Introduction to Derivatives

Introduction to Derivatives
Derivative is a product/contract which does not have any value on its own i.e. it derives its value from some underlying.


Forward contracts
A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India).
Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place.
Forward contracts suffer from poor liquidity and default risk.


Future contracts
Future contracts are organised/ standardised contracts, which are traded on the exchanges.
These contracts, being standardised and traded on the exchanges are very liquid in nature.
In futures market, clearing corporation/ house provides the settlement guarantee.
Every futures contract is a forward contract. They :
are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
are of standard quantity; standard quality (in case of commodities).
have standard delivery time and place.


Forward / Future Contracts
Features Forward Contract Future Contract
Operational Mechanism Not traded on exchange Traded on exchange
Contract Specifications Differs from trade to trade. Contracts are standardised contracts.
Counterparty Risk Exists Exists, but assumed byClearing Corporation/ house.
Liquidation Profile Poor Liquidity Very high Liquidity
contracts Type contracts are tailor maid. contracts are standardised .
Price Discovery Poor. Better.


Options
Options are instruments whereby the right is given by the option seller to the option buyer to buy or sell a specific asset at a specific price on or before a specific date.
Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.
Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.
Call Option - Option to buy.
Put Option - Option to sell.
American Option - An option which can be exercised anytime on or before the expiry date.
European Option - An option which can be exercised only on expiry date.
Strike Price/ Exercise Price - Price at which the option is to be exercised.
Expiration Date - Date on which the option expires.
Exercise Date - Date on which the option gets exercised by the option holder/buyer.
Option Premium - The price paid by the option buyer to the option seller for granting the option.


Introduction of futures in India
The first derivative product to be introduced in the Indian securities market is going to be "INDEX FUTURES".
In the world, first index futures were traded in U.S. on Kansas City Board of Trade (KCBT) on Value Line Arithmetic Index (VLAI) in 1982.

Glossary of Futures & Options

Terms
This glossary has been compiled by the Chicago Mercantile Exchange from a number of sources. The definitions are not intended to state or suggest the correct legal significance or meaning of any word or phrase. The sole purpose of this compilation is to foster a better understanding of futures and options on futures.

Arbitrage
The simultaneous purchase and sale of identical or equivalent financial instruments or commodity futures in order to benefit from a discrepancy in their price relationship.

Ask
Also called "offer". Indicates a willingness to sell a futures contract at a given price. (See bid.)

Back Months
The futures or options on futures months being traded that are furthest from expiration.

Bear
One who believes prices will move lower.

Bear Market
A market in which prices are declining.

Bid
The price that the market participants are willing to pay. See offer.

Bull
One who expects prices to rise.

Bull Market
A market in which prices are rising.

Buy On Close
To buy at the end of a trading session at a price within the closing range.

Buy On Opening
To buy at the beginning of a trading session at a price within the opening range.

Cabinet Trade or cab
A trade that allows options traders to liquidate deep out-of-the-money options by trading the option at a price equal to one-half tick.

Call
An option to buy a commodity, security or futures contract at a specified price anytime between now and the expiration date of the option contract.

Cash Commodity
The actual physical commodity as distinguished from a futures commodity.

Close.
The period at the end of the trading session. Sometimes used to refer to the closing range.

Closing Range (or Range)
The high and low prices, or bids and offers, recorded during the period designated as the official close. (See settlement price.)

Combined
Combined refers to the prices for a given contract. It means that the prices are calculated from both Day (RTH) and Night Sessions. (See RTH.)

Commission (or Round Turn)
The one-time fee charged by a broker to a customer when a futures or options on futures position is liquidated either by offset or delivery.

CFTC
CFTC - The Commodity Futures Trading Commission as created by the Commodity Futures Trading Commission Act of 1974. This government agency currently regulates the nation's commodity futures industry.

Contract
Unit of trading for a financial or commodity future. Also, actual bilateral agreement between the parties (buyer and seller) of a futures or options on futures transaction as defined by an exchange.

Contract Month
The month in which futures contracts may be satisfied by making or accepting delivery. (See delivery month.)

Day Order
An order that is placed for execution during only one trading session. If the order cannot be executed that day, it is automatically cancelled.

Day Trading
Refers to establishing and liquidating the same position or positions within one day's trading, thus ending the day with no established position in the market.

Deferred
Another term for "back months."

Delivery
The tender and receipt of an actual commodity or financial instrument, or cash in settlement of a futures contract.

Exercise Or Strike Price
The price at which the holder (buyer) may purchase or sell the underlying futures contract upon the exercise of an option.

Expiration Date
The last day that an option may be exercised into the underlying futures contract. Also, the last day of trading for a futures contract.

Floor Broker
An exchange member who is paid a fee for executing orders for Clearing Members or their customers. A Floor Broker executing orders must be licensed by the CFTC. Floor Trader
An exchange member who generally trades only for his/her own account or for an account controlled by him/her. Also referred to as a "local."

Futures
A term used to designate all contracts covering the purchase and sale of financial instruments or physical commodities for future delivery on a commodity futures exchange.

Futures Commission Merchant
A firm or person engaged in soliciting or accepting and handling orders for the purchase or sale of futures contracts, subject to the rules of a futures exchange and, who, in connection with solicitation or acceptance of orders, accepts any money or securities to margin any resulting trades or contracts. The FCM must be licensed by the CFTC.

Hedge
The purchase or sale of a futures contract as a temporary substitute for a cash market transaction to be made at a later date. Usually it involves opposite positions in the cash market and futures market at the same time. (See long hedge, short hedge.)

Holder
One who purchases an option.

Initial Performance Bond
The funds required when a futures position (or a short options on futures position) is opened. (Previously referred to as Initial Margin)

Limit Order
An order given to a broker by a customer that specifies a price; the order can be executed only if the market reaches or betters that price.

Limit Price
(See maximum price fluctuation.)

Liquidation
Any transaction that offsets or closes out a long or short futures position.

Long
One who has bought a futures or options on futures contract to establish a market position through an offsetting sale; the opposite of short.

Long Hedge
The purchase of a futures contract in anticipation of an actual purchase in the cash market. Used by processors or exporters as protection against and advance in the cash price. (See hedge, short hedge.)

Margin
A sum, usually smaller than--but part of--the initial performance bond, which must be maintained on deposit in the customer's account at all times. If a customer's equity in any futures position drops to, or under, the maintenance performance bond level, a "performance bond call" is issued for the amount of money required to restore the customer's equity in the account to the initial margin level.

Mark-To-Market
The daily adjustment of margin accounts to reflect profits and losses.

Market Order
An order for immediate execution given to a broker to buy or sell at the best obtainable price.

Maximum Price Fluctuation
The maximum amount the contract price can change, up or down, during one trading session, as stipulated by Exchange rules.

Minimum Price Fluctuation
Smallest increment of price movement possible in trading a given contract, often referred to as a "tick."

M.I.T.
Market-If-Touched. A price order that automatically becomes a market order if the price is reached.

Nearby
The nearest active trading month of a futures or options on futures contract. Also referred to as "lead month."

Offer
Also called "ask". Indicates a willingness to sell a futures contract at a given price. (See bid.)

Offset
Selling if one has bought, or buying if one has sold, a futures or options on futures contract.

Open Interest
Total number of futures or options on futures contracts that have not yet been offset or fulfilled by delivery. An indicator of the depth or liquidity of a market (the ability to buy or sell at or near a given price) and of the use of a market for risk- and/or asset-management.

Open Order
An order to a broker that is good until it is canceled or executed.

Opening
The period at the beginning of the trading session during which all transactions are considered made or first transactions were completed.

Opening Price (Or Range)
The range of prices at which the first bids and offers were made or first transactions were completed.

Option
A contract giving the holder the right, but not the obligation, hence, "option," to buy (call option) or sell (put option) a futures contract in a given commodity at a specified price at any time between now and the expiration of the option contract.

Out-Trades
A situation that results when there is some confusion or error on a trade. A difference in pricing, with both traders thinking they were buying, for example, is a reason why an out-trade may occur.

Position
An interest in the market, either long or short, in the form of open contracts. (See open interest.)

Performance Bond (Previously referred to as Margin)
Funds that must be deposited as a performance bond by a customer with his or her broker, by a broker with a clearing member, or by a clearing member, with the Clearing House. The performance bond helps to ensure the financial integrity of brokers, clearing members and the Exchange as a whole.

Performance Bond Call (previously referred to as Margin Call)
A demand for additional funds because of adverse price movement.

Premium
1.) The excess of one futures contract price over that of another, or over the cash market price. 2.) The amount agreed upon between the purchaser and seller for the purchase or sale of a futures option -- purchasers pay the premium and sellers (writers) receive the premium.

Put
An option to sell a commodity, security, or futures contract at a specified price at any time between now and the expiration of the option contract.

Rally
An upward movement of prices following a decline; the opposite of a reaction.

Range
The high and low prices or high and low bids and offers, recorded during a specified time.

Reaction
A decline in prices following an advance. The opposite of rally.

Registered Representative
A person employed by, and soliciting business for, a commission house or Futures Commission Merchant.

Round-Turn
Procedure by which a long or short position is offset by an opposite transaction or by accepting or making delivery of the actual financial instrument or physical commodity.

RTH (Regular Trading Hours)
The normal Trading Hours for a commodity. Also referred to as Day Session. (See Combined)

Scalp
To trade for small gains. Scalping normally involves establishing and liquidating a position quickly, usually within the same day, hour or even just a few minutes. Settlement Price
A figure determined by the closing range that is used to calculate gains and losses in futures market accounts. Settlement prices are used to determine gains, losses, margin calls, and invoice prices for deliveries. (See closing range.)

Short
One who has sold a futures contract to establish a market position and who has not yet closed out this position through an offsetting purchase; the opposite of long.

Short Hedge
The sale of a futures contract in anticipation of a later cash market sale. Used to eliminate or lessen the possible decline in value of ownership of an approximately equal amount of the cash financial instrument or physical commodity. (See hedge, long hedge.)

Speculator
One who attempts to anticipate price changes and, through buying and selling futures contracts, aims to make profits; does not use the futures market in connection with the production, processing, marketing or handling of a product. The speculator has no interest in making or taking delivery.

Spread
The simultaneous purchase and sale of futures contracts for the same commodity or instrument for delivery in different months, or in different but related markets. A spreader is not concerned with the direction in which the market moves, but only with the difference between the prices of each contract.

Stop Order (Or Stop)
An order to buy or sell at the market when and if a specified price is reached.

Tick
Refers to a change in price, either up or down. (See minimum price fluctuation.)

Trend
The general direction of the market.

Volume
The number of transactions in a futures or options on futures contract made during a specified period of time.

Writer
An individual who sells an option.

option

Options are of two basic types: The Call and the Put OptionA call option gives the holder the right to buy an underlying asset by a certain date for a certain price. The seller is under an obligation to fulfill the contract and is paid a price of this which is called "the call option premium or call option price".A put option, on the other hand gives the holder the right to sell an underlying asset by a certain date for a certain price. The buyer is under an obligation to fulfill the contract and is paid a price for this, which is called "the put option premium or put option price".The price at which the underlying asset would be bought in the future at a particular date is the "Strike Price" or the "Exercise Price". The date on the options contract is called the "Exercise date", "Expiration Date" or the "Date of Maturity".There are two kind of options based on the date. The first is the European Option which can be exercised only on the maturity date. The second is the American Option which can be exercised before or on the maturity date.In most exchanges the options trading starts with European Options as they are easy to execute and keep track of. This is the case in the BSE and the NSECash settled options are those where, on exercise the buyer is paid the difference between stock price and exercise price (call) or between exercise price and stock price (put). Delivery settled options are those where the buyer takes delivery of undertaking (calls) or offers delivery of the undertaking (puts).

index

What’s an Index?
An Index is a number used to represent the changes in a set of values between a base time period and another time period।

What’s a Stock Index?
A Stock Index is a number that helps you measure the levels of the market. Most stock indexes attempt to be proxies for the market they exist in.
Returns on the index thus are supposed to represent returns on the market i।e. the returns that you could get if you had the entire market in your portfolio.

Why do we need an Index?
Students of Modern Portfolio Theory will appreciate that the aim of every portfolio manager is to beat the market.
In order to benchmark the portfolio against the market we need some efficient proxy for the market.
Indexes arose out of this need for a proxy।

What does the number mean?
The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular portfolio.
This portfolio is called the index portfolio and attempts a high degree of correlation with the market.
Indexes differ based on the method of assigning the weightages to the stocks in the portfolio।

But why a portfolio? Why not the entire market?
This is because for someone who wishes to replicate the return on the market it is infinitely more expensive to buy the whole market and for small portfolio sizes it is almost impossible.
The alternative is to choose a portfolio that has a high degree of correlation with the market.

How are the stocks in the portfolio weighted?
There are basically three types of weighing :
Market Capitalisation weighted
Price weighted
Equal weighted
As may be discerned, the stocks in the index could be weighted based on their individual prices, their market capitalisation or equally।

What is the better weighing option?
The market capitalisation weighted model is the most popular and widely considered to be the best way of determining the index values.
In India both the BSE-30 Sensex and the S&P CNX Nifty are market capitalisation weighted indexes।

Who owns the index? Who computes it ?
Typically exchanges around the world compute their own index and own it too. The Sensex and the Nifty are case in point.
There are notable exceptions like the S&P 500 Index in the U।S. (owned by S&P which is a credit rating company) and the Strait Times Index in Singapore (owned by the newspaper of the same name).

Who decides what stocks to include? How?
Most index providers have a index committee of some sort that decides on the composition of the index based on standardised selection and elimination criteria.
The criteria for selection of course depends on the philosophy of the index and its objective.
Selection Criteria
Most indexes attempt to strike a balance between the following criteria.
Better Industry representation
Maximum coverage of market capitalisation
Higher Liquidity or Lower Impact cost.
Industry Representation
Since the objective of any index is to be a proxy for the market it becomes imperative that the broad industry sectors are faithfully represented in the Index too.
Though this seems like an easy enough task, in practice it is very difficult to achieve due to a number of issues, not least of them being the basic method of industry classification.
Market Capitalisation
Another objective that most index providers strive to achieve is to ensure coverage of some minimum level of the capitalisation of the entire market.
As a result within every industry the largest market capitalisation stocks tend to select themselves.
However it is quite a balancing act to achieve the same minimum level for every industry.
Liquidity or Impact Cost
It is important from the point of usability for all the stocks that are part of the index to be highly liquid. The reasons are two-fold.
An illiquid stock has stale prices and this tends to give a flawed value to the index.
Further for passive fund managers, the entry and exit cost at a particular index level is high if the stocks are illiquid। This cost is also called the impact cost of the index।

What is a Benchmark Index?
An index which acts as the benchmark in the market has an important role to play.
While it has to be responsive to the changes in the market place and allow for new industries or give up on dead industries, at the same time it should also maintain a degree of continuity in order to survive as an benchmark index.
What are the popular indexes in India?
BSE-30 Sensex
BSE-100 Natex
BSE Dollex
BSE-200
BSE-500
S&P CNX Nifty
S&P CNX Nifty Jr.
S&P CNX Defty
S&P CNX Midcap
S&P CNX 500

What are Sectoral Indexes?
These indexes provide the benchmark for sector specific funds.
Fund managers and other investors who track particular sectors of the economy like Technology, Pharmaceuticals, Financial Sector, Manufacturing or Infrastructure use these indexes to keep track of the sector performance।

What are the uses of an Index ?
Index based funds
These funds tend to replicate the index as it is in order to match the returns on the market.This is also know as passive management. Their argument is that it is not possible to beat the market over a sustained period of time through active management and hence it’s better to replicate the index. Example in India are
UTI’s fund on the Sensex
IDBI MF’s fund on the Nifty
Exchange traded funds (ETFs)
These are similar to index funds that are traded on an exchange.
These are pretty popular world wide with non-resident investors who like to take an exposure to the entire market.
S&P’s SPDRs and MSCI’s WEBS products are amongst the most popular products.
Index futures
Index futures are possibly the single most popular exchange traded derivatives products today.
The S&P 500 futures products is the largest traded index futures product in the world.
In India both the BSE and NSE are due to launch their own index futures product on their benchmark indexes the Sensex and the Nifty।

What is the trend abroad?
Although we have a whole host of popular exchange owned indexes abroad including the DAX 30, the CAC 40 and the Hang Seng we see an increasing trend where global index providers are seen to have more influence among the foreign funds and investing community।

What do Global Index providers bring ?
In the age of cross border capital flows and global funds, global index provider provide the uniformity and standardization in their index philosophy and methodologies that allows a global fund to compare performance across regions or sectors.
By following a common industry classification standard in all the countries that they operate in, index providers hope to wean away liquidity from the more popular and home grown indexes.
Also global providers are currently, the only ones in a position to provide pan-continental or pan-global indexes।

What does the future look like?
The future in India looks pretty exciting with Index futures being launched and Index options expected to follow. Hopefully with the growing popularity of ETF’s we might see SEBI allowing them in India too.
Globally while the debate between active and passive fund management still rages, we see standardised indexes growing in popularity.