Module 1

Introduction to cash & Derivative market- an overview

Module 1

Risk
Risk can be defined as deviations of the actual results from expected.

Risk can be classified two ways 1) risk of small losses with frequent occurrence and 2) risk of large losses with infrequent occurrence. The impact or magnitude of risk is normally estimated from following two factors

1.The probability of an adverse event happening, and 2.In case the event occurs the magnitude of the loss it can cause.

Managing Risk
The ways to manage risk include attempt to control potential damage, diffuse, diversify and transfer risk to those willing to accept it. One can manage the risk by transferring it to another party who is willing to assume risk. Insurance company does not do anything to contain the risk per se but assumes risk on your behalf.

Management of risk through derivatives is commonly referred as hedging which enable offsetting of risk emanating from one situation.

Types of Risks
Business risks are characterised by small losses but with high probability The risk of large losses with small probability is normally referred as event risk.

Event risk is normally managed by insurance. companies and Business risk is concerned about Changes in prices, Changes exchange rates, and Changes in interest rates.

Derivatives
Three kinds of business risk of price, exchange rate and interest rate can be managed through products that are classified as derivatives.

Derivatives are products that derive their value from some other asset called underlying asset but in other aspects they may remain distinctly different from and independent of the underlying asset.

DERIVATIVES
A derivative instrument is a financial contract whose payoff structure is determined by the value of an underlying commodity, interest rate, share price index, exchange rate, oil price Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

The underlying securities for derivatives are

1. Commodities (grain, coffee beans, gur, pepper, potatoes) 2. Precious metals(gold, silver) 3. Short term debt securities(treasury bills) 4. Interest rate 5. Common shares/ stock 6. Stock Index Value(NSE Nifty)

DERIVATIVES
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. This transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the "underlying". Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A.

Derivative products
Variety of derivatives are available both standard product as well as tailor-made, to suit various applications.

Four broad types of instruments are: Forwards Futures Options, and Swaps,

Types of Derivative instruments

Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. We take a brief look at various derivatives contracts that have come to be used. Forwards: A forward contract is a customized contract between two entities, where settlement takes place on a specific date in the future at today's pre-agreed price.

Types of Derivative instruments

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.

Types of Derivative instruments

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

Types of Derivative instruments

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. 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.

Types of Derivatives Instruments

Type Forward Future Option Nature of Contract Customized Standardized Customized/ Standardized Customized Customized Market OTC Organized market OTC/ Organized market OTC OTC

Swap Hybrid

The classification of financial derivatives can be depicted as

Parameters Future Forward Option
OTC Market Nature of Contract Organized Standardized OTC Customized OTC Customized Organized Organized Standardized

Margin Counter- Party Valuation

Margin payment Clearing house Marked to market everyday By organized market Absent

No margin Known bank or client No special method of valuation Self regulation Depend on counterparty

Upfront Payable by Known bank or client No special method of valuation Self regulation Depend on counterparty

premium buyer Clearing house Marked to market everyday By organized market Absent

Regulation Counter-Party Risk

Settlement

Clearing house

Dependent on terms of contract

Dependent on terms of contract

Clearing house

Gain/ Loss

Unlimited

Unlimited

Gain loss/ to the extent

Unlimited Premium paid upfront

Classification of Derivatives
Based on the underlying asset The underlying asset can be Commodities Currencies Shares/Indices Interest Rates Credit Weather

Classification of Derivatives
Based on how traded Derivatives can be traded either on the exchange or OTC Over-the-counter (OTC) Exchange Traded

Over the counter products

Over the counter derivatives have advantage of meeting the specific needs of the counterparties. Exchange traded products Exchange traded derivatives have known transaction costs, have no counterparty risk, and provide easy entry and exit.

ETM versus OTC Markets

Basis of differences
1. Counterparty Risk

ETM
In an exchange traded market, the exchange or the regulatory becomes the counterpart to every transaction and delivery of securities is guaranteed. Thus there is no counterparty risk is in ETM.

OTC Market
Counterparty risk is more in OTC markets, because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore. They are subject to counterparty risk, like an ordinary contract. Since each counterparty relies on the other to perform. In OTC markets price discovery depends on the number of dealers who trade in a particular security. So there will be more chances of manipulation by operators.

2. Price Discovery

Best price discovery is in exchange traded markets as there are number of traders who trade on a single and centralized system. So there will be less chances of manipulation by operators.

3. Liquidity

In exchange traded market there will be Less liquidity is in OTC market as there buyers and sellers in almost all counters. are less number of clients and So there will be more liquidity in ETM. participants. All firms that offer exchange traded products must be members and register with the exchange, there is greater regulatory oversight which can make exchange traded markets a much safer place for individuals to trade. There is absence of proper regulatory body in OTC markets. Because here contracts are traded directly between two parties, without going through an exchange or other intermediaries.

4. Proper Regulatory Body

Participants in Derivative Markets

Hedgers: are those who use derivatives for hedging i.e. reduce or eliminate risk.

Speculators: are those take positions in derivatives to increase returns by assuming increased risk. They provide much needed liquidity to markets.
Arbitrageurs: are those who exploit mispricing in different markets; They assume riskless and profitable positions. All 3 participants are essential for efficient functioning.

Types of traders in Derivatives Markets

1. 2. 3. Hedgers Speculators Arbitrageurs

1. Hedgers: are those who wish to eliminate price risk associated with the underlying security being traded. The objectives of these kinds of traders is to safeguard their existing positions by reducing the risk. They are not in the derivatives market to make profits.
2. Speculators: While hedgers might be adept at managing the risks of exporting and producing petroleum products around the world, there are parties who adept at managing and even making money out of such exogenous risk. These are people who take positions and assume risks to profit from fluctuations in prices. They are willing to take risks and they bet upon whether the markets would go up or come down.

Speculators may be either day traders or position traders. The former speculate on the price movements during one trading day, while latter attempt to gain keep their position for longer time period to gain from price fluctuations.

3. Arbitrageurs: From the French for arbitrage or judge, these market

participants look for mis-pricing and market mistakes, and by taking advantage of them; they disappear and never become too large. Arbitrage is the process of simultaneous purchase of securities or derivatives in one market at a lower price and sale thereof in another market at a relatively higher price.

Functions of Derivatives
3 major functions of derivatives are: Enable price discovery Facilitate Transfer of Risk Provide Leverage

Misuses & Criticism of Derivatives

Increased volatility: Though used for efficient price discovery, derivatives when used as a speculative product can make increase volatility in prices. Increased bankruptcies: Derivatives being leveraged products have caused disproportionate positions leading to several disasters and bankruptcies. Increased burden of regulations: Most derivatives hide more than they reveal. For financial discipline and better disclosures new rules have to be devised.

History and background of Derivatives market in India

Derivatives market in India have been in existence from a long time. In the areas of commodities, the Bombay Cotton Trade Association started futures trading way back in 1875. Derivative trading shifted to informal forwards markets. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001 on the recommendation of L.C. Gupta Committee. SEBI permitted the derivative segment of two stock exchanges, NSE3 and BSE4. SEBI approved trading in index futures contracts based on various stock market indices such as, S&P CNX, Nifty and sensex.

Derivatives in India: A Chronology Date

14 Dec, 1995

Progress
NSE asked SEBI for permission to trade index futures

18 Nov, 1996
11 May, 1998 7 July, 1999 24 May, 2000 25 May, 2000 9 June, 2000 12 June, 2000 31 August, 2000

SEBI setup L.C. Gupta Committee to draft a policy framework for index futures
L.C. Gupta Committee submitted report RBI gave permission for OTC Forward Rate Agreements (FRAs) and interest rate swaps. SIMEX chose Nifty for trading futures and options on an Indian index. SEBI gave permission to NSE and BSE to do index futures trading. Trading of BSE Sensex futures commenced at BSE. Trading of nifty futures commenced at NSE. Trading of futures and options on Nifty to commence at SIMEX.

Date
June, 2001 July, 2001

Progress
Trading of Equity Index Options at NSE Trading of Stock Options at NSE

9 Nov, 2002
June, 2003 13 Sept, 2004 1 Jan, 2008 1 Jan, 2008 29 Aug, 2008 2 Oct, 2008

Trading of Single Stock futures at BSE.

Trading of Single Stock futures at BSE. Weekly options at BSE. Trading of Chhotav (Mini) Sensex at BSE. Trading of Mini Index Futures & Options at NSE. Trading of Currency Futures at NSE. Trading of Currency Futures at BSE.

FACTORS DRIVING THE GROWTH OF DERIVATIVES

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international markets, 3. Marked improvement in communication facilities and sharp decline in their costs, 4. Development of more sophisticated risk management tools, providing economic agents a wider choice of risk management strategies, and 5. 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.

History of Derivative Markets:

Early forward contracts in the US addressed merchants' concerns about ensuring that there were buyers and sellers for commodities. However 'credit risk" remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1848.

History of Derivative Markets:

The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first 'exchange traded" derivatives contract in the US, these contracts were called 'futures contracts". In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest "financial" exchanges of any kind in the world today.

History of Derivative Markets:

The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and EuroDollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex etc.

Emergence of financial derivative products

Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form of such products for almost three hundred years.

Financial derivatives came into spotlight in the post-1970 period due to growing instability in the financial markets.

Emergence of financial derivative products

However, since their emergence, these products have become very popular and by 1990s, they accounted for about twothirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover.

Regulatory framework of Derivatives

Derivatives Market Financial Derivatives market Regulated by Commodities futures options Regulated by

Forward market commission SEBI Stock exchange RBI OTC

Basic cash market concepts.

Introduction:
It is a public financial market, in which financial instruments are traded and delivered immediately. It is known as spot market. The cash/spot market refers to that segment of the foreign exchange market in which sale and purchase transactions are settled within two days of the deal. The spot sale and purchase of foreign exchange makes the spot market. The rate at which foreign currency is bought and sold in the spot market is called the spot exchange rate.

Features of Cash Market:

1. It is a buying strategy in which the buyer makes an immediate payment that is equal to the current market price for commodities and other types of securities. 2. Upon the receipt of the payment, the seller relinquishes all claims to the property and bestows ownership upon the buyer.

3. Immediate satisfaction and transfer of ownership. 4. Cash market is spot market. Deals are initiated and completed on the spot, rather than requiring an extended period of time to resolve. 5. Cash market tends to be fast paced, since the turn around time on transaction is so short.

Spot rate
It is that exchange rate which applies to those transactions in foreign exchange for which payments and receipts are to be effected on the spot. India quotes its exchange rates in terms of the amount of rupees that can be exchanged for one unit of foreign currency. In this method, known as the European terms, the rate is quoted in terms of the number of units of the foreign currency for one unit of the domestic currency. This is called an indirect quote.

The alternative method, called the American terms, expresses the home currency price of one unit of the foreign currency. This is also called a direct quote. Both direct quote and indirect quotes are in use. In US it is common to use the direct quote for domestic business. For international business, banks generally use European terms.

Mechanisms of Cash market

Drivers of the stock market: 1. Earning growth 2. Valuation 3. Monetary policy and Interest rate 4. Economy and the business cycle 5. Inflation 6. Sentiments

Spot versus future market

Spot market
Principal v/s exchange Spot forex trades are contractual obligations between two counterparties. A trade between dealer and a customer is a principle transaction between those two parties .no other entity is involved in clearing or guaranteeing the performance of the parties.
Spot forex trades are can be done in any size and are usually for value two business days after the trade date. Either currency can be the base currency.

Future market
Future market trade are executed in a centralized exchange through a futures broker who also performs the role of the customers clearing firm. The other party to the transaction is anonymous, and the trades are guaranteed by the exchanges clearing organization.
Future market trades must be done in standardized units for specific value date in the future. The base currency is fixed.

Contract terms

Spot versus future market

Spot market
Price quote conventi ons Spot forex trades are quoted in European terms. This traditionally means that most currencies , when trade against the us dollar ,are quoted as the number of currency units per one us dollar.

Future market
Many future market contracts are quoted in American terms. A currency is quoted in the quantity of us dollar per unit of foreign currency.

Dealer v/s broker

A forex dealer is not a brokerage Future market customers often firm, it is a market market and a refer to their account principal to all transections. representatives as their brokers.

Difference between cash/spot market and derivative market

Basis Physical cash/ spot market Derivative market

Illiquid

liquid

Market power

Spot price affects derivatives.

Comers and squeezes Expensive and risky can cause forward price to to execute. affect spot. Take open position that requires more delivery then is available . Limits on open positions. Transitory effects, with little benefit in the spot. Surveillance programs.

Method

Withholding physical supply from the market. Limits on physical market share.

prevention

Stock Indices
An index is a number arrive at through certain calculations. It is used to measure and track the movement of specific value. Example : CPI is calculated to measure and track changes in consumer prices of good. A stock index is a number computed to measure and track the value of a portfolio of stocks used to represent the stock market. A stock market index is created by selecting a group of stocks that are capable of representing the whole market or a specified sector or segment of the market. The change in the prices of this basket of securities is measured with reference to a base period. The impact of change in the price of individual securities forming part of the index on the value of the index depends upon the method of calculation.

Stock Indices
Basically , there are two methods of computation Price weighted index & value weighted index In price weighted index, only the price of individual securities are considered and each securities has equal weightage in the index. This type of index is also known as an equally weighted index. In value weighted index , each securities in the index has weighted proportionate to its market capitalization. A company with higher capitalization will have greater impact on the index than a company with smaller capitalization.

Market capitalization weighted index:

In this type of index, the equity price is weighted by the market capitalization of the company (share price * number of outstanding shares). Hence each constituent stock in the index affects the index value in corporation to the market value of all the outstanding shares. This index forms the underlying for a lot of index based products like index funds and index futures.

Market capitalization weighted index calculation

Company Current Market Base Market Capitalization(Rs Capitalization(Rs Lakh) Lakh)

Grasim Inds
Telco SBI

1668791.10
8726686.30 1452587.65

1654247.50
860018.25 1465218.80

Wipro
Bajaj Total

2675613.30
660887.85 7330566.20

2669339.55
662559.30 7311383.40

 Index =(Current Market Capitalization)*(base value) / Base Market Capitalization Current Market Capitalization = sum of current market price * Outstanding of shares of all securities in Index Base Market capitalization = Sum of (Market Capitalization price*Issue Size) of all securities as on base date

 Index = 7,330,566.20 * 1000 7,311,383.40 = 1002.62 In the example below we can see that each stock affects the index value in proportion to the market value of all the outstanding shares. In the present example, the base index = 1000 and the index value works out to be 1002.60

Share A1

Base price 120

Current price 200

A2
A3 Total

150
110 380

900
150 1250

Price Weighted Method

Market price weighted index = (1250/380)*100 = 329

Equal weighted index = 100 + 201.01 = 301.01

Share Percentage change in shares Weighted Weighted average

A1

66.67

1/3

22.22

A2
A3 Total

500
36.36

1/3
1/3

166.67
12.12 201.01

Various indices of the world

international 1 BBC Global 30 world stock market index of 30 of the largest companies by stock market value in Europe, Asia and the America 2 iShares MSCI EAFE Index (EFA) it provides investment results generally equivalent to publicly traded securities in the European, Australasian and Far Eastern markets. Maintained by Morgan Stanley capital international

Various indices of the world

international 3 MSCI WORLD free float weighted equity index. Index includes stocks of all the developed markets. Common benchmark for world stock funds. 4. S&P Global 1200 global stocks index covering 31 countries and around 70 percent of global market capitalization.

Various indices of the world

United states 1. AMEX Composite composite value of all of the stocks traded on the American Stock Exchange. 2 Dow Jones Indexes leading global index provider 3. Dow Jones Industrial Average one of the most widely quoted of all the market indicators. Consists of 30 of the largest publicly traded firms in the U.S.

Various indices of the world

United states 4. Dow Jones Wilshire 5000 Designed to track the performance of all publicly traded companies based in the U.S. 5.NASDAQ companies Broad market index for of all of the common stocks and similar securities traded on the NASDAQ stock market 6. Russell Indexes leading U.S. equity index family for institutional investors.

Various indices of the world

United states 7. Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S equity market. 8. S&P 500 stock market index containing the stocks of 500 large-cap corporations. Comprises over 70% of the total market cap of all stocks traded in the U.S. owned by standard & poors.

Various indices of the world

China SSE Composite Index of all listed stocks(A shares and B shares) at Shanghai stock Exchange.

Various indices of the world

India 1. BSE Sensex 30 it includes the 30 largest and most actively traded stocks on the Bombay Stock Exchange. 2 S&P CNX Nifty index for 50 large companies on the National Stock Exchange of India.

Various indices of the world

Japan Nikkei 225 stock market index for the Tokyo Stock Exchange.

Various indices of the world

Europe 1. Dow Jones Euro Stoxx 50 Free-float market capitalization-weighted index of 50 Eurozone stocks. Provides a blue-chip represntation of Super-sector leaders in the Eurozone. 2. FTS Eurofirst 300 Index free-float capitazation-weighted price index. Measures the performance of Europes largest 300 companies by market capitalization. Covers 70% of Europes market cap.

Various indices of the world

Europe 3. OMX Baltic Index covers stock exchange in Estonia, Latvia and Lithuania. 4. OMX Nordic 40 Market value-weighted index of the 40 mosttraded stock classes of shares in Copenhagen, Helsinki, Reykjavik and Stockholm

Various indices of the world

Europe 5. S&P Europe 350 free float market cap weighted index. Covers atleast 70% of European equity market capitalization.

Computation of various Indices

Indian indices S&P global 1200 index NASDAQ composite Dow Jones euro stoxx 50 BBC global 30 index Dow Jones industrial average NYSE composite Shanghai composite index (SSEC) Nikkei 225

left
The derivative market in India: Trading , clearing and settlement system The regulation of derivative trading in India: role of SEBI, FMC and RBI, visiting the websites of these regulatory bodies and explain their functions.