JUNIOR may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of JUNIOR futures contracts is Re.0.05. c) Base Prices
Base price of JUNIOR futures contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands
Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. e) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
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3.1.6 Cnxit Futures A futures contract is a forward contract, which is traded on an Exchange. CNX IT Futures Contract would be based on the index CNX IT index. (Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. Contract Specifications Trading Parameters 3.1.6.1 Security descriptor The security descriptor for the CNX IT futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : CNXIT Expiry date : Date of contract xpiry Instrument type represents the instrument i.e. Futures on Index. Underlying ymbol denotes the underlying index which is CNXIT Expiry date identifies the ate of expiry of the contract 3.1.6.2 Underlying Instrument The underlying index is CNX IT. 3.1.6.3 Trading cycle CNX IT futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. 3.1.6.4 Expiry day CNX IT futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.6.5 Trading Parameters a) Contract size The value of the futures contracts on CNXIT may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time.
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b) Price steps The price step in respect of CNX IT futures contracts is Re.0.05. c) Base Prices Base price of CNX IT futures Contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands There are no day minimum/maximum price ranges applicable for CNX IT futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. e) Quantity freeze
Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. f) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
3.1.7 CNX 100 Futures A futures contract is a forward contract, which is traded on an Exchange. CNX100 futures contracts would be based on the CNX 100 index. (Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date.
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Contract Specifications Trading Parameters 3.1.7.1 Security descriptor The security descriptor for the CNX 100 futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : CNX100 Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is CNX 100 Expiry date identifies the date of expiry of the contract 3.1.7.2 Underlying Instrument The underlying index is CNX 100 3.1.7.3 Trading cycle CNX100 futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. 3.1.7.4 Expiry day CNX100 futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.7.5 Trading Parameters a) Contract size The value of the futures contracts on CNX100 may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of CNX100 futures contracts is Re.0.05. c) Base Prices Base price of CNX100 futures contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts.
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d) Price bands Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
3.1.8 BANK Nifty Futures A futures contract is a forward contract, which is traded on an Exchange. BANK Nifty futures Contract would be based on the index CNX Bank index. (Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. Contract Specifications Trading Parameters
3.1.8.1 Security descriptor The security descriptor for the BANK Nifty futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : BANKNIFTY Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is BANK Nifty. Expiry date identifies the date of expiry of the contract
3.1.8.2 Underlying Instrument The underlying index is BANK NIFTY. 3.1.8.3 Trading cycle BANKNIFTY futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. 3.1.8.4 Expiry day BANKNIFTY futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.8.5 Trading Parameters a) Contract size The value of the futures contracts on BANKNIFTY may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of BANKNIFTY futures contracts is Re.0.05. c) Base Prices Base price of BANKNIFTY futures Contracts on the first day of trading would be theoretical futures price.. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands There are no day minimum/maximum price ranges applicable for BANKNIFTY futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 10 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order.
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e) Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. f) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
3.1.9 Nifty Midcap 50 Futures A futures contract is a forward contract, which is traded on an Exchange. NFTYMCAP50 futures contracts would be based on the Nifty Midcap 50 index.(Selection criteria for indices) NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. Contract Specifications Trading Parameters
3.1.9.1 Security descriptor The security descriptor for the Nifty Midcap 50 futures contracts is: Market type : N Instrument Type : FUTIDX Underlying : NFTYMCAP50 Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying index which is Nifty Midcap 50 Expiry date identifies the date of expiry of the contract
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3.1.9.2 Underlying Instrument The underlying index is NIFTY MIDCAP 50. 3.1.9.3 Trading cycle NFTYMCAP50 futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). A new contract is introduced on the trading day following the expiry of the near month contract. The new contract will be introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market i.e., one near month, one mid month and one far month duration respectively. 3.1.9.4 Expiry day NFTYMCAP50 futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.9.5 Trading Parameters a) Contract size The value of the futures contracts on NFTYMCAP50 may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of NFTYMCAP50 futures contracts is Re.0.05. c) Base Prices Base price of NFTYMCAP50 futures contracts on the first day of trading would be theoretical futures price. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands e) Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason
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whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. f) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
3.1.10 Futures on Individual Securities A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in futures on individual securities on November 9, 2001. The futures contracts are available on 267 securities stipulated by the Securities & Exchange Board of India (SEBI). (Selection criteria for securities) NSE defines the characteristics of the futures contract such as the underlying security, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. Contract Specifications Trading Parameters
3.1.10.1 Security descriptor The security descriptor for the futures contracts is: Market type : N Instrument Type : FUTSTK Underlying : Symbol of underlying security Expiry date : Date of contract expiry Instrument type represents the instrument i.e. Futures on Index. Underlying symbol denotes the underlying security in the Capital Market (equities) segment of the Exchange Expiry date identifies the date of expiry of the contract 3.1.10.2 Underlying Instrument Futures contracts are available on 267 securities stipulated by the Securities & Exchange Board of India (SEBI). These securities are traded in the Capital Market segment of the Exchange.
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3.1.10.3 Trading cycle Futures contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). New contracts are introduced on the trading day following the expiry of the near month contracts. The new contracts are introduced for a three month duration. This way, at any point in time, there will be 3 contracts available for trading in the market (for each security) i.e., one near month, one mid month and one far month duration respectively. 3.1.10.4 Expiry day Futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 3.1.10.5 Trading Parameters a) Contract size The value of the futures contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction for the first time at any exchange. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of futures contracts is Re.0.05. c) Base Prices Base price of futures contracts on the first day of trading (i.e. on introduction) would be the theoretical futures price. The base price of the contracts on subsequent trading days would be the daily settlement price of the futures contracts. d) Price bands There are no day minimum/maximum price ranges applicable for futures contracts. However, in order to prevent erroneous order entry by trading members, operating ranges are kept at +/- 20 %. In respect of orders which have come under price freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation the Exchange may approve such order. e) Quantity freeze Orders which may come to the exchange as a quantity freeze shall be based on the notional value of the contract of around Rs.5 crores. Quantity freeze is calculated for each underlying on the last trading day of each calendar month and is applicable through the
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next calendar month. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limits. f) Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Spread order
Summary If a company knows that it has to sell a particular asset at a particular time in the future, it can hedge by taking a short position, therefore locking in the price of delivery. This is called a short hedge. Similarly, a company that knows that it will need an asset in the future can take a long hedge, thus locking in the price of purchase. It is very important to note that hedging does not necessarily improve the financial outcome, it just reduces the uncertainty S&P CNX Nifty is a well diversified 50 stock index accounting for 21 sectors of the economy. It is used for a variety of purposes such as benchmarking fund portfolios, index based derivatives and index funds. A futures contract is a forward contract, which is traded on an Exchange. NSE commenced trading in index futures on June 12, 2000. The index futures contracts are based on the popular market benchmark S&P CNX Nifty index. (Selection criteria for indices) The stock shall be chosen from amongst the top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basis. The stocks median quarter-sigma order size over the last six months shall be not less than Rs. 0.10 million (Rs. 1 lac). For this purpose, a stocks quarter-sigma order size shall mean the order size (in value terms) required to cause a change in the stock price equal to one-quarter of a standard deviation. A futures contract is a forward contract, which is traded on an Exchange. JUNIOR futures contracts would be based on the CNX Nifty Junior index. (Selection criteria for indices)
NSE defines the characteristics of the futures contract such as the underlying index, market lot, and the maturity date of the contract. The futures contracts are available for trading from introduction to the expiry date. Questions 1. Explain the eligibility criteria for selection of securities and Indices for Futures? 2. Explain the CNX Nifty Junior Futures 3. What do you understand about Nifty Midcap 50 Futures? 4. What are the Trading Parameters for FUTIDX? 5. What are the Contract Specifications for NIFTY MIDCAP 50?
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CHAPTER II
INTEREST RATE FUTURES
3.2.1 Introduction Interest Rate Futures Contracts are contracts based on the list of underlying as may be specified by the Exchange and approved by SEBI from time to time. To begin with, interest rate futures contracts on the following underlyings shall be available for trading on the F&O Segment of the Exchange : Notional T Bills Notional 10 year bonds (coupon bearing and non-coupon bearing)
The list of securities on which Futures Contracts would be available and their symbols for trading are as under :
S.No 1 2 3 Symbol Description
NSETB91D Futures contract on National 91 days T bill NSE10Y06 Futures contract on Notional 10 year coupon bearing bond
NSE10YZC Futures contract on Notional 10 year zero coupon bond
3.2.2 Security Descriptor The security descriptor for the interest rate future contracts is: Market type : N Instrument Type : FUTINT Underlying : Notional T- bills and Notional 10 year bond (coupon bearing and non-coupon bearing) Expiry Date : Last Thursday of the Expiry month. Instrument type represents the instrument i.e. Interest Rate Future Contract. Underlying symbol denotes the underlying. Expiry date identifies the date of expiry of the contract 3.2.3 Underlying Instrument Interest rate futures contracts are available on Notional T- bills , Notional 10 year zero coupon bond and Notional 10 year coupon bearing bond stipulated by the Securities & Exchange Board of India (SEBI).
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3.2.4 Trading cycle The interest rate future contract shall be for a period of maturity of one year with three months continuous contracts for the first three months and fixed quarterly contracts for the entire year. New contracts will be introduced on the trading day following the expiry of the near month contract. 3.2.5 Expiry day Interest rate future contracts shall expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts shall expire on the previous trading day. Further, where the last Thursday falls on the annual or half-yearly closing dates of the bank, the expiry and last trading day in respect of these derivatives contracts would be pre-poned to the previous trading day. 3.2.6 Product Characteristics
Contract underlying Contract descriptor Contract Value Lot size Tick size Expiry date Contract months Price limits Settlement Price Notional 10 year bond (6 % coupon ) N FUTINT NSE10Y06 26JUN2003 Rs.2,00,000 Notional 10 year zero coupon bond N FUTINT NSE10YZC 26JUN2003 Notional 91 day T-Bill N FUTINT NSETB91D 26JUN2003
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2000 Re.0.01 Last Thursday of the month The contracts shall be for a period of a maturity of one year with three months continuous contracts for the first three months and fixed quarterly contracts for the entire year. Not applicable As may be stipulated by NSCCL in this regard from time to time.
3.2.7 Trading Parameters 3.2.7.1 Contract size The permitted lot size for the interest rate futures contracts shall be 2000. The minimum value of a interest rate futures contract would be Rs. 2 lakhs at the time of introduction. 3.2.7.2 Price steps The price steps in respect of all interest rate future contracts admitted to dealings on the Exchange is Re.0.01.
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The Futures contracts having face value of Rs 100 on notional ten year coupon bearing bond and notional ten year zero coupon bond would be based on price quotation and Futures contracts having face value of Rs. 100 on notional 91 days treasury bill would be based on Rs. 100 minus (-) yield. 3.2.7.3 Base Price & operating ranges Base price of the Interest rate future contracts on introduction of new contracts shall be theoretical futures price computed based on previous days closing price of the notional underlying security. The base price of the contracts on subsequent trading days will be the closing price of the futures contracts. However, on such of those days when the contracts were not traded, the base price will be the daily settlement price of futures contracts. There will be no day minimum/maximum price ranges applicable for the futures contracts. However, in order to prevent / take care of erroneous order entry, the operating ranges for interest rate future contracts shall be kept at +/- 2% of the base price. In respect of orders which have come under price freeze, the members would be required to confirm to the Exchange that the order is genuine. On such confirmation, the Exchange at its discretion may approve such order. If such a confirmation is not given by any member, such order shall not be processed and as such shall lapse. 3.2.7.4 Quantity freeze Orders which may come to the Exchange as a quantity freeze shall be 2500 contracts amounting to 50,00,000 which works out on the day of introduction to approximately Rs 50 crores. In respect of such orders which have come under quantity freeze, the member shall be required to confirm to the Exchange that the order is genuine. On such confirmation, the Exchange at its discretion may approve such order subject to availability of turnover/ exposure limits, etc. If such a confirmation is not given by any member, such order shall not be processed and as such shall lapse. 3.2.7.5 Order type/Order book/Order attribute Regular lot order Stop loss order Immediate or cancel Good till day Good till cancelled* Good till date Spread order 2L and 3L orders
* Good till cancelled (GTC) orders shall be cancelled at the end of the period of 7 calendar days from the date of entering an order. 3.2.8 Clearing and Settlement 3.2.8.1 Settlement Procedure & Settlement Price Daily Mark to Market Settlement and Final settlement for Interest Rate Futures Contract Daily Mark to Market settlement and Final Mark to Market settlement in respect of admitted deals in Interest Rate Futures Contracts shall be cash settled by debiting/ crediting of the clearing accounts of Clearing Members with the respective Clearing Bank. All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on a day, shall be marked to market at the Daily Settlement Price (for Daily Mark to Market Settlement) and settled. All positions (brought forward, created during the day, closed out during the day) of a F&O Clearing Member in Futures Contracts, at the close of trading hours on the last trading day, shall be marked to market at Final Settlement Price (for Final Settlement) and settled. Daily Settlement Price shall be the closing price of the relevant Futures contract for the Trading day. Final settlement price for an Interest rate Futures Contract shall be based on the value of the notional bond determined using the zero coupon yield curve computed by National Stock Exchange or by any other agency as may be nominated in this regard. Open positions in a Futures contract shall cease to exist after its expiration day.
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3.2.8.2 Daily Settlement Price Daily settlement price for an Interest Rate Futures Contract shall be the closing price of such Interest Rate Futures Contract on the trading day. The closing price for an interest rate futures contract shall be calculated on the basis of the last half an hour weighted average price of such interest rate futures contract. In absence of trading in the last half an hour, the theoretical price would be taken or such other price as may be decided by the relevant authority from time to time. Theoretical daily settlement price for unexpired futures contracts, shall be the futures prices computed using the (price of the notional bond) spot prices arrived at from the applicable ZCYC Curve. The ZCYC shall be computed by the Exchange or by any other agency as may be nominated in this regard from the prices of Government securities traded on the Exchange or reported on the Negotiated Dealing System of RBI or both taking trades of same day settlement(i.e. t = 0).
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In respect of zero coupon notional bond, the price of the bond shall be the present value of the principal payment discounted using discrete discounting for the specified period at the respective zero coupon yield. In respect of the notional T-bill, the settlement price shall be 100 minus the annualized yield for the specified period computed using the zero coupon yield curve. In respect of coupon bearing notional bond, the present value shall be obtained as the sum of present value of the principal payment discounted at the relevant zero coupon yield and the present values of the coupons obtained by discounting each notional coupon payment at the relevant zero coupon yield for that maturity. For this purpose the notional coupon payment date shall be half yearly and commencing from the date of expiry of the relevant futures contract. For computation of futures prices from the price of the notional bond (spot prices) thus arrived, the rate of interest may be the relevant MIBOR rate or such other rate as may be specified from time to time. 3.2.8.3 Final Settlement Price for mark to market settlement of interest rate futures contracts Final settlement price for an Interest rate Futures Contract on zero coupon notional bond and coupon bearing bond shall be based on the price of the notional bond determined using the zero coupon yield curve computed as explained above. In respect of notional Tbill it shall be 100 minus the annualised yield for the specified period computed using the zero coupon yield curve. 3.2.8.4 Settlement value in respect of notional T-bill Since the T-bills are priced at 100 minus the relevant annualised yield, the settlement value shall be arrived at using the relevant multiplier factor. Currently it shall be 91/365 3.2.8.5 Settlement Schedule
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3.2.9 Interest Rate Derivatives - Risk Containment 3.2.9.1 Margins Initial Margins Computation of Initial Margin Exposure Limits (2nd line of defense) Trading Member wise/ Custodial Participant wise Position Limit 3.2.9.2 Initial Margins Initial margin shall be payable on all open positions of Clearing Members, upto client level, at any point of time, and shall be payable upfront by Clearing Members in accordance with the margin computation mechanism and/ or system as may be adopted by Clearing Corporation from time to time. Presently, the initial margins would be based on the zero coupon yield curve computed at the end of the day as explained above with trades of same day settlement (t =0). However, in case of large deviation between the yields generated using only t = 0 trades and all trades, initial margins revised accordingly may be computed and collected by the Clearing corporation from the members at its discretion. Initial Margin shall include SPAN margins and such other additional margins, that may be specified by Clearing Corporation from time to time. 3.2.9.3 Computation of Initial Margin Clearing Corporation will adopt SPAN (Standard Portfolio Analysis of Risk) system or any other system for the purpose of real time initial margin computation. Initial margin requirements shall be based on 99% value at risk over a one day time horizon. Provided, however, in the case of futures contracts, where it may not be possible to collect mark to market settlement value, before the commencement of trading on the next day, the initial margin may be computed over a two day time horizon, applying the appropriate statistical formula. The methodology for computation of Value at Risk percentage will be as per the recommendations of SEBI from time to time. 3.2.9.4 Initial margin requirement for a member: a) For client positions - shall be netted at the level of individual client and grossed across all clients, at the Trading/ Clearing Member level, without any setoffs between clients. b) For proprietary positions - shall be netted at Trading/ Clearing Member level without any set offs between client and proprietary positions.
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For this purpose, various parameters shall be as specified hereunder or such other parameters as may be specified by the relevant authority from time to time: (a) Price scan range In the case of Notional Bond Futures, the price scan range shall be 3.5 Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 2% of the notional value of the Futures Contracts, which shall be scaled up by look ahead period as may be specified from time to time. For Notional T-Bill Futures, the price scan range shall be 3.5 Standard Deviation (3.5 sigma) and in no case the initial margin shall be less than 0.2% of the notional value of the futures contract, which shall be scaled up by look ahead period as may be specified from time to time. (b) Calendar Spread Charge The margin on calendar spread shall be calculated at a flat rate of 0.125% per month of spread on the far month contract subject to a minimum margin of 0.25% and a maximum margin of 0.75% on the far side of the spread with legs upto 1 year apart. A Calendar spread positions will be treated as non-spread (naked) positions in the far month contract, 3 trading days prior to expiration of the near month contract. 3.2.9.5 Exposure Limits (2nd line of defense) Clearing Members shall be subject to Exposure limits in addition to initial margins. Exposure Limit shall be 100 times the liquid net worth i.e. 1% of the notional value of the gross open positions in Notional 10 year bond futures (both coupon bearing and zero coupons) and shall be 1000 times the liquid net worth i.e. 0.1% of the gross open positions in notional 91 day T-Bill futures. Exposure limit for calendar spreads: the Calendar spread shall be regarded as an open position of one third of the mark to market value of the far month contract. As the near month contract approaches expiry, the spread shall be treated as a naked position in the far month contract three days prior to the expiry of the near month contract 3.2.9.6 Trading Member wise/ Custodial Participant wise Position Limit Each Trading Member/ Custodial Participant shall ensure that his clients do not exceed the specified position limit. The position limits shall be at the client level and for near month contracts and shall be 15% of the open interest or Rs. 100 crores, whichever is higher. For futures contracts open interest shall be equivalent to the open positions in that futures contract multiplied by its last available closing price.
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CHAPTER III
CUURENCY FUTURES
3.3.1 Introduction A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. Over the years, most investors have not been careful in characterizing this risk to returns from unhedged portfolios. One simplistic view was to measure the return in domestic currency terms and compare it with returns in local currency terms, and characterize the difference as the currency effect. The reasoning was that if the exchange rate remains constant from the time of purchase of the foreign asset to its sale, then the currency risk has had zero impact. On the other hand, if the domestic currency has weakened (strengthened) against the foreign currency, the exposure would result in a gain (loss). In August 1998, the Association for Investment Management Research (AIMR) argued that the use of changes in spot exchange rates (over the investment period) as a measure of the influence of currency risk on foreign asset returns was misleading. AIMR preferred an alternate approach, one that involved splitting the currency effect into components: expected or known effect captured by forward premium or discount; and unexpected or surprise effect. In other words, currency surprise can be interpreted as the unexpected movement of the foreign currency relative to its forward rate or market predicted rate. The assumption here is that the forward premium or discount (expected currency effect) will be embedded in the return from a fully hedged portfolio. This implies that Unhedged foreign asset return (US$) = Currency surprise + Hedged foreign asset return (US$) Currency surprise is essentially noise. So every investor in foreign assets must make an explicit decision on whether or not he wants to take on exposure to this noise factor. 3.3.2 To Hedge or Not to Hedge? Over the years, there has been considerable controversy on this question. As might be expected, there are multiple view points regarding the relative merits of hedging away currency risks. Here are a couple of classic arguments in favor of not hedging. 3.3.3 Uncorrelated risks On a historical basis, changes in exchange rates (and hence currency returns) have had very low correlations with foreign equity and bond returns. The belief is that this lack of any systematic relationship could in theory lower portfolio risk.
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3.3.4 Expected returns are zero Viewed over a long investment horizon, currency movements cancel out each other the mean-reversion argument. In other words, exchange rates have an expected return of zero. So why bother hedging against currency surprise. The arguments in favor of hedging are as follows: 3.3.5 a) How long is the long-run? Financial planners advice their clients to pursue buy-and-hold strategies. If one trades with the attitude of investing for the long-run, ignoring short-term dynamics of currency returns could be a perfectly valid strategy. Folks who invest other peoples money, fund managers, though tend to be compensated on their quarterly performances relative to benchmark indices. In addition, there is sufficient evidence on the high turnover rates of actively managed fund portfolios. In such instances, it behooves the fund manager to take into account the impact of currency movements on the risk-return characteristics of his or her portfolio. Realized versus expected returns Currency returns tend to be episodic. In other words, there can be sufficient movement in exchange rates in the short run that in theory could be exploited to generate positive returns. More important, these movements also tend to exhibit some degree of persistence. 3.3.5 b) Risk-return trade-off A study by Bob Doyen compares risk and return from hedged and unhedged equity portfolios. It specifically looks at the MSCI EAFE Index for the period January 1980 to June 1999. (Morgan Stanley Capital International Europe, Australia, Far East Index is the most commonly cited international equity index.) Jan 1980 to Jun 1999 Annualized return Volatility Unhedged EAFE return in US$ 13.48% 17.52% Hedged (US$) EAFE return 13.51% 15.29% It vividly illustrates the zero impact of currency movements on asset returns over the long run. But it also presents sufficient evidence that hedging reduces the volatility of the return. From an efficient portfolio perspective, hedging does seem to be an attractive strategy. To conclude, whether foreign assets are being held for the short- or the long-run, it is apparent that hedging can help improve a fund managers performance and thus deliver value to investors. 3.3.6 Instruments for Hedging Currency Risk Foreign currency markets are deep, highly liquid, and relatively inexpensive. Fund managers seeking to manage their currency exposures can pursue one or more strategies: trade over-the-counter (OTC) market currency forwards and options, exchange-traded futures and options on futures, or hire the services of an overlay manager. Overlay managers are essentially specialist currency trading firms that will actively manage a currency hedge mandate, and in addition, attempt to generate a positive excess return. These firms too rely on currency futures, forwards and options contracts.
3.3.7 Exchange-Traded Currency Futures Exchange-traded currency products offer at least three major advantages vis-vis the inter-bank over-the-counter (OTC) market: 1. Price transparency and efficiency, 2. Elimination of counterparty credit risk, and 3. Accessibility for all Types of market participants. Price Transparency and Efficiency Futures and options exchanges bring together in one place divergent categories of buyers and sellers to determine foreign exchange prices. This efficient price discovery process is further enhanced by transparent trading arrangements. Whether the trading venue is open outcry or electronic, the prices for exchangetraded foreign currency products are disseminated worldwide via major quote vendors such as Reuters, Bloomberg, and others. Electronic trading on computerized trading systems (e.g., GLOBEX at Chicago Mercantile Exchange (CME) Inc.) takes place on a nearly 24-hour basis. Elimination of Counterparty Credit Risk Exchange-traded currency contracts have the exchange clearing house as the counterparty to every trade. For example, the CME Clearing House is the buyer to every seller and the seller to every buyer of all its currency products. Market participants then need not evaluate the credit worthiness of multiple counterparties. The CME Clearing House is their counterparty. All clearing members of the CME Clearing House stand behind trades at the exchange. Importantly, there has never been a single default in the 104-year history of the exchange. The OTC inter-bank market operates on the basis of credit limits for every potential counterparty. BIS requires banks to maintain adequate levels of capital to cover forward-maturity currency transaction risk. These requirements are waived for foreign exchange transactions booked on exchanges, where performance bonds are required and daily mark to market of open positions is done. 3.3.8 Accessible to All Market Participants The advent of financial futures began in the early 1970s because some inventive and persistent commodity traders at Chicago Mercantile Exchange did not have access to the inter-bank foreign exchange markets when they believed significant moves were about to take place in currency prices. They established the International Monetary Market (now a division of CME), which launched trading in seven currency futures contracts on May 16, 1972creating the worlds first financial futures. No longer was the arena of foreign exchange trading limited to large commercial banks and their big corporate customers. Individuals, small and medium-sized banks and corporations, investment funds and governments can buy and sell currencies for future delivery or cash settlement. Universal access to its markets is an important defining characteristic of exchange-traded foreign currency futures and options.
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3.3.9 Illustrating the Use of Currency Futures Example 1: Hedging Mexican Peso Foreign Currency Risk A U.S. hedge fund continues to find Mexican Treasury bill (CETES) yields attractive and decides to rollover an investment in CETES, whose principal plus interest at maturity in five months will be 850 million Mexican pesos (MP). Knowing that its all-in return is subject to U.S. dollar versus Mexican peso exchange rate risk, the U.S. hedge fund wanted to hedge its exposure of converting the CETES investment back into U.S. dollars. After assessing the available alternatives, the U.S. hedge fund chose to hedge with exchangetraded Mexican peso futures contracts. The trading unit of the Mexican peso futures is 500,000 MP. Therefore, on May 1st, the U.S. hedge fund sells 1,700 September 2003 Mexican peso futures at $0.08950 per MP (equivalent to 850 million MP). Over the course of the next five months the U.S. dollar exchange rate for the Mexican peso falls to $0.08600 per MP. As the Mexican peso futures price falls, the hedge funds trading account at its clearing member firm is credited the gains on the position by the exchange clearing house. The price move from US$0.08950 to US$0.08600 per Mexican peso on the short Mexican peso futures position represents a gain of US$0.00350 per Mexican peso. This is equal to a profit of US$1,750 per contract times 1,700 contracts for a net position gain of US$2,975,000. (For the purpose of these examples, calculations do not include brokerage or clearing fees that may be associated with exchange transactions.) This U.S. dollar profit when added to the U.S. dollars resulting from conversion of the Mexican pesodenominated CETES principal and interest into U.S. dollars at the lower dollar / peso exchange rate (of US$0.08600 per Mexican peso), results in an effective rate equivalent to the Mexican peso futures price at the start of the hedge. Example 2: Hedging equity portfolio risk using CME$INDEX futures contracts In recent months, CME has introduced a new dollar index futures contract. The CME$INDEX is a geometric index of seven foreign currencies, weighted to reflect the relative competitiveness of U.S. goods in foreign markets. It is designed to provide investors with a new instrument for currency market participation and risk management. Here is an example illustrating the use of CME$INDEX futures to hedge international equity portfolio risk. During the period January to February of 2003, a large U.S. pension fund invested in various overseas equity markets. Though the fund manager was comfortable with the near-term market risk of these individual countries, given the recent weakness in the US dollar, plus the impending war in Iraq, he sought to reduce portfolio risk by hedging a portion of the currency risk. The foreign investment portfolio was valued at approximately $100 million, and the manager believed that the U.S. dollar would not remain weak for an extended period of time. On March 11, 2003, the June CME$INDEX futures contract traded at 103.45. At this price, the notional value of each contract was $103,450. Since the fund manager wanted to hedge half of his currency exposure, he bought 483 dollar index contracts, a number which he derived by dividing $50 million by $103,450. In purchasing CME$INDEX futures
contracts, the fund manager took on a position that was long the U.S. dollar and short a basket of seven currencies, thereby hedging his exposure to the underlying currency risk. Scenario A Suppose that during mid-May 2003, the US dollar begins to reverse its course. By early June, the U.S. dollar is up 3.5% on average, and the pension fund has cut back on its exposure to overseas equity markets by 25%. The CME$INDEX June futures contract is now trading at 107.20 and if he so desires, the fund manager can sell 121 contracts at this price, or 25% of his 483 contract holdings, in order to book a gain of $453,750 on his currency hedge. In this instance, the unhedged portion of the portfolio would result in a loss due to the strengthening of the U.S. dollar. The remaining 362 ME$INDEX futures contracts could then be rolled over to the next quarterly contract. Scenario B Referencing Scenario A above, assume that the U.S. dollar instead remains weak and is down by 2% by early June. The fund manager can take physical delivery on 121 contracts, whereby he would receive US dollars and would pay the appropriate amount of each of the seven currencies in the index. (In a simple scenario, he would be using the foreign currency proceeds from the sale of various stocks to make these payments.) This hedge has simply reduced the potential gain from the US dollar weakness. During periods of intense market risk, issues related to hedging different risk factors become critical. This paper has focused on currency risks. We started with a complete definition of currency effect on foreign portfolio returns, and argued in favor of protecting against this risk. The main benefit of a full hedge would be in the form of a reduction in portfolio volatility. Fund managers can choose from a range of instruments to hedge their currency risks. The paper argues that exchange-traded futures contracts have certain advantages that make them suitable for managing single currency as well as multiple currency exposures, providing examples of hedging U.S. dollars versus Mexican pesos and hedging equity portfolio risk using the new CME$INDEX. 3.3.10 Summary A key difference between investing in domestic and foreign assets is that the latter exposes the investor to a currency risk. Over the years, most investors have not been careful in characterizing this risk to returns from unhedged portfolios. One simplistic view was to measure the return in domestic currency terms and compare it with returns in local currency terms, and characterize the difference as the currency effect. The reasoning was that if the exchange rate remains constant from the time of purchase of the foreign asset to its sale, then the currency risk has had zero impact. On the other hand, if the domestic currency has weakened (strengthened) against the foreign currency, the exposure would result in a gain (loss).
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Over the years, there has been considerable controversy on this question. As -might be expected, there are multiple view points regarding the relative merits of hedging away currency risks. Here are a couple of classic arguments in favor of not hedging. Financial planners advice their clients to pursue buy-and-hold strategies. If one trades with the attitude of investing for the long-run, ignoring short-term dynamics of currency returns could be a perfectly valid strategy. Folks who invest other peoples money, fund managers, though tend to be compensated on their quarterly performances relative to benchmark indices. In addition, there is sufficient evidence on the high turnover rates of actively managed fund portfolios. In such instances, it behooves the fund manager to take into account the impact of currency movements on the risk-return characteristics of his or her portfolio Questions 1 2 3 4 5 What do you understand by Currency Futures? What is the need for Currency Futures? Illustrate the use of Currency Futures What do you understand by Exchange-Traded Currency Futures? State its advantages What is meant by Risk-return trade-off?
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OPTIONS
CHAPTER I
OPTION MARKET
4.1.1 Introduction Futures and Forwards share a very important characteristic: when the delivery date arrives, the delivery must take place. The agreement is binding for both parties: the party with the short position has to deliver the goods, and the party with the long position has to pay the agreed price. Options give the party with the long position one extra degree of freedom: she can exercise the contracts if she wants to do so; whereas the short party have to meet the delivery if they are asked to do so. This makes options a very attractive way of hedging an investment, since they can be used as to enforce lower bounds on the financial losses. In addition, options offer a very high degree of gearing or leverage, which makes them attractive for speculative purposes too. 4.1.2 The Main Characteristics of a Option Contract a) The maturity : The time in the future, up to which the contract is valid;
b) The strike or exercise price : The delivery price. Remember that the long party will assess whether or not this price is better than the current market price. If so, then the option will be exercised. If not the option will be left to expire worthless; c) Call or put: The call option gives the long party the right to buy the underlying security at the strike price from the short party. The put option gives the long party the right to sell the underlying security at the strike price to the short party. The short party has to obey the long partys will; d) American or European: The American option gives the right to the long party to exercise the contract at any time they wish, up to the maturity date. If the option is European, it can be exercised on the maturity date only; and e) Details concerning the delivery. Apart from the plain vanilla contracts which are American or European, a lot of other exotic options have appeared recently, mostly as OTC contracts. These include Asian options, digital options, lookback options, etc. Traders have been rather imaginative when it comes to designing new derivative securities.
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Unlike the forward or futures contracts, and because of the payoff asymmetries, the initial value of an option, say, is not equal to zero. Apart from the above characteristics, the option price is generally affected by: a) The volatility [or uncertainty] of the underlying asset, from today up to the maturity date. In fact, it is common in the literature for option markets to be described as markets where volatility is traded; b) The level of the interest rates, in fact the whole term structure, and the stochastic behavior of them if they are unknown; c) The dividends, coupon payments, costs of storage, and other cash flows that are possible before the maturity date; and d) Commissions and the way the margin is marked. As an example of the payoff asymmetries, the profits from a long European call option position look typically like the ones given in figure. A great deal of time will be dedicated discussing how option contracts are priced.
European call option payoffs 4.1.3 The market participants Three kinds of dealers engage in market activities: hedgers, speculators and arbitrageurs. Each type of dealer has a different set of objectives, as discussed below. a) Hedgers: Hedging includes all acts aimed to reduce uncertainty about future [unknown] price movements in a commodity, financial security or foreign currency. This can be done by undertaking forward or futures sales or purchases of the commodity security or currency in the OTC forward or the organized futures market. Alternatively, the hedger can take out an option which limits the holders exposure to price fluctuations. b) Speculators: Speculation involves betting on the movements of the market and try to take advantage of the high gearing that derivative contracts offer, thus making windfall profits. In general, speculation is common in markets that exhibit substantial fluctuations over time. Normally, a speculator would take a bullish or bearish
view on the market and engage in derivatives that will profit her if this view materializes. Since in order to buy, say, a European call option one has to pay a minute fraction of the possible payoffs, speculators can attempt to materialize extensive profits. c) Arbitrageurs: They lock riskless profits by taking positions in two or more markets. They do not hedge nor speculate, since they are not exposed to any risks in the very first place. For example if the price of the same product is different in two markets, the arbitrageur will simultaneously buy in the lower priced market and sell in the higher priced one. In other situations, more complicated arbitrage opportunities might exist. Although hedging and [mainly] speculating are the reasons that have made derivatives [im]famous, the analysis of pricing them fairly depends solely on the actions of the arbitrageurs, since they ensure that price differences between markets are eliminated, and that products are priced in a consisted way. 4.1.4 Mini Option contracts on S&P CNX Nifty index A mini derivative option contract is similar to any other existing option contract except for the minimum contract size. Currently SEBI has prescribed a minimum contract value of not less than Rs 1 lac for mini derivative contracts as compared to Rs 2 lacs for normal derivative contracts. MINIFTY option contracts would be based on the S&P CNX Nifty index. (Selection criteria for mini derivative contracts) NSE defines the characteristics of the mini derivative option contracts such as the underlying index, market lot, and the maturity date of the contract. The option contracts are available for trading from introduction to the expiry date. The mini option contracts are European style and cash settled. 4.1.4.1 Contract Specifications The contract specifications for Mini Option contracts on S&P CNX Nifty index are exactly as applicable to the underlying S&P CNX Nifty index. The trading symbol for these contracts is MINIFTY. 4.1.4.2 Trading Parameters The trading specifications for Mini Option contracts on S&P CNX Nifty index are exactly as applicable to the underlying S&P CNX Nifty index. The value of the option contracts on MINIFTY may not be less than Rs. 1 lakhs at the time of introduction. The permitted lot size for future & option contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. 4.1.5 CNXIT OPTIONS An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which
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he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option. The options contracts are European style and cash settled and are based on the CNX IT index. (Selection criteria for indices) Contract Specifications Trading Parameters
4.1.5.1 Contract Specifications Security descriptor The security descriptor for the CNX IT options contracts is: Market type Instrument Type Underlying Expiry date Option Type :N : OPTIDX : CNXIT : Date of contract expiry : CE/ PE
Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on Index. Underlying symbol denotes the underlying index, which is CNXIT Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option., CE - Call European, PE Put European. 4.1.5.2 Underlying Instrument The underlying index is CNXIT. 4.1.5.3 Trading cycle CNX IT options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration.
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4.1.5.4 Expiry day CNX IT options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 4.1.5.5 Strike Price Intervals The number of contracts provided in options on the index is related to the range in which previous days closing value of the index falls as per the following table:
NOTES
Index Level
Strike Interval Scheme of strikes to be introduced (ITM-ATMOTM) upto 2000 25 4-1-4 >2001 upto 4000 50 4-1-4 >4001 upto 6000 50 5-1-5 >6000 50 6-1-6
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous days index close values, as and when required. In order to decide upon the at-the-money strike price, the index closing value is rounded off to the nearest applicable strike interval. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price. 4.1.5.6 Trading Parameters a) Contract size The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of CNX IT options contracts is Re.0.05. c) Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums.
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The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1)where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts. The closing price shall be calculated as follows: If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.
If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on BlackScholes model of calculation of options premiums. d) Price bands Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion,
not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. e) Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order
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4.1.6 CNX 100 Options An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option. The options contracts are European style and cash settled and are based on the popular market CNX 100 index. 4.1.6.1 Contract Specifications Security descriptor The security descriptor for the CNX Nifty Junior options contracts is: Market type : N Instrument Type : OPTIDX Underlying : CNX 100 Expiry date : Date of contract expiry Option Type : CE/ PE Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on Index. Underlying symbol denotes the underlying index, which is CNX 100 Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option., CE - Call European, PE Put European. 4.1.6.2 Underlying Instrument The underlying index is CNX 100
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4.1.6.3 Trading cycle CNX100 options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration. 4.1.6.4 Expiry day CNX100 options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 4.1.6.5 Strike Price Intervals The number of contracts provided in options on the index is related to the range in which previous days closing value of the index falls as per the following table:
Index Level
Strike Interval 25 50 50 50
upto 2000 >2001 upto 4000 >4001 upto 6000 >6000
Scheme of strikes to be introduced (ITM-ATMOTM) 4-1-4 4-1-4 5-1-5 6-1-6
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous days index close values, as and when required. In order to decide upon the at-the-money strike price, the index closing value is rounded off to the nearest applicable strike interval. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price. 4.1.6.6 Trading Parameters a) Contract size The value of the option contracts on CNX100 may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of CNX 100 options contracts is Re.0.05.
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c) Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts. The closing price shall be calculated as follows: If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.
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If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on BlackScholes model of calculation of options premiums.
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d) Price bands Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. e) Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order
4.1.7 BANKNIFTY OPTIONS An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.
The options contracts are European style and cash settled and are based on the BANK NIFTY index. 4.1.7.1 Contract Specifications Security descriptor The security descriptor for the BANKNIFTY options contracts is: Market type Instrument Type Expiry date Option Type :N : OPTIDXUnderlying : BANKNIFTY : Date of contract expiry : CE/ PE
Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on Index. Underlying symbol denotes the underlying index, which is BANKNIFTY
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Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option., CE - Call European, PE Put European. 4.1.7.2 Underlying Instrument The underlying index is BANK NIFTY. 4.1.7.3 Trading cycle BANKNIFTY options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration. 4.1.7.4 Expiry day BANKNIFTY options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 4.1.7.5 Strike Price Intervals The number of contracts provided in options on the index is related to the range in which previous days closing value of the index falls as per the following table:
NOTES
Index Level upto 2000 >2001 upto 4000 >4001 upto 6000 >6000
Scheme of strikes to be introduced (ITM-ATM-OTM) 4-1-4 4-1-4 5-1-5 6-1-6
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous days index close values, as and when required. In order to decide upon the at-the-money strike price, the index closing value is rounded off to the nearest applicable strike interval. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price. 4.1.7.6 Trading Parameters a) Contract size The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time.
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b) Price steps The price step in respect of BANK Nifty options contracts is Re.0.05. c) Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts. The closing price shall be calculated as follows: If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.
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If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on BlackScholes model of calculation of options premiums. d) Price bands Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. e) Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order
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4.1.8 NIFTY MIDCAP 50 OPTIONS An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option. The options contracts are European style and cash settled and are based on the popular market Nifty Midcap 50 index.
4.1.8.1 Contract Specifications Security descriptor The security descriptor for the Nifty Midcap 50 options contracts is: Market type : N Instrument Type : OPTIDX Underlying : NFTYMCAP50 Expiry date : Date of contract expiry Option Type : CE/ PE
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Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on Index. Underlying symbol denotes the underlying index, which is Nifty Midcap 50 Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option., CE - Call European, PE Put European. 4.1.8.2 Underlying Instrument The underlying index is NIFTY MIDCAP 50 4.1.8.3 Trading cycle NFTYMCAP50 options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration. 4.1.8.4 Expiry day NFTYMCAP50 options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 4.1.8.5 Strike Price Intervals The number of contracts provided in options on the index is related to the range in which previous days closing value of the index falls as per the following table:
Index Level
upto 2000 >2001 upto 4000 >4001 upto 6000 >6000
Scheme of strikes to be introduced (ITMATM-OTM) 4-1-4 4-1-4 5-1-5 6-1-6
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous days index close values, as and when required. In order to decide upon the at-the-money strike price, the index closing value is rounded off to the nearest applicable strike interval. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price.
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4.1.8.6 Trading Parameters a) Contract size The value of the option contracts on NFTYMCAP50 may not be less than Rs.2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of NFTYMCAP50 options contracts is Re.0.05. c) Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts. The closing price shall be calculated as follows:
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If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.
If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on BlackScholes model of calculation of options premiums. d) Price bands Quantity freeze Orders which may come to the exchange as quantity freeze shall be such that have a quantity of more than 15000. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limit. In all other cases, quantity freeze orders shall be cancelled by the Exchange. e) Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order
4.1.9 Options on Individual Securities An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short in the option.
NSE became the first exchange to launch trading in options on individual securities. Trading in options on individual securities commenced from July 2, 2001. Option contracts are American style and cash settled and are available on 267 securities stipulated by the Securities & Exchange Board of India (SEBI).
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4.1.9.1 Contract Specifications Security descriptor The security descriptor for the options contracts is: Market type : N Instrument Type : OPTSTK Underlying : Symbol of underlying security Expiry date : Date of contract expiry Option Type : CA / PA Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on individual securities. Underlying symbol denotes the underlying security in the Capital Market (equities) segment of the Exchange Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option., CA - Call American, PA - Put American. 4.1.9.2 Underlying Instrument Option contracts are available on 267 securities stipulated by the Securities & Exchange Board of India (SEBI). These securities are traded in the Capital Market segment of the Exchange. 4.1.9.3 Trading cycle Options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration. 4.1.9.4 Expiry day Options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. 4.1.9.5 Strike Price Intervals The Exchange provides a minimum of seven strike prices for every option type (i.e Call & Put) during the trading month. At any time, there are three contracts in-the-money (ITM), three contracts out-of-the-money (OTM) and one contract at-the-money (ATM).
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4.1.9.6 The Strike Price Interval Price of Underlying Less than or equal to Rs. 50 > Rs.50 to less than or equal to Rs. 250 > Rs.250 to less than or equal to Rs. 500 > Rs.500 to less than or equal to Rs. 1000 > Rs.1000 to less than or equal to Rs. 2500 > Rs.2500 50 Strike Price interval (Rs.) 2.50 5 10 20 30
New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous days underlying close values, as and when required. In order to decide upon the at-the-money strike price, the underlying closing value is rounded off to the nearest strike price interval. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price interval. 4.1.9.7 Trading Parameters a) Contract size The value of the option contracts on individual securities may not be less than Rs. 2 lakhs at the time of introduction for the first time at any exchange. The permitted lot size or futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. b) Price steps The price step in respect of the options contracts is Re.0.05. c) Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and the price for a Put is : P = X * e- rt * N (-d2) - S * N (-d1) where : d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t) d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t)
C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e (2.71828182845904). Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days, will be the daily close price of the options contracts. The closing price shall be calculated as follows: If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.
NOTES
If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on BlackScholes model of calculation of options premiums. d) Price bands Quantity freeze Orders which may come to the exchange as a quantity freeze shall be based on the notional value of the contract of around Rs.5 crores. Quantity freeze is calculated for each underlying on the last trading day of each calendar month and is applicable through the next calendar month. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limits.
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e) Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order
OPTION Permitted lot size
Underlying BANK Nifty CNX 100 CNX IT CNX Nifty Junior Nifty Midcap 50 S&P CNX Nifty S&P CNX Nifty Derivatives on Individual Securities 3I Infotech Ltd. Aban Offshore Ltd. Abb Ltd. Aditya Birla Nuvo Limited Adlabs Films Ltd Aia Engineering Limited Allahabad Bank Alok Industries Ltd. Alstom Projects India Ltd Ambuja Cements Ltd. Amtek Auto Ltd. Andhra Bank Ansal Prop & Infra Ltd Aptech Limited Arvind Limited Ashok Leyland Ltd Associated Cement Co. Ltd.
Symbol BANKNIFTY CNX100 CNXIT JUNIOR NFTYMCAP50 NIFTY MINIFTY Symbol 3IINFOTECH ABAN ABB ABIRLANUVO ADLABSFILM AIAENG ALBK ALOKTEXT APIL AMBUJACEM AMTEKAUTO ANDHRABANK ANSALINFRA APTECHT ARVIND ASHOKLEY ACC
Market Lot 25 50 50 25 75 50 20 Market Lot 2700 50 250 200 225 200 2450 3350 200 2062 600 2300 1300 650 4300 4775 188
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Underlying Aurobindo Pharma Ltd. Axis Bank Ltd. Bajaj Auto Limited Bajaj Hindustan Ltd. Bajaj Holdings & Investment Ltd. Ballarpur Industries Limited Balrampur Chini Mills Ltd. Bank Of Baroda Bank Of India Bata India Ltd. Bharat Earth Movers Ltd. Bharat Electronics Ltd. Bharat Forge Co Ltd Bharat Heavy Electricals Ltd. Bharat Petroleum Corporation Ltd. Bharti Airtel Ltd Bhushan Steel & Strips Lt Biocon Limited. Birla Corporation Ltd Bombay Dyeing & Mfg. Co Ltd. Bombay Rayon Fashions Ltd Bongaigaon Refinery Ltd. Brigade Enterprises Ltd. Cairn India Limited Canara Bank Central Bank Of India Century Textiles Ltd Cesc Ltd. Chambal Fertilizers Ltd. Chennai Petroleum Corporation Ltd. Cipla Ltd. Cmc Ltd. Symbol AUROPHARMA AXISBANK BAJAJ-AUTO BAJAJHIND BAJAJHLDNG BALLARPUR BALRAMCHIN BANKBARODA BANKINDIA BATAINDIA BEML BEL BHARATFORG BHEL BPCL BHARTIARTL BHUSANSTL BIOCON BIRLACORPN BOMDYEING BRFL BONGAIREFN BRIGADE CAIRN CANBK CENTRALBK CENTURYTEX CESC CHAMBLFERT CHENNPETRO CIPLA CMC Market Lot 700 225 200 950 250 7300 2400 700 950 1050 125 138 1000 75 550 250 250 450 850 300 1150 2250 550 1250 800 2000 212 550 3450 900 1250 200
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Underlying Colgate Palmolive Ltd Corporation Bank Crompton Greaves Ltd. Cummins India Ltd Dabur India Ltd. Deccan Aviation Limited Dena Bank Develop Credit Bank Ltd Divi'S Laboratories Ltd. Dlf Limited Dr. Reddy'S Laboratories Ltd. Edelweiss Capital Ltd Educomp Solutions Ltd Escorts India Ltd. Essar Oil Ltd. Everest Kanto Cylinder Ltd Federal Bank Ltd. Financial Technologies (I) Ltd Gail (India) Ltd. Gateway Distriparks Ltd. Gitanjali Gems Limited Glaxosmithkline Pharma Ltd. Gmr Infrastructure Ltd. Grasim Industries Ltd. Great Offshore Ltd Gtl Ltd. Gujarat Alkalies & Chem Gujarat Narmada Fertilizer Co. Ltd. Havells India Limited Hcl Technologies Ltd. Hdfc Bank Ltd. Hero Honda Motors Ltd. Symbol COLPAL CORPBANK CROMPGREAV CUMMINSIND DABUR AIRDECCAN DENABANK DCB DIVISLAB DLF DRREDDY EDELWEISS EDUCOMP ESCORTS ESSAROIL EKC FEDERALBNK FINANTECH GAIL GDL GITANJALI GLAXO GMRINFRA GRASIM GTOFFSHORE GTL GUJALKALI GNFC HAVELLS HCLTECH HDFCBANK HEROHONDA Market Lot 550 600 500 475 2700 850 2625 1400 155 400 400 250 75 2400 1412 1000 851 150 750 2500 500 300 1250 88 250 750 1400 1475 400 650 200 400
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Underlying Hindalco Industries Ltd. Hinduja Ventures Ltd. Hindustan Construction Co Hindustan Oil Exploration Hindustan Petroleum Corporation Ltd. Hindustan Unilever Ltd Hindustan Zinc Limited Hotel Leela Ventures Ltd Housing Development And Infrastructure Ltd. Housing Development Finance Corporation Ltd. ibn18 Broadcast Limited Icici Bank Ltd. Idea Cellular Ltd. Ifci Ltd. I-Flex Solutions Ltd. India Cements Ltd. India Infoline Limited Indian Bank Indian Hotels Co. Ltd.
Symbol HINDALCO HINDUJAVEN HCC HINDOILEXP HINDPETRO HINDUNILVR HINDZINC HOTELEELA HDIL HDFC IBN18 ICICIBANK IDEA IFCI I-FLEX INDIACEM INDIAINFO INDIANB INDHOTEL
Market Lo 1759 500 1400 1600 1300 1000 250 3750 516 75 1250 175 2700 1970 150 725 1250 1100 1899 600 1475 1925 1200 150 200 1475
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Indian Oil Corporation Ltd. IOC Indian Overseas Bank IOB Indusind Bank Ltd. INDUSINDBK Industrial Development Bank Of India IDBI Ltd. Info Edge (I) Ltd NAUKRI Infosys Technologies Ltd. INFOSYSTCH Infrastructure Development Finance IDFC Company Ltd.
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Summary Futures and forwards share a very important characteristic: when the delivery date arrives, the delivery must take place. The agreement is binding for both parties: the party with the short position has to deliver the goods, and the party with the long position has to pay the agreed price. A mini derivative option contract is similar to any other existing option contract except for the minimum contract size. An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. Options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. Orders which may come to the exchange as a quantity freeze shall be based on the notional value of the contract of around Rs.5 crores. Quantity freeze is calculated for each underlying on the last trading day of each calendar month and is applicable through the next calendar month. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. Questions 1. What are the main characteristics of Option Contract? Explain 2. Who are the Market Participants in Option Market? 3. Explain the Mini Option contracts on S&P CNX Nifty index 4. What do you understand by Strike Price Intervals? 5. Explain the Options on Individual Securities
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CHAPTER II
FINANCIAL SWAPS MARKET
4.2.1 Introduction A Swap is an agreement between two parties, called Counterparties, who exchange cash flows over a period of time in the future. When exchange rate and Interest rates fluctuate, risks of forward and money market positions are so great that the forward market & money market may not function properly. Currency futures and options are inflexible and available only for selected currencies. In such cases, MNCs & governments may use swap arrangements to protect the value of export sales, import orders and outstanding loans dominated in foreign currencies. 4.2.2 There are Three Basic Motivations for Swaps: Firms use swaps to provide protection against future changes in exchange rates and interest rates. Firms use swaps to eliminate interest-rate risks arising from normal commercial operations 4.2.3 Firms use Swaps to Reduce Financing Costs Financial swaps are now used by Multinational companies, commercial banks, world organizations and sovereign governments to minimize currency and interest-rate risks. Thus swaps have become another risk management tool along with currency forwards, futures and options. The origins of swap market can be traced back to 1970s when traders developed currency swaps to evade British controls on movement of foreign currency. The market has grown rapidly ever since and in year 2002 about $44 trillion was traded via swaps 4.2.4 Parallel Loans A Parallel Loan refers to a loan which involves an exchange of currencies between 4 parties, with a promise to re-exchange the currencies at a predetermined exchange rate on a specified future date. Typically, the parties consist of two pairs of affiliated companies. Parallel loans are commonly arranged by two multinational parent companies in two different countries. The structure of a typical parallel loan is illustrated in the following example.
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IBM in USA with a subsidiary in Italy wants to obtain a one year Lira loan for its subsidiary. Olivetti in Italy wishes to invest in US via a loan to its US subsidiary. With a Parallel loan, these loans can be arranged without currency crossing the national border. IBM lends $10M to Olivettis US subsidiary at US interest rates. Olivetti in return lends $10M in Lira to IBMs Italian subsidiary. 4.2.5 Back-to-Back Loans Bank to back loan involves an exchange of currencies between two parties, with a promise to re-exchange the currencies at a specified rate on a specified future date. Back to back loans involve two companies domiciled in two different countries. For example, IBM borrows money in US dollars and lends the borrowed funds to Olivetti in Italy, which in return borrows funds in Italy and lends those funds to IBM in the United States. By this simple arrangement, each firm has access to capital markets in foreign country and makes use of their comparative advantage of borrowing in different capital markets. 4.2.6 Drawbacks of parallel and back to back loans The difficulty in finding counterparties with matching needs. Firms must find firms with mirror-image financing needs. Financing requirements include principals, types of interest payments, frequency of interest payments, and length of the loan period. The search cost for finding such counterparty is quite considerable. One is still obligated to comply with the loan terms even when the other defaults. In the above example, IBM is still liable for the loan even if Olivetti defaults. To avoid default risks, a separate agreement defining the right of offset must be drafted. The loans are carried on the accounting books of both the firms. This limits additional borrowing and hence limits the leverage of these firms. Swaps on the other hand overcome the above drawbacks by:
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Making it easier to find counterparties via swap brokers. Defining an offset agreement as a part of the swap. Principal amounts in a swap do not appear on the accounting books. These off book transactions help banks avoid increases in their capital requirements under applicable regulations As a result, Swaps are very popular financial instruments. In 2000, the size of world swap market was greater than $25 billion 4.2.7 Swap Banks Financial institutions which assist in the completion of a swap is called Swap Bank. The swap bank makes profits from the bid-ask spread it imposes on the swap coupon. A Swap broker is a swap bank who acts strictly as an agent without taking any financial position in the swap transaction, i.e., mearly matches counterparties and does not assume any risk of a swap. A Swap Dealer is a swap bank who actually transacts for its own account to help complete the swap. In this capacity, the swap dealer assumes a position in the swap and thus assumes certain risks. 4.2.8 Types of Swaps 4.2.8.1 Plain Vanilla Swaps It is the simplest kind of swaps. Here two counterparties agree to make payments to each other on the basis of some underlying assets. These payments include interest payments, commissions and other service payments. The swap agreement contains specifications of the assets to be exchanged, the rate of interest applicable to each, the timetable by which the payments are to be made and other provisions. The two parties may or may not exchange the underlying assets, which are called Notional Principals, in order to distinguish them from physical exchanges in the cash markets. 4.2.8.2 Interest Rate Swaps An interest rate swap is a swap in which counterparties exchange cash flows of a floating rate for cash flows of a fixed rate or vice-versa. No notional principal changes hands, but it is a reference amount against which interest is calculated. Interest swaps can be international or purely domestic. 4.2.8.3 The Most Common Motive for Interest Rate Swaps are: Changes in financial markets may cause interest rates to change Borrowers may have different credit ratings in different countries
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Borrowers have different preferences for debt service payment schedule Interest rate swaps are normally arranged by an international bank which serves as a swap broker or a swap dealer. Through interest rate swaps, borrowers obtain a lower cost of debt service payments and lenders obtain profit guarantees. 4.2.8.4 Currency Swaps A Currency swap is a swap in which one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount in a different currency. For example, An US firm wants to exchange its Dollars for Italian Lira while an Italian firm want to exchange Lira to US dollars. Given these two needs, the two may engage in a swap deal. Currency swap is similar to parallel loans, but swaps are better due to: Ease of finding counterparties The right to offset the loan payments Off books transactions. 4.2.9 Swaptions, Caps, Floor and Collars A swaption is an option to enter into a plain vanilla swap. A Call swaption gives the holder the right to receive fixed-interst payments. A put swaption gives the holder the right to make fixed interest payments. Call swaptions are attractive when interest rates are expected to fall. Put swaptions are attractive when interest rates are expected to rise. Banks & investment firms usually act as dealers rather than as brokers. An interest rate cap sets the maximum rate of interest on floating rate interest payments; An interest rate floor set the minimum rate of interest on a floating rate interest payments; and an interest rate collar combines a cap with a floor. A buyer of these instruments pays a one time premium, which is a small percentage of the notional capital. 4.2.10 Motivation for Swaps There are three basic motivations for swaps. First, companies use swaps to provide protection against future changes in exchange rates. Second, Companies use swaps to eliminate interest rate risks arising from normal commercial operations. Third, companies use swaps to reduce financing costs. 4.2.11 Closing Thoughts Swap market has emerged largely because financial swaps escape many of the limitations inherent in currency futures and options markets. Swaps are custom tailored to the needs of two parties; swap agreements are more likely to meet the specific needs of
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the counterparties than currency futures and options. Swap market is done via financial institutions and offers privacy when compared to foreign exchange markets. Lastly swaps are not as highly regulated as options and futures markets 4.2.12 Interest Rate Swaps One of the largest components of the global derivatives markets and a natural adjunct to the fixed income markets is the interest rate swaps market. Understanding the over-thecounter swaps market can give a deeper insight into the capital flows that drive the bond markets, the way in which the companies whose stock investor manage their exposure to fluctuations in interest rates and the way banks and financial institutions make a great deal of their income. Simply put, it is the exchange of one set of cash flows for another. A pre-set index, notional amount and set of dates of exchange determine each set of cash flows. The most common type of interest rate swap is the exchange of fixed rate flows for floating rate flows. Differences in the credit quality between entities borrowing money motivate the interest rate swap market. Specifically, some agents may have a better borrowing profile in the short maturities than they do in the long maturities. Other agents (with more creditworthy status) have a comparative advantage raising money in the longer maturities. A counter-partys creditworthiness is an assessment of their ability to repay money lent to them over time. If a company has a good credit rating, they are more likely to be able to pay back a loan over time than a company with a poor credit rating. This effect is magnified with time. By making it easier for less creditworthy agents to borrow in the short term than in the long term, lenders make sure that they are less exposed to this risk. Therefore, we would expect that in fixed-floating interest rate swaps, the entity paying fixed and receiving floating is usually the less creditworthy of the two counterparties. The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entitys relative advantage in raising funds in the shorter maturity buckets. As we shall see in a later article, this arbitrage opportunity is expanded when we consider agents who can borrow money in a number of different currencies. In that case, we can think of a matrix of currency and maturity to describe an entitys relative arbitrate opportunities. This can be addressed using currency swaps. Of course, fixed-floating interest rate swaps are not the only kinds of interest rate swaps we can construct. Any kind of interest rate swap is possible, as long as the two counter-parties can come up with differing indices. We could imagine a swap in which there are two different kinds of floating indices or another in which there are two different kinds of fixed indices.
In subsequent articles, we shall also see how swaps can be constructed using equity indices and commodity indices and the rationale for using these structures instead of outright purchases of the underlying equities and commodities. How do we value swaps? There are several steps: a) Identify the cash flows. To simplify things, many people draw diagrams with inflows and outflows of funds over time. b) Construct the swap curve, obtained from the government yield curve and the swap spread curve. c) Construct a zero-coupon curve from the swap curve. (See the Fixed Income section). d) Present value the cash flows using the zero-coupon rates. The swap spread is obtained from market makers. It is the market-determined additional yield that compensates counter-parties who receive fixed payments in a swap for the credit risk involved in the swap. The swap spread will differ with the creditworthiness of the counter-party. Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money. Most swaps are priced to be at-the-money at inception meaning that the value of the floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving the fixed rate flow will become more valuable than receiving the floating rate flow if interest rates drop or if credit spreads tighten. Investment banks and commercial banks are the market makers for most of these swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate risk of the cash flows. As you can imagine, the management of these risks can be very complex with swaps maturing on a daily basis and the difficulties of managing a variety of similar but not identically matched products. 4.2.13 Currency Swaps In the case of a currency swap, principal exchange is not redundant. The exchange of principal on the notional amounts is done at market rates, often using the same rate for the transfer at inception as is employed at maturity. For example, consider the US-based company (Acme Tool & Die) that has raised money by issuing a Swiss Franc-denominated Eurobond with fixed semi-annual coupon payments of 6% on 100 million Swiss Francs. Upfront, the company receives 100 million Swiss Francs from the proceeds of the Eurobond issue (ignoring any transaction fees, etc.). They are using the Swiss Francs to fund their US operations.
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Why issue bonds in Swiss Francs? The only rationale for doing this is because there are investors with Swiss Franc funds who are looking to diversify their portfolios with US credits such as Acmes. They are willing to buy Acmes Eurobonds at a lower yield than Acme can issue bonds in the US. A Eurobond is any bond issued outside of the country in whose currency the bond is denominated. Because this issue is funding US-based operations, we know two things straightaway. Acme is going to have to convert the 100 million Swiss Francs into US dollars. And Acme would prefer to pay its liability for the coupon payments in US dollars every six months. Acme can convert this Swiss Franc-denominated debt into a US dollar-like debt by entering into a currency swap with the First London Bank. Acme agrees to exchange the 100 million Swiss Francs at inception into US dollars, receive the Swiss Franc coupon payments on the same dates as the coupon payments are due to Acmes Eurobond investors, pay US dollar coupon payments tied to a pre-set index and re-exchange the US dollar notional into Swiss Francs at maturity. Acmes US operations generate US dollar cash flows that pay the US-dollar index payments. Currency swaps are used to hedge or lock-in the value-added of issuing Eurobonds. They are often negotiated as part of the whole issuance package with the main issuing financial institution. 4.2.14 Flexibility Currency swaps give companies extra flexibility to exploit their comparative advantage in their respective borrowing markets. Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the long-end of the maturity spectrum. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities. The success of the currency swap market and the success of the Eurobond market are explicitly linked. 4.2.15 Exposure Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap.
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Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currencys notional against the other currencys notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain. This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange. This explains why currency swaps tie up greater credit lines than regular interest rate swaps. Currency swaps allow companies to exploit the global capital markets more efficiently. They are an integral arbitrage link between the interest rates of different developed countries. The future of banking lies in the securitization and diversification of loan portfolios. The global currency swap market will play an integral role in this transformation. Banks will come to resemble credit funds more than anything else, holding diversified portfolios of global credit and global credit equivalents with derivative overlays used to manage the variety of currency and interest rate risk. 4.2.16 Hedging Swaps Dealers at commercial banks do most of the market making that is done in the interest rate swap and currency swap markets. In addition to making markets to their customers, these traders will also make prices to other financial institutions in the wholesale or interbank market, often in transactions facilitated by interbank brokers. In any given day, the dealer at the bank may engage in several transactions or several dozen transactions, all of which are added to his general position. The combination of all of the different swaps and bond trades and futures trades that the dealer has conducted constitutes a portfolio. While it may be easier for us to understand intuitively the way in which the dealer manages the risk of an individual swap transaction, in practice this is prohibitively difficult and it does not take advantage of the natural hedges within the portfolio. Therefore, the swaps dealer will manage the risks of his position using portfolio management techniques that are similar to but more sophisticated than the portfolio management techniques used for a simple cash position in fixed income or equities. In portfolio hedging, the dealers objective is to construct a portfolio of hedges using swaps, forward rate agreements (FRAs), futures and bonds the changes in value of which offsets the change in value of the underlying swap portfolio for a given set of fluctuations in interest rates, currency rates or basis between the futures and the bonds.
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4.2.17 Identifying the risk of the swaps portfolio The first necessary step in hedging the swaps portfolio is to measure the risk of the swaps portfolio. Namely, the dealer must answer a series of questions. How much will the portfolio lose on a mark-to-market basis if interest rates move up in a parallel fashion (i.e. all interest rates increase by the same amount) by 50 basis points? How much will the portfolio lose on a mark-to-market basis if interest rates fall in a parallel fashion by 50 basis points? How much will the portfolio lose if the spread between the 30-year government bond and the 2-year government note increases by 25 basis points? How will the positions sensitivity to interest rates change if the level of interest rates change? Cash flows are grouped in maturity buckets (or intervals of consecutive maturity). One example might be all of the cash flows from 1 year to 1 year and 3 months. Another example might be all of the cash flows from 29 years to maturity to 30 years to maturity. These grouped cash flows are then valued at market rates. Doing so enables the dealer to get a true picture of the cash flows local sensitivity to market rates. The sensitivity of the portfolio maturity bucket may be dependent on the level of interest rates because of the convexity of fixed income flows. One way of looking at the delta is just the fixed income instrument with a term to maturity equal to the average maturity for the interval in question that is as sensitive in profit and loss terms to small changes in the interest rate for that bucket as the swaps portfolio is for that bucket. Similarly, the gamma is an expression of the changes in the position size (i.e. the changes in the delta) for changes in the level of interest rates. Vega is the sensitivity of the portfolio to changes in implied volatilities for at-themoney options associated with the maturity bucket in question. This may be important, for example, if the portfolio contains swaptions. In categorizing the risk of the swaps portfolio, the dealer must look at different types of yield curve risk including parallel shifts in the yield curve, non-parallel shifts in the yield curve and changes in swap spreads. Sophisticated dealers may incorporate some assumptions about the correlation between swap spreads and interest rates in doing their scenario analysis. It may be reasonable to believe that swap spreads will widen out if interest rates back up because of degrading credit conditions, for example. 4.2.18 Constructing the Hedge Portfolio The dealer will then take this analysis of the behavioural characteristics of the swap portfolio and he will construct a hedging portfolio using one or more financial instruments in order to offset those aspects of the risk that he is unhappy carrying. Note that the dealer will not close out all of the aspects of the risk.
4.2.19 Why will the Dealer only Partially Hedge the Swaps Portfolio? Hedging costs money. The main benefit of hedging activity is to reduce the risk of the portfolio. This benefit must be compared to the hedging cost. If the marginal benefit of reducing the risk with an individual transaction is less than its marginal cost, it is not worthwhile to hedge that risk. Another reason for not completely hedging the swaps portfolio is the fact that the dealer may carry a proprietary position in one or more aspects of the risk. If, for example, he thinks that interest rates are going to fall in the 2-year to 3-year bucket, he may be happy to continue received fixed interest payments for that period. If he is correct, he will make money on a mark-to-market basis that he can realize by hedging the position at a preferable level. 4.2.20 Floating Rate Cash Flow Management One of the more difficult aspects of managing a swap portfolio is managing the shortterm cash flows or the floating rate cash flows. There are two problems that confront the dealer. 4.2.21 Mismatches in the Timing of Short-Term Cash Flows. Consider a hedge that was entered into two years ago to hedge a two year fixedfloating plain vanilla interest rate swap where the hedge transaction took place a week after the initial customer transaction. Unless the dealer matched the dates precisely at the time he conducted the hedge transaction, there will be a one-week mismatch of flows. Matching the dates may have cost extra money in terms of the market prices at the time of transaction making it too expensive to match the timing of the cash flows. Some people might argue that one week is not very much of a difference. That is no way to run a business. To paraphrase an old saying, ten grand here and one hundred grand there and pretty soon youre talking about some real money. 4.2.22 Mmismatches in the Type of Index used to Hedge. Consider a swap in which the floating rate index is the 3-month US Bankers Acceptance rate. If the best swap available at the time is the 3-month US LIBOR (London Interbank Offered Rate for US dollars), then there is an index mismatch risk. If the correlation between these two indices changes (and correlation between financial indices is rarely stable), then the swap portfolio is exposed to refunding risk. One way for the commercial bank to hedge its floating rate cash flows is to establish a separate book dedicated to hedging such risks, one which participates actively in the futures markets such as the IMM Eurodollar market and one which takes aggressive positions in short-term interest rates.
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An alternative might be to pay the hedging costs necessary for closing out the mismatches. This can get expensive. With the increased commoditization of global derivatives markets, dealers are losing much of their pricing edge, a phenomenon that makes paying for outside hedging more difficult. By giving an appreciation for the way swaps dealers manage their combined portfolio risk, this article has identified some of the key types of risk in interest rate swaps and interest rate products, generally. 4.2.23 Interest Rate Swaps One of the largest components of the global derivatives markets and a natural adjunct to the fixed income markets is the interest rate swaps market. Understanding the over-thecounter swaps market can give you a deeper insight into the capital flows that drive the bond markets, the way in which the companies whose stock investor own manage their exposure to fluctuations in interest rates and the way banks and financial institutions make a great deal of their income. What is an interest rate swap? Simply put, it is the exchange of one set of cash flows for another. A pre-set index, notional amount and set of dates of exchange determine each set of cash flows. The most common type of interest rate swap is the exchange of fixed rate flows for floating rate flows. The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than they could raise such funds in the capital markets by taking advantage of the entitys relative advantage in raising funds in the shorter maturity buckets. 4.2.24 Valuation of swaps a) Identify the cash flows. To simplify things, many people draw diagrams with inflows and outflows of funds over time. b) Construct the swap curve, obtained from the government yield curve and the swap spread curve. c) Construct a zero-coupon curve from the swap curve. (See the Fixed Income section). d) Present value the cash flows using the zero-coupon rates. The swap spread is obtained from market makers. It is the market-determined additional yield that compensates counter-parties who receive fixed payments in a swap for the credit risk involved in the swap. The swap spread will differ with the creditworthiness of the counter-party. Just like an option, a swap can be at-the-money, in-the-money or out-of-the-money. Most swaps are priced to be at-the-money at inception meaning that the value of the floating rate cash flows is exactly the same as the value of the fixed rate cash flows at the
inception of the deal. Naturally, as interest rates change, the relative value may shift. Receiving the fixed rate flow will become more valuable than receiving the floating rate flow if interest rates drop or if credit spreads tighten. Investment banks and commercial banks are the market makers for most of these swaps. Most of them warehouse the risk in portfolios, managing the residual interest rate risk of the cash flows. 4.2.25 Equity Swaps Having discussed interest rate swaps and their cross-currency extension to currency swaps as exchanges of cash flows predicated on pre-set indices, it is natural for us to think of structuring swaps involving non-interest indices. Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. An equity index is a measure of the performance of an individual stock or a basket of stocks. Common equity indices with which the general investor is probably familiar include the Standard & Poors 500 Index, the Dow Jones Industrial Average or the Toronto Stock Exchange Index. The outstanding performance of equity markets in the 1980s and the 1990s, technological innovations that have made widespread participation in the equity market more feasible and more marketable and the demographic imperative of baby-boomer saving has generated significant interest in equity derivatives. In addition to the listed equity options on individual stocks and individual indices, a burgeoning over-the-counter (OTC) market has evolved in the distribution and utilization of equity swaps. There are many reasons to use equity swaps, some of which come from the motivation behind index trading. This passive investing strategy is gaining ground in the fund management community. Instead of trying to buy individual stocks that are deemed to be undervalued by some method of fundamental analysis, the index trading mechanism chooses a basket of stocks that is selected for its ability to represent the general market or one particular sector of the stock market. The fees associated with funds that engage in index trading are much lower because the investment management is mechanically deterministic. It is prescribed by the index that the investors have chosen. The investment manager is not paid for his discretionary expertise. 4.2.26 Equity swaps make the index trading strategy even easier. Consider the Bulldog S&P 500 Mutual Fund that is a fund promising to deliver the return of the S&P 500 (less administrative and managerial costs). How do they do it? One way would be to buy the 500 stocks that comprise the index in their exact proportions. However, the execution of this would be cumbersome, particularly if the level
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of funds in the Bulldog S&P 500 Mutual Fund were to fluctuate as people put more money to work or as they withdraw from the fund. Another way would be to participate in the S&P 500 through the futures market by using the mutual funds money to purchase S&P 500 Futures. The Futures contract would have to be rolled on a quarterly basis. There would be complex administration with the Futures Exchange. There is a third alternative: the equity swap. The investment manager at Bulldog calls up First Derivatives bank and asks for an S&P 500 swap in which the fund pays First Derivatives some money market return in exchange for receiving the return on the S&P 500 index for a period of five years with monthly payments. The return on the S&P 500 index consists of capital gains as well as income distributions. The structure is easy for the passive investment manager to implement administratively. And it fully accomplishes the goal with very little costs. Index trading funds typically have much lower costs associated with them. Summary A Swap is an agreement between two parties, called Counterparties, who exchange cash flows over a period of time in the future. When exchange rate and Interest rates fluctuate, risks of forward and money market positions are so great that the forward market & money market may not function properly. A Parallel Loan refers to a loan which involves an exchange of currencies between 4 parties, with a promise to re-exchange the currencies at a predetermined exchange rate on a specified future date. Financial swaps are now used by Multinational companies, commercial banks, world organizations and sovereign governments to minimize currency and interest-rate risks. The difficulty in finding counterparties with matching needs. Firms must find firms with mirror-image financing needs. Financing requirements include principals, types of interest payments, frequency of interest payments, and length of the loan period. The search cost for finding such counterparty is quite considerable. One of the largest components of the global derivatives markets and a natural adjunct to the fixed income markets is the interest rate swaps market. Understanding the over-thecounter swaps market can give you a deeper insight into the capital flows that drive the bond markets, the way in which the companies whose stock investor own manage their exposure to fluctuations in interest rates and the way banks and financial institutions make a great deal of their income.
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Equity swaps are powerful tools in the hand of the passive investment manager, the investor looking to tailor the timing of his tax events, investment managers looking for opportunities abroad and the average investor looking to enhance his return despite the letter of government provisos. Questions 1 2 3 4 5 6 What do you mean by Interest Rate Swap? Briefly Explain What are the Types of Swaps? Explain Explain about the Floating Rate Cash flow Management What are the drawbacks of Parallel and Back to back loans? Why will the dealer only partially hedge the swaps portfolio? Equity swaps make the index trading strategy even easier. Explain
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ACCOUNTING
CHAPTER I
ACCOUNTING TREATMENT FOR DERIVATIVE TRANSACTIONS
5.1.1 Introduction The accounting of financial instruments is based on whether those are used for hedging or not. Where they are not used for hedging they could fall under any of the four categories: (i) Financial asset/liability at fair value through profit and loss account (ii) Held-to-maturity investments (iii) Loans and receivables and (iv) Available for sale. Financial asset/liability at fair value through profit and loss account would generally cover trading items and those that management voluntarily wishes to classify under this category. All the fair value changes in the financial asset/liability are taken to the income statement and consequently the income statement would become highly volatile. Derivatives would fall under this category, unless they are used for hedging purposes in which case hedge accounting would apply. Held-to-maturity financial assets are those investments where there is positive intention to hold those assets till the maturity period. They do not include derivatives since they are included in the first category. A financial asset that fulfills the definition of loans and receivables are also not included. Besides an investment which is otherwise held-to-maturity may be classified voluntarily by the management in the fair value category or available for sale category. Held-to-maturity investments are accounted for through the effective interest rate method and the consequent gains and losses are recognised in the income statement. 5.1.2 Getting Ready The markets for derivatives have been remarkable and continued growth over the past decade. This reflects the increasing use of such instruments by business, either for speculation or hedging purposes. Accordingly, the accounting treatment for derivatives and hedging activities has taken on a high degree of importance.
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Hedge accounting does not sit well with the standard setters desired goal for financial instrument accounting, i.e. a full fair value model. Further, hedge accounting relies on management intent to link for accounting purposes what the standard setters see as two or more separate transactions. It also overrides accounting requirements that would otherwise apply to those transactions when viewed separately. Standard setters believe that separate accounting is the best way to tell it as it is, in other words, to apply the full fair value model. However, the wider financial reporting community could not be persuaded to accept the abolition of hedge accounting. Accounting Standard AS-30 on Financial Instruments-Recognition and Measurement has been issued by the institute as published in January 2008 journal. This Accounting Standard will become mandatory in respect of accounting period commencing on or after April 1, 2011, for all commercial, industrial and business entities except to a small and medium size entity. Correspondingly, a limited revision has also been made to AS-11 so as to withdraw the requirements concerning forward exchange contracts from that Standard. ICAI is also in process of formulating a separate Accounting Standard AS-32 on Financial InstrumentsDisclosures. As such AS-30 deals with Recognition and Measurement, and AS-32 deals with exclusively on Disclosure. 5.1.3 Hedge Accounting As required by the standard, on the date of this standard becoming mandatory, an entity should; measure all derivatives at fair value; and eliminate all deferred losses and gains, if any, arising on derivatives that under the previous accounting policy of the entity were reported as assets or liabilities. Any resulting gain or loss (as adjusted by any related tax expense/benefit) should be adjusted against opening balance of revenue reserves and surplus. On the date of this standard becoming mandatory, an entity should not reflect in its financial statements a hedging relationship of a type that does not qualify for hedge accounting under this standard (for example, hedging relationships where the hedging instrument is a cash instrument or written option; where the hedged item is a net position; or where the hedge covers interest risk in a held-to-maturity investment). However, if an entity designated a net position as a hedged item under its previous accounting policy, it may designate an individual item within that net position as a hedged item under Accounting Standards, provided that it does so on the date of this standard becoming mandatory. It, before the date of this standard becoming mandatory, an entity had designated a transaction as a hedge but the hedge does not meet the conditions for hedge accounting in this standard, the entity should apply paragraphs 102 and 112 to discontinue hedge
accounting. Transactions entered into before the date of this standard becoming mandatory should not be retrospectively designated as hedges. 5.1.4 Embedded Derivatives As entity that applies this standard for the first time should assess whether an embedded derivative is required to be separated from the host contract and accounted for as a derivative on the basis of the conditions that existed on the date it first became a party to the contract or on the date on which a reassessment is required by appendix A paragraph A56, whichever is the later date. 5.1.5 Recent Announcement Notwithstanding the applicability of AS-30, it is very important to understand the impact and effect of this announcement. The announcement on accounting for derivatives issued by ICAI on March 29, 2008, clarifies the best practice treatment to be followed for all derivatives is as follows: i. All derivatives except forward contracts covered by AS 11, can be accounted for on the basis of the requirements prescribed in AS 30, Financial Instruments: Recognition and Measurement. ii. In case an entity does not follow AS 30, keeping in view the principle of prudence as enunciated in AS 1, Disclosure of Accounting Policies, the entity is required to provide for losses in respect of all outstanding derivative contracts at the balance sheet date by marking them to market. The effect of the above announcement is as follows: i. In case an entity does not follow AS 30, the losses in respective of derivative contracts at the balance sheet date have to be provided for and disclosed. ii. In case an entity follows AS 30, then the effect will be broadly as follows: In case the derivatives do not meet the hedge accounting criteria as laid down in AS 30, the gains or losses in respect thereof will have to be recognised in the statement of profit and loss. The derivatives will have to be shown as financial assets or financial liabilities on the balance sheet, as the case may be, as per the requirements of the accounting standard. In case the hedge accounting criteria, e.g., hedge effectiveness, qualifying hedges, documentation etc, as laid down in AS 30 are met, the entity will have to consider, keeping in view the requirements of AS 30, whether the hedge is a fair value hedge or cash flow hedge. Fair value hedge and cash flow hedge have been explained in AS 30 as follows:
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a) Fair value hedge: A hedge of the exposure to changes in fair value of a recognised asset or liability or an unrecognised firm commitment, or an identified portion of such an asset, liability or firm commitment, that is attributable to a particular risk and could affect profit or loss. b) Cash flow hedge: A hedge of the exposure to variability in cash flows that (i) is attributable to a particular risk associated with a recognised asset or liability (such as all or some future interest payments on variable rate debt) or a highly probable forecast transaction and (ii) could affect profit or loss. As per the standard, a hedge of the foreign currency risk of a firm commitment may be accounted for as a fair value hedge or a cash flow hedge. 5.1.6 Fair value hedges are accounted for as follows: The gain or loss for re-measuring the derivative hedge instruments at fair value should be recognised in the statement of profit and loss, and The gain or loss on the hedged items (the underlying) should adjust the carrying amount of the said items and be recognised in the statement of profit and loss. 5.1.7 Cash flow hedges are accounted for as follows: i. In case of effective cash flow hedges, the gain or loss on the hedging derivative is recognised directly in an appropriate equity account, say, hedge reserve account (the ineffective hedge portion is recognised in the statement of profit and loss account). ii. If a hedge of a forecast transaction subsequently results in the recognition of a financial asset or a financial liability, the associated gains or losses that were recognised directly in the appropriate equity account in accordance should be reclassified into, i.e., recognised in the statement of profit and loss in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that interest income or interest expense is recognised). iii. If a hedge of a forecast transaction, subsequently results in the recognition of a nonfinancial asset or a non-financial liability, or a forecast transaction for a non-financial asset or non-financial liability becomes a firm commitment for which fair value hedge accounting is applied, then the entity should adopt (a) or (b) below: a) It reclassifies, i.e., recognises, the associated gains and losses that were recognised directly in the appropriate equity account into the statement of profit and loss in the same period or periods during which the asset acquired or liability assumed affects profit or loss (such as in the periods that depreciation expense or cost of sales is recognised). b) It removes the associated gains and losses that were recognised directly in the equity account, and includes them in the initial cost or other carrying amount of the asset or liability.
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An entity should adopt either (a) or (b) as its accounting policy and should apply it consistently to all hedges to which iv. above relates. v. For cash flow hedges, other than those covered by paragraphs (ii) and (iii) above, amounts that had been recognised directly in the equity account should be reclassified into, i.e., recognised in the statement of profit and loss in the same period or periods during which the hedged forecast transaction affects profit or loss (for example, when a forecast sale occurs). 5.1.8 New Accounting Rules for Derivatives and Hedging Activity For the last six years, the Financial Accounting Standards Board (FASB) has been considering the way derivative instruments are reported in corporations financial statements. The Board concluded that current accounting rules for derivatives are incomplete, inconsistent, difficult to apply and not transparent in financial statements, and therefore proposed a new standard. Four fundamental principals underlie the new accounting rules: a) Derivatives are assets and liabilities, and should be reported in financial statements as such; b) Fair value is the only relevant measure for derivative instruments; c) Gains or losses on derivatives cannot be deferred; however, d) Special accounting is permitted for items which qualify as hedges. Of importance is that the new rules provide no circumstance for which a company can retain off-balance sheet accounting treatment for derivatives. Any derivative instrument must be reflected in the balance sheet at its fair value. Derivatives that meet the criteria for an effective hedge qualify for special hedge accounting treatment. Three types of hedges are recognized: fair value hedges, cash flow hedges and hedges of corporations net investments in foreign operations. 5.1.9 Fair Value Hedges Derivatives can be used to hedge changes in the fair value (market value) of financial assets or liabilities like debt securities. For instance, a fixed rate bonds market value changes when interest rates go up or down. Hedging the bonds price risk with a derivative would be considered a fair value hedge. Changes in the fair value of the derivative flow directly to the income statement, but are offset by changes in the fair value of the hedged item which are recognized in the income statement at the same time.
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Example
Fair Value Hedge Accounting
Company issues fixed rate debt, then swaps debt to floating rate. Accounting for swap: Swap is marked to market and changes in value are recognized in current earnings. Accounting for debt: Change in value of debt related to change in market interest rates is recognized in earnings. Combination of swap change in value plus debt change in value is offset in earnings.
5.1.10 Cash Flow Hedges Derivatives can also be used to hedge changes in future cash flows arising from existing assets or liabilities, or from forecasted transactions. For example, interest payments on a companys variable rate debt expose a company to interest rate risk. Hedging this exposure using an interest rate swap (to convert the debt from floating rate to fixed interest rate) would be considered a cash flow hedge under the new rules. In a cash flow hedge, changes in the fair value of the interest rate swap would accumulate first in the statement of comprehensive income. (This is similar to how foreign exchange translation gains and losses are accumulated as a separate component of equity under existing accounting rules.) A portion of these gains or losses would be transferred out of comprehensive income to the income statement whenever interest is paid on the hedged debt. The net result will be a fixed rate of interest expense. Cash Flow Hedge Accounting
Example: Accounting for swap: Company issues floating rate debt, then swaps to fixed rate. Swap is marked to market and changes in value are recognized first in statement of comprehensive income and then in earnings as interest payments on hedged debt are made. At maturity, swap's value reduces to zero. Swap's carrying value is adjusted each period to reflect actual swap payments or receipts. Variable interest rate expense is recognized in earnings as incurred.
Accounting for floating rate debt: Combination of swap change in value plus debt change in value is offset in earnings.
5.1.11 Hedges for Net Investment in Foreign Operations The new rules still permit companies to hedge foreign currency exposure related to an investment in a foreign operation. The new accounting is similar to current rules except that
the translation gains or losses on the investment and the hedge are reported in the statement of comprehensive income instead of equity. 5.1.12 Derivatives and Income Statement Volatility Income statements of companies that utilize derivatives as hedges will be largely unaffected by the accounting changes. Under the new rules, effective hedges (hedges which have a high correlation to the asset or liability being hedged) should not introduce income statement volatility. So as long as the hedge works effectively, changes in the fair value of the derivative should be opposite to and offset changes in the fair value/cash flow of the hedged item. 5.1.13 Increased Derivatives Disclosure One of the benefits of the new rules is that more information about a companys hedging program will be revealed to investors. In addition to the more detailed information provided in financial statements, a company must also provide an expanded description of its risk management philosophy and strategy. From this, investors and analysts will be better able to determine whether or not a company is hedging critical financial exposures. This increases the likelihood that companies with prudent hedging programs will be rewarded by the market. 5.1.14 Derivatives Management Systems 5.1.14.1 Derivatives Systems A critical but often overlooked aspect of a competent derivatives trading operation are the computer systems used to manage the risk, account for the positions on a mark-tomarket basis, track derivatives-related events (such as expiries and rollovers) and measure Value-at-Risk. Once you have read some of the articles in the Derivatives section of the Financial Pipeline, you will realize how quickly a portfolio of transactions can become complicated. In the section on hedging swaps, we discussed some of these complications including the problems associated with mismatched short term cash flows and maturity bucket grouping. Options produce their own problems because of the convexity of these products. Taking snapshots of delta, gamma and vega at an instantaneous specification of prices is insufficient (although necessary) for competent financial risk management. One must also have an appreciation of how these risks change with the progress of time and the evolution of prices. In the first edition of Risk Professional magazine published by the Global Association of Risk Professionals (see http://www.garp.com), Geoff Kates establishes a framework for evaluating a financial risk management system and he uses this framework to assess some of the more common off-the-shelf products on the market. This article will discuss those criteria and it will explain the importance.
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5.1.14.2 Integration At the beginning of the global derivatives markets development, almost every bank pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one group managed interest rate derivatives, another group managed equity derivatives and a third group managed foreign exchange derivatives. For many banks, this is still the case. However, an increasing number of financial institutions are turning to a more integrated approach, stripping the derivatives desks from each asset class cash group and combining them into a more efficient cross-marketing machine. Once you understand interest rate derivatives, it is straightforward to understand equity derivatives or foreign exchange derivatives. Conversely, it is not necessarily the case that a manager who has spent his entire career overseeing spot foreign exchange salespeople will be able to understand the way in which a derivatives book works. It is not something youre likely to learn from a book or a classroom. You have to have experience. 5.1.14.3 To Buy or to Build The next question the banks senior management must ask itself is whether or not the bank should buy an off-the-shelf system or build one using its own internal IT resources. Buying a system is convenient, particularly if it is one that is in widespread use. Popular systems have been tested and have had all of the kinks worked out. The more popular the system, the less likely that it is vulnerable to internal control irregularities. That is, the more popular the system, the less likely it is possible for individuals to manipulate the banks official records for fraudulent purposes. Systems are typically very expensive, with charges for both a site license and individual annual user permits. Many of the companies that sell these systems make it easy for the user to customize reports, batch files, pricing modules, etc. However, many financial institutions are reticent to relinquish the responsibility for risk management computer systems to a third party. The managers of these institutions would prefer to have their own internal risk management personnel design the system that is then implemented by the banks IT staff. Not only is this more expensive than buying an off-the-shelf system in terms of up-front dollar cost and delays in implementation but the system is vulnerable to the expertise of a handful of individuals. Lets say you are the head of trading at ABC Bank and you commission your risk management department, all of three people (Larry, Curly and Moe) to design and implement your interest rate risk management system. If Larry, Curly and Moe leave to go as a team to DEF Bank, you will have lost all of your core knowledge base and you will have to start from scratch. There is also the possibility that Larry, Curly or Moe designed secret entrances into the system for themselves so that they could manipulate tickets and positions and profit and loss statements.
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5.1.14.4 Speed In order to be effective, risk management information must be at least as fast as the markets to which it refers. On the face of it, for most people using applications designed for home use, this is not problematic. However, for financial institutions with portfolios consisting of thousands of different instruments, some of which use very complicated formulae, and arrays of parameters to revalue, this is a serious database design problem. 5.1.14.5 Interface One of the key aspects of a well-designed system is its flexibility. A good risk management system will have a user interface that is customizable. Many of them are beginning to use the Internet as their interface platform. The interface is also the mechanism in which reports are designed. For an example of the kinds of reports dealers and risk managers require, see our earlier article entitled How Do Options Traders Look At Their Portfolios 5.1.14.6 Asset Class Coverage Further to our discussion of the integration of asset classes in the management of derivatives sales and trading operations at leading financial institutions, a good risk management system will provide the senior management with the ability to immediately access information on all of the derivatives activities in which the financial institution is engaged, across all asset classes. It is not uncommon for banks to have systems in place that enable their management to take a snapshot of the firms financial price risk with the simple click of a button at any point during the trading day, in real-time. Covering all of the asset classes also allows for greater overall risk-taking because it allows for the portfolio effects of diversification of risk across the different asset classes. 5.1.14.7 Pricing Model Flexibility Model risk refers to the problems associated with discrepancies between the theoretical pricing of a financial instrument and the way in which it actually trades in the market. The difference in price, for a given set of input parameters, is a result of the assumptions that are necessary for solution of the mathematical model of the price of the financial product in question. For some financial products, particularly the more exotic or novel ones, the choice of pricing model is a controversial one. A good risk management system will allow management to pick and choose the pricing model it prefers for a particular instrument and it will also allow management to compare the model risk in different market environments associated with individual pricing models.
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5.1.14.8 Ability to Link to Other Systems The derivatives risk management system is only one of a handful of systems with which the dealer at a financial institution must be familiar. Other systems include ticketing systems for cash instruments, accounting systems, credit risk management systems and, possibly, spreadsheets tracking customer portfolios. A dealers life is made much easier when the primary system he uses on a daily basis, the risk management system, can communicate its information to the other relevant systems automatically. Otherwise, the dealer (or more likely his assistant) will have to input multiple tickets for a single transaction. This is not just a question of personal effort. It is an operational risk issue, as well. Every time the dealer inputs a ticket, there is room for an error. Too many errors and the bank begins to lose customers as well as money. 5.1.14.9 The key point here is that technological sophistication leads to better management. These are just some of the criteria that a financial institution risk manager may choose to apply to the selection of a financial risk management computer system. In the next wave of development, risk management platforms will be entirely web-based. Already, Goldman Sachs and other leading American investment banks are offering web-based risk management systems, including pricing models, to their clients. Helping their clients understand the financial price risk they face makes it easier for the client to understand the efficacy of financial products (products which they hopefully transact with Goldman Sachs). Summary Financial asset/liability at fair value through profit and loss account would generally cover trading items and those that management voluntarily wishes to classify under this category. All the fair value changes in the financial asset/liability are taken to the income statement and consequently the income statement would become highly volatile. The markets for derivatives have been remarkable and continued growth over the past decade. This reflects the increasing use of such instruments by business, either for speculation or hedging purposes. Accordingly, the accounting treatment for derivatives and hedging activities has taken on a high degree of importance. However, if an entity designated a net position as a hedged item under its previous accounting policy, it may designate an individual item within that net position as a hedged item under Accounting Standards, provided that it does so on the date of this standard becoming mandatory. Derivatives can be used to hedge changes in the fair value (market value) of financial assets or liabilities like debt securities.
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At the beginning of the global derivatives markets development, almost every bank pursued derivatives in a stand-alone asset-class-by-asset-class fashion. That is to say, one group managed interest rate derivatives, another group managed equity derivatives and a third group managed foreign exchange derivatives. For many banks, this is still the case. Accounting standards groups around the world have been watching the FASBs progress as it tackles the issue of accounting for derivative instruments. The International Accounting Standards Committee continues to review the new US standard and is expected to make a decision shortly about whether it will follow the US lead. As well, the Canadian Institute of Chartered Accountants may adopt FASBs standards so Canadian companies would be required to adhere to these new rules in the not-too-distant future. Questions 1. Explain the Accounting Treatment For Derivative Transactions 2. What do you understand by Hedge Accounting? 3. What do you mean by Embedded Derivatives? 4. How are the Fair value hedges accounted? 5. What do you understand by Hedges for Net Investment in Foreign Operations? 6. Explain the Derivatives Management Systems
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CHAPTER II
CREDIT DERIVATIVES
5.2.1 Introduction A credit derivative is a financial instrument used to mitigate or to assume specific forms of credit risk by hedgers and speculators. These new products are particularly useful for institutions with widespread credit exposures. Some observers suggest that credit derivatives may herald a new form of international banking in which banks resemble portfolios of globally diversified credit risk more than purely domestic lenders. Local banks can take advantage of their informational edge in terms of assessing the default risk and recovery rates in their regional market. They make loans based upon this credit assessment and then use credit derivatives to swap these cash flows for more internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk. Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate debt. This is just one example. 5.2.2 Credit Swaps Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve. The credit spread is volatile in and of itself and it may be correlated with the level of interest rates. For example, in a declining, low interest rate environment combined with strong domestic growth, we might expect corporate bond spreads to be smaller than their historical average. The corporate who has issued the bond will find it easier to service the cash flows of the corporate bond and investors will be hungry for any kind of premium they can add to the risk-free rate. Imagine the fund manager who specializes in corporate bonds who has a view on the direction of credit spreads on which he would like to act without taking a specific position in an individual corporate bond or a corporate bond index. One way for the fund manager to take advantage of this view is to enter into a credit swap. Lets say that the fund manager believes that credit spreads are going to tighten and that interest rates are going to continue to decline.
He would then want to enter into a swap in which he paid the corporate yield at sixmonth intervals against receiving a fixed yield equal to the inception Treasury yield plus the corporate credit spread. That is to say, at the six-month reset for the tenor of the swap, the fund manager agrees to pay a cash flow determined to be equal to the current annual yield on some benchmark corporate bond or corporate bond index in consideration for receiving a fixed cash flow. This is an off-balance sheet transaction and the swap will typically have zero value at inception. If corporate yields continue to fall (i.e. through a combination of a lower risk-free rate and a lower corporate credit spread than the one he locked in with the swap), he will make money. If corporate yields rise, he will lose money. 1998 was a dynamic year for corporate bond spreads with the backup in interest rates in the aftermath of the Russian devaluation-inspired liquidity crisis concentrated mainly in corporate yields. The volatility of these spreads was extreme when compared to their historical movement. Credit swaps would have been an excellent way to play this spread volatility. Moreover, credit swaps (particularly ones based on a spread index) are clean structures without the messy difficulty of finding individual corporate bond supply, etc. Another example of a credit swap might be the exchange of fixed flows (determined by the yield on a corporate bond at inception) against paying floating rate flows tied to the risk-free Treasury rate for the corresponding maturity. Naturally, swaps are flexible in their design. If you can imagine a cash flow exchange, you can structure the swap. There might be a cost associated with it but you can certainly put it on the books. 5.2.3 Credit Default Swaps A credit default swap is a swap in which one counterparty receives a premium at preset intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place. One possible type of credit event for a credit default swap is a downgrade in the credit status of some preset entity. Consider two banks: First Chilliwack Bank and Banque de Bas. Chilliwack has made extensive loans in its corporate credit portfolio to a property developer called Churchill Developments. It is looking for some kind of insurance against a downgrade of Churchill by the major ratings agency, a real possibility since the main
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project Churchill has taken on is running into unforeseen delays. Chilliwack approaches Banque de Bas with the concept of a credit default swap. They pay Banque de Bas a premium every six months for the next five years in exchange for which de Bas agrees to make payments to Chilliwack of a pre-set amount should Churchill be downgraded. De Bas now has exposure to Churchill, a position they could not take directly because they are not part of Churchills lending syndicate. Chilliwack has some degree of protection against a Churchill credit downgrade. This reduction in their overall credit profile means that they do not need to hold as much capital in reserve, freeing Chilliwack up to take other business opportunities as they present themselves. 5.2.4 Options on Credit Risky Bonds Finally, our fund manager from the first example could use an options position to take advantage of his view on the level of the corporate yield. If he believed that corporate yields were set to fall through some combination of lower risk-free interest rates and tighter corporate bond spreads, then he could just buy a call on a corporate bond of the appropriate maturity. These are just a few of the examples of credit derivatives. Institutional investors often use credit derivatives when positioning themselves in emerging markets for the ease of transaction in the same way that they might use equity swaps. Fund managers can use credit derivatives to hedge themselves against adverse movements in credit spreads. Corporates can use credit swaps to hedge near-term issues of corporate bonds. Banks and other financial institutions can use credit derivatives to optimize the employment of their capital by diversifying their portfolio-wide credit risk. Summary Local banks can take advantage of their informational edge in terms of assessing the default risk and recovery rates in their regional market. They make loans based upon this credit assessment and then use credit derivatives to swap these cash flows for more internationally diverse cash flows. Imagine a US regional bank that lends money in Carolina to a local hotel. They take this credit risk and add it to their overall portfolio of credit risk. Deciding to reduce their local exposure, they exchange the cash flows from a portfolio of their mid-grade Carolina debt for cash flows of highly rated Northern Italian corporate debt. This is just one example. Corporate bonds trade at a premium to the risk-free yield curve in the same currency. US Corporate Bonds trade at a premium (called a credit spread) to the US Treasury curve. The credit spread is volatile in and of itself and it may be correlated with the level of interest rates
A credit default swap is a swap in which one counterparty receives a premium at preset intervals in consideration for guaranteeing to make a specific payment should a negative credit event take place. If he believed that corporate yields were set to fall through some combination of lower risk-free interest rates and tighter corporate bond spreads, then he could just buy a call on a corporate bond of the appropriate maturity. Questions 1. What do you mean by Credit Derivatives? 2. Explain the Credit Swaps 3. What do you understand by Options on Credit Risky Bonds? 4. What is meant by Credit Default Swaps?
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MBA

DBA 1754 FINANCIAL DERIVATIVES

IV SEMESTER COURSE MATERIAL

Centre for Distance Education

Author Dr. J. Dr. J. Gopu

Reviewer Ms. Yasmeen Haider Ms. Yasmeen

Editorial Board Dr.T.V.Geetha .T.V Dr.T.V.Geetha

Dr.H.Peeru .H.Peer Dr.H.P eer u Mohamed

Dr.C Chellappan .C. Dr.C. Chella ppan

Dr.A.K .A.Kannan Dr.A.K annan

Copyrights Reserved (For Private Circulation only) ii

Dr. J. Gopu Author

DBA 1754 FINANCIAL DERIVATIVES

1.5 1.6 1.7

UNIT II CHAPTER I FINANCIAL DERIVATIVES MARKET IN INDIA

CHAPTER II REGULATIONS OF FINANCIAL DERIVATIVES IN INDIA

UNIT III CHAPTER I HEDGING STRATEGIES USING INDEX FUTURES

CHAPTER II INTEREST RATE FUTURES

CHAPTER III CUURENCY FUTURES

3.3.9 Illustrating the Use of Currency Futures 3.3.10 Summary

UNIT IV CHAPTER I OPTION MARKET

CHAPTER II FINANCIAL SWAPS MARKET

4.2.21 4.2.22 4.2.23 4.2.24 4.2.25 4.2.26

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UNIT V CHAPTER I ACCOUNTING TREATMENT FOR DERIVATIVE TRANSACTIONS

CHAPTER II CREDIT DERIVATIVES

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Market participants Large firms

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The cash flows of the speculator are

The present value of this investment is

F(t, ) e r(t ) + Et [S()] e r1 (t )

F(t, ) = Et [S()]e (rr1) ( t ) .

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