What are derivatives?
Derivatives, as the name suggests, are financial instruments that
derive their value from an underlying security or asset. The
underlying could be equity shares or an index, a commodity, a currency
or the exchange rate, bonds, etc. Sounds complicated? In a way, it is.
But once you are clear about how a derivative product derives its
value from an underlying asset and yet has a price and an identity of
its own, it will become just another financial product to you. Then
again, derivative products have more variants than any other financial
products since they have been created to meet a variety of niche
needs.
Dependent on other products, yet a life of their own…
Here’s a little story about a sugarcane contract. There is a farmer
who will be harvesting a crop of sugarcane three months down the line.
As he is uncertain about how high or low the price of sugarcane will
be then, he decides to negotiate a price with his purchase agent right
now. They fix a price per quintal, which is suitable to both of them
and ink it into a contract that specifies how much the farmer will
supply, on what date and at what price
Now,
suppose after one month, the purchase agent decides that he does not
want to be a counter party to this contract anymore, he may find
another agent who is ready to relieve him of the contract. However, if
the price of sugarcane has already begun to fall in the market, the
second agent may not be one hundred percent comfortable with the terms
printed in the contract. He may feel that the contracted price is too
high. So, to compensate him, the first agent may pay him the
difference between the original contracted price and the price that he
feels is right.
If you can imagine that this contract can be traded over and over
again, between agents or any intermediaries, replicating the
transaction described above, until its expiry date, you have envisaged
a derivative product. You have understood how the value of the
contract depends upon the price of sugarcane but the actual price that
the contract commands could keep changing every time it changes hands,
for a variety of other reasons too.
There
are various derivative products, which derive their value from equity
shares or an index, a commodity, a currency or the exchange rate,
bonds, etc. These derivative products vary according to their
structure and terms and conditions. The most popular derivative
products are Forwards, Futures, Options, Warrants and Swaps. Some of
these are short term in nature while others are long term. For example
stock and index options that can be traded on stock exchanges are
short term in nature, while options like warrants and rights have a
longer term.
Who
benefits from such trades?
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The
first category of people who benefit from such trades are people
who wish to mitigate their risk, more specifically, the risk
originating from potential future adverse price movements. The
‘sugarcane farmer’ in the story would fall into this category and
could be considered a hedger, as he is hoping to avoid risks. The
second category of people that participate in this market are
people with an appetite for risk. These are speculators who take
over the risk from the hedgers in anticipation of good returns.
The ‘purchase agents and intermediaries’ who traded on the
sugarcane contract typify this class of derivative market
participants. The third popular category of people who stand to
gain from the market are arbitrageurs. These are participants who
try to gain from differences in the price of the derivative
product and its underlying asset. Both speculators and
arbitrageurs help to improve market liquidity since they buy
products with the intention of selling as soon as they see a
suitable price. |
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Is
there scope for retailers to participate in these markets?
Since
the introduction of futures and options segments on stock exchanges
and the setting up of commodity futures markets, even retail investors
can participate in these markets. In order to participate in either
market, you have to go through a broker who is affiliated with the
exchange on which you plan to trade. You will be required to deposit
an appropriate amount of token Margin money with your broker and fill
in requisite forms, before you begin to trade. However, the most
important prerequisite in order to trade in derivative products is,
understanding how each one works and the risks and potential returns
associated with them.
Derivative markets in India
Globally, the last four decades have seen phenomenal growth in
derivative markets. In the process, many new products have been
developed and this has also led to a sharp rise in volumes over the
years. Today, derivative markets have become an integral feature of
financial markets in developed countries and this phenomenon is
gaining momentum in developing countries, too.
Since
the introduction of futures and options in the Indian equity markets,
the turnover in this segment has increased manifold. For instance, in
the case of the National Stock Exchange (NSE), the average daily
turnover in the futures and options segment stood at Rs 410 crore for
the financial year 2001-02. By fiscal 2004-05, it increased 24 times
over to more than Rs 10,000 crore! In the financial year 2005-06, the
average daily turnover stood at a whopping Rs 19,000 crore!
Commodity derivatives in
India
are another active segment of the derivative markets in India.
Currently, we have around 25 commodity derivative exchanges with
around 100 commodities available for trading
More on Futures
A futures contract or a ‘future’ is a legally binding agreement
between two parties that one will buy from the other, a specific
quantity of a commodity or financial instrument at a specified price
with delivery set at a specified time in the future. Sounds just like
a forward contract, so far? However, futures contracts offer certain
beneficial features that forwards do not.
Types of futures
From
the point of view of settlement, there are 2 types of futures
contracts - those that provide for physical delivery (in the case of
commodities) and those, which are settled in cash. The delivery or
settlement is a pre-decided feature of the contract. The month and
date during which delivery or settlement is to occur is specified.
Thus, if you were to purchase a July futures contract, it would be due
for delivery or settlement on the last Thursday in July.
A
more popular classification of futures contracts however is based on
the underlying asset. There are four popular financial commodities,
which become underlying assets in futures. These are:
. Currencies (‘currency futures’). The underlying asset is a currency
(say the US dollar).
2. A
stock market index (‘index futures’). The underlying asset is a stock
market index (such as the NSE Nifty index).
3. Interest rates (‘interest rate futures’). The underlying asset is
an interest-earning debt security (such as a Treasury Bill).
4. Stocks (‘stock futures’). The underlying asset is an individual
stock (say shares of ABC Ltd.).
Features
1. Liquidity while trading
Futures contracts are standardized in terms of quantity and quality
(in the case of commodities) of the product traded, contract price and
settlement mechanism. Further, these are traded on exchanges, as
opposed to being tailor made to cater to the needs of only the parties
involved. As a result of these standardized features and the fact that
these products are traded on exchanges, there is always a ready market
for them.
. 2)No
counter party risk
Futures contracts are absolutely risk-free as regards counter party
risks (the risk that one of the parties to the contract may default)
for both buyers and sellers. This is so because this risk is assumed
by the clearing house, which becomes the counter party to all the
trades or unconditionally guarantees their settlement. So, if you were
to purchase a futures contract, you would, in effect, be purchasing it
from the exchange and hence you would be dealing directly with the
exchange who would guarantee your trade. As the financial integrity of
the entire system is ensured by the exchange through the clearing
house, credit risk of the transactions is eliminated.
. Better
price discovery
3)The obvious corollary to the above two points is that efficient
markets ensure better price discovery in the case of futures
contracts. Electronic exchange based trading creates a common ground
for buyers and sellers, ensuring larger volumes and minimized price
manipulation.
Trading in futures
A
futures transaction always has two parties, a buyer and a seller. If
you buy a contract, it is called taking a long position, and if you
sell a contract, you are taking a short position. In the futures
market, every contract has an equal number of long and short
positions.
When you
buy or sell a futures contract, you will simply be buying or selling a
specific type and quantity of the underlying asset at an agreed price,
for delivery or final settlement at a future date.
It may
appear that you are obligated to hold the futures contract till
maturity (expiration). However, in reality, you may also square up
your position in the contract with an offsetting trade (selling the
same number and type of futures that you have purchased earlier and
vice versa) at any time before the expiry of the contract.
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With
financial futures products, settlement of a contract at maturity
is in cash rather than by physical delivery. Commodity futures,
however, can be settled by delivery, i.e. actually taking delivery
of the physical commodity depending upon the contract
specifications. |
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Pricing of futures contracts
The
theoretical way of pricing any future is to factor in the current
price and holding costs (called ‘the cost of carry’) i.e. Futures
Price = Spot Price + Cost of Carry where:
• The
spot price = the price at which the underlying asset is currently
trading in the cash market; and,
• The cost of carry = the sum of all costs incurred if you take a
similar position in the cash market and carry it to the maturity of
the futures contract, less any revenue which may accrue during this
period. The costs typically include interest, in case of financial
futures, or interest, insurance and storage costs in case of commodity
futures. The revenue may be dividends, in case of stock futures.
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To
take a simplified example - If you buy 100 shares of XYZ Ltd. in
the cash market at Rs 120 each and hold them for the next 3
months, you would have invested Rs 12,000 (100 x 120). Instead, if
you had purchased 100 futures of XYZ Ltd, you would only be
required to invest say, 20 per cent of the value in the form of
margin i.e. Rs 2,400. By purchasing the shares in the cash
market, you are losing interest on part of your capital, i.e. Rs
9,600 (Rs 12,000 – Rs 2,400) for 3 months. If the interest cost is
7 per cent, you are in effect losing Rs 168 (7 per cent of Rs
9,600 for 3 months). Theoretically, this will become your 'cost of
carry' that is added to the cash price to arrive at the 3 month
futures price. Apart from this theoretical value, the actual value
may vary depending on the demand-supply of the underlying asset at
present and expectations about the future. |
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Basis
Basis =
Futures price – Spot price
The
difference between the price of the underlying asset in the cash
market and the futures price is called the basis. As a futures
contract reaches its expiry date, the basis tends to become less till
it becomes zero at the time of settlement. This is because the futures
contract is settled at the closing market price of the underlying
asset
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In
general, since the futures price is greater than the spot price,
the basis is positive. However, at times, the futures price may be
lower than the spot price. This may happen when expectations are
bearish in the near future or the cost of carry is negative etc. |
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Futures market participants
Operators in the futures markets can be broadly categorized in the
following 3 kinds:
1. Hedgers
Hedgers are the players who protect their long / short positions in
their regular business or trading ventures by entering the futures
markets. Let’s say you own 100 shares of ABC Ltd. If you fear that the
price of these shares will fall in the near future, you could protect
yourself financially, by selling ABC Ltd. futures in the market.
Here's how you remain insulated from any fall in price. If the cash
market price of ABC Ltd. at present is Rs 130 per share, you should
sell futures comprising of the same number of shares that you hold,
i.e. 100 shares, at a futures price that is as close to the prevailing
current price. For simplicity sake, let's say you manage to sell
futures at Rs 130 per share.
Three
months later, if the price of ABC Ltd. has fallen to Rs 110 you would
have made a loss of Rs 2,000 (Rs 20 x 100 shares) in your shares.
However, your futures contract will be settled at Rs 110 per share,
giving you a gain of Rs 2,000 (Futures sale price of Rs 130 -
settlement price of Rs 110 x 100 shares). Thus, your net value of
holding is protected.
Similarly, if the price of ABC Ltd. in the cash market rises, the
value of your net holdings will still remain unchanged, since the
appreciation in your shares will be nullified by the loss that you
make by settling your futures at a higher price than your selling
price.
2. Speculators
Speculators accept risk in pursuit of profit. This is a highly
specialized business and speculators’ success is dependent on their
ability to forecast the future prices of the underlying assets
accurately. As opposed to hedgers, they take naked positions in the
futures market i.e. they go long or short in various futures contracts
available in the market (without owning the underlying asset).
Speculators perform a very important function by acting as counter
parties to hedgers. It can hence be said that derivatives facilitate
the transfer of risk from hedgers to speculators.
3. Arbitrageurs
Arbitrageurs lock in their non-speculative profits by operating in
various markets simultaneously (long in one market and short in
another market). In the process, they remove mis-pricing, if any, in
either the cash or derivatives markets and align the prices through
operating in both the markets.
Speculators and arbitrageurs give enormous liquidity to the products
traded on the exchanges. This liquidity, in turn, results in better
price discovery, lower transaction costs and less manipulation of the
market |
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