Financial Derivaties -Notes

7/26/2019 Financial Derivaties -Notes

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FINANCIAL DERIVATIVES 14MBAFM411

Dept. of MBA- SJBIT Page 1

Subject Code: 14MBAFM411 IA Marks: 50No. of Lecture Hours / Week: 04 Exam Hours: 03Total Number of Lecture Hours: 56 Exam Marks: 100Practical Component: 01 Hour / Week

SyllabusModule I

Financial Derivatives - Introduction, economic benefits of derivatives - Types of financialderivatives - Features of derivatives market - Factors contributing to the growth of derivatives -functions of derivative markets - Exchange traded versus OTC derivatives - traders in derivativesmarkets - Derivatives market in IndiaModule II

Futures and forwards - differences-valuation of futures, valuation of long and short forwardcontract. Mechanics of buying & selling futures, Margins, Hedging using futures - specificationof futures - Commodity futures, Index futures, interest rate futures arbitrage opportunities.Module III

Financial Swaps - features and uses of swaps - Mechanics of interest rate swaps valuation ofinterest rate swapscurrency swapsvaluation of currency swaps.Module IV

Options: Types of options, option pricing, factors affecting option pricingcall and put optionson dividend and non-dividend paying stocks put-call parity - mechanics of options - stockoptions - options on stock index - options on futures interest rate options. Concept of exoticoption. Hedging & Trading strategies involving options, valuation of option: basic model, onestep binomial model, Black and Scholes Model, option Greeks. Arbitrage profits in options. Module V

Commodity derivatives: commodity futures market-exchanges for commodity futures in India,Forward markets, commissions and regulation-commodities traded trading and settlements

physical delivery of commodities.Module VI

Interest rate markets-Type of rates, Zero rates, Bond pricing, Determining Zero rates, Forwardrules, Forward rate agreements (FRA), Treasury bond & Treasury note futures, Interest ratederivatives (Black model).Module VIICredit risk-Bond prices and the probability of default, Historical default experience,Reducing exposure to Credit risk, Credit default swaps, and Total return swaps, and Creditspread options, Collateralized debt obligation.Module VIIICredit risk - Bond prices and the probability of default, Historical default experience, reducing

exposure to Credit risk, Credit default swaps, Total return swaps, Credit spread options,Collateralized debt obligation.Value at Risk (VAR)-Measure, Historical simulation, Model building approach, linearapproach, Quadratic model, Monte Carlo simulation, stress testing and back testing.


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Table of content

MODULES CONTENT PAGE NUMBER

1 Financial Derivatives 03-08

2 Futures and forwards 09-12

3 Financial Swaps 13-15

4 Options 16-26

5 Commodity derivatives 27-35

6 Interest rate markets 36-43

7 Credit risk & Value at

Risk (VAR)44-49


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Module 1

Financial Derivatives

Introduction

Financial derivatives are financial instruments that are linked to a specific financial instrument orindicator or commodity, and through which specific financial risks can be traded in financialmarkets in their own right. Transactions in financial derivatives should be treated as separatetransactions rather than as integral parts of the value of underlying transactions to which theymay be linked. The value of a financial derivative derives from the price of an underlying item,such as an asset or index. Unlike debt instruments, no principal amount is advanced to be repaidand no investment income accrues. Financial derivatives are used for a number of purposesincluding risk management, hedging, arbitrage between markets, and speculation.

Financial derivatives enable parties to trade specific financial risks (such as interest rate risk,currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more

willing, or better suited, to take or manage these riskstypically, but not always, without tradingin a primary asset or commodity. The risk embodied in a derivatives contract can be traded eitherby trading the contract itself, such as with options, or by creating a new contract which embodiesrisk characteristics that match, in a countervailing manner, those of the existing contract owned.This latter is termed offsetability, and occurs in forward markets. Offsetability means that it willoften be possible to eliminate the risk associated with the derivative by creating a new, but"reverse", contract that has characteristics that countervail the risk of the first derivative. Buyingthe new derivative is the functional equivalent of selling the first derivative, as the result is theelimination of risk. The ability to replace the risk on the market is therefore considered theequivalent of tradability in demonstrating value. The outlay that would be required to replace theexisting derivative contract represents its valueactual offsetting is not required to demonstrate

value.

Financial derivatives contracts are usually settled by net payments of cash. This often occursbefore maturity for exchange traded contracts such as commodity futures. Cash settlement is alogical consequence of the use of financial derivatives to trade risk independently of ownershipof an underlying item. However, some financial derivative contracts, particularly involvingforeign currency, are associated with transactions in the underlying item.

Economic benefits of derivatives

1.

Price Di scovery

Futures market prices depend on a continuous flow of information from around the world andrequire a high degree of transparency. A broad range of factors (climatic conditions, politicalsituations, debt default, refugee displacement, land reclamation and environmental health, forexample) impact supply and demand of assets (commodities in particular) - and thus the currentand future prices of the underlying asset on which the derivative contract is based. This kind ofinformation and the way people absorb it constantly changes the price of a commodity. Thisprocess is known as price discovery.


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o With some futures markets, the underlying assets can be geographically dispersed, havingmany spot (or current) prices in existence. The price of the contract with the shortest time toexpiration often serves as a proxy for the underlying asset.

o Second, the price of all future contracts serve as prices that can be accepted by those whotrade the contracts in lieu of facing the risk of uncertain future prices.

o

Options also aid in price discovery, not in absolute price terms, but in the way the marketparticipants view the volatility of the markets. This is because options are a different form ofhedging in that they protect investors against losses while allowing them to participate in theasset's gains.

2. Risk Management

This could be the most important purpose of the derivatives market. Risk management is theprocess of identifying the desired level of risk, identifying the actual level of risk and altering thelatter to equal the former. This process can fall into the categories of hedging and speculation.Hedging has traditionally been defined as a strategy for reducing the risk in holding a market

position while speculation referred to taking a position in the way the markets will move. Today,hedging and speculation strategies, along with derivatives, are useful tools or techniques thatenable companies to more effectively manage risk.

3. They Improve Market Ef fi ciency for the Underl ying Asset

For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fundor replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either of thesemethods will give them exposure to the index without the expense of purchasing all theunderlying assets in the S&P 500. If the cost of implementing these two strategies is the same,investors will be neutral as to which they choose. If there is a discrepancy between the prices,

investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In thiscontext, derivatives create market efficiency.

4. Deri vatives Al so Help Reduce Market Transaction Costs

Because derivatives are a form of insurance or risk management, the cost of trading in them hasto be low or investors will not find it economically sound to purchase such "insurance" for theirpositions

Types of financial derivatives.

1. Forward- This is a form of contract wherein two parties agree on buying or selling an asset atan agreed price. The actual exchange then happens on a future date, thus the term forwards. Thecontract happens among the parties themselves without an outside party interfering. The contractin a forward type of financial derivative is non-standardized. It is subject to the choices of theparties engaged in a forward contract.


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2. Futures- A futures contract is similar in some manner to the forward type. It also involves anagreement on sales of an asset on a future time. However, financial derivatives contracts of thiscategory have a standardized contract form. The terms and conditions of the contract arearranged by a third party called a clearing house.

3. Options- This type of contract allow the person involved to have the option of exercising hisright on the assets. Transactions start at a specified price called a strike price. A maturity date isthen set for the owner to exercise his option of buying or selling the asset. The owner has theoption of using his right on the exact date of maturity and not before in a European option. TheAmerican option allows the owner to exercise his right on or before the maturity date.

4. Swaps- Contracts involving swaps allow transactions to occur before a future date. Like allfinancial derivative types, swaps derive their financial value based on the underlying asset.

Factors driving the growth of Derivatives

Increased volatility in asset prices in financial markets Increased integration of national financial markets with the international markets. Marked improvement in communication facilities and sharp decline in their costs, Development of more sophisticated risk management tools, providing economic agents

A wider choice of risk management strategies, and 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. Transactions costs as compared to individual financial assets.

Functions of derivative markets

1. Prices in an organized derivatives market reflect the perception of market participantsabout the future and lead the prices of underlying to the perceived future level. The prices ofderivatives converge with the prices of the underlying at the expiration of the derivative contract.Thus derivatives help in discovery of future as well as current prices.

2. The derivatives market helps to transfer risks from those who have thembut may not like them to those who have an appetite for them.

3. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With theintroduction of derivatives, the underlying market witnesses higher trading volumes because of

participation by more players who would not otherwise participate for lack of an arrangement totransferrisk.

4. Speculative trades shift to a more controlled environment of derivatives market. In the absenceof an organized derivatives market, speculators trade in the underlying cash markets. Margining,monitoring and surveillance of the activities of various participants become extremely difficult inthese kind of mixed markets.


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5. An important incidental benefit that flows from derivatives trading is that it acts as a catalystfor new entrepreneurial activity. The derivatives have a history of attracting many bright,creative, well-educated people with an entrepreneurial attitude. They often energize others tocreate new businesses, new products and new employment opportunities, the benefit of whichare immense.

Exchange traded versus OTC derivatives

The Difference between Exchange trading & Over-The-Counter trading (OTC Trading).Many financial markets around the world, such as stock markets, do their trading throughexchange. However, forex trading does not operate on an exchange basis, but trades as Over-The-Counter markets (OTC). The stocks, bonds and other instruments traded on theseexchanges are known as listed securities. Over the counter, or OTC, traded securities encompassall other financial securities. Understanding the differences between listed and an OTCtransaction is crucial whether you want to trade shares or sell your firms shares to investors.

Difference between Exchange Trading & OTC Trading:

1. Centralization ofMarket:In a market that operates with exchange trading, transactions arecompleted through a centralized source. In other words, one party acts as the mediatorconnecting buyers and sellers. There is a specified number of traders that will trade on thatsingle centralized system. On the other hand, over-the counter markets are generallydecentralized. Here, there are many mediators who compete to link buyers to sellers. Theadvantage to this is that it ensures that costs for intermediary services are as low as possible.
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2. Standardization: An Exchange Trade is a standard contract whereinStock exchange acts asa guarantor for all the trades. But, OTC contracts are customized as there is no specifiedguarantor and hence the risk increases a lot.

3. Counterparty Risk:When you buy or sell something OTC in a private transaction, there is

always the risk of not getting what you bargained for. The other party might not be able todeliver the stock, bond or other security within the agreed upon time frame. It might alsodeliver a different kind of stock or bond than promised. These risks are broadly referred to ascounterparty risk. In an exchange, however, counterpart risk is not an issue. The tradingoccurs through brokers who are closely monitored by both the exchange and the Securitiesand Exchange Commission. Investors buy exchange traded securities with greater confidenceand therefore pay more for such stocks. Because of this, businesses are better off sellingshares through an exchange rather than in a private transaction.

4. Visibility: As Exchange market is an open market wherein there is a clear visibility forprices, start date, expiration dates &counterparties involved in a deal etc. But, this is not the

case with OTC market as all the terms & conditions associated with any deal is between thecounterparties only.

5. Parties Involved: In exchange traded markets, the exchange is the counterparty to all of thetrades. Additionally, there is price standardization and execution. One negative theseexchanges involves less price competition. OTC, or over the counter markets, have nocentralized trading facility. This promotes heavy competition between counterparties andlowertransaction costs. The lack of regulation can introduce fraudulent firms and transactionexecution quality may decrease.

Traders in derivatives markets

There are three types of traders in the derivatives market:

1. Hedger2. Speculator3. Arbitrageur

Hedger: A hedge is a position taken in order to offset the risk associated with some otherposition. A hedger is someone who faces risk associated with price movement of an asset andwho uses derivatives as a means of reducing that risk. A hedger is a trader who enters the futuresmarket to reduce a pre-existing risk.

Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy andsell derivatives to make profit and not to reduce risk. Speculators willingly take increased risks.Speculators wish to take a position in the market by betting on the future price movements of anasset. Futures and options contracts can increase both the potential gains and losses in aspeculative venture. Speculators are important to derivatives markets as they facilitate hedgingprovide liquidity ensure accurate pricing, and help to maintain price stability. It is the speculatorswho keep the market going because they bear risks which no one else is willing to bear.
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Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two ormore markets to take advantage of discrepancy between prices in these markets For example, ifthe futures price of an asset is very high relative to the cash price, an arbitrageur will make profitby buying the asset and simultaneously selling futures. Hence, arbitrage involves making profitsfrom relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and

uniform pricing, and enhance price stability.All three types of trades and investors are required for a healthy functioning of the derivativesmarket. Hedgers and investors provide economic substance to this market, and without them themarkets would become mere tools of gambling. Speculators provide liquidity and depth to themarket. Arbitrageurs help in bringing about price uniformity and price discovery. The presenceof Hedgers, speculators and arbitrageurs, not only enables the smooth functioning of thederivatives market but also helps in increasing the liquidity of the market.

Derivatives Market in India:

In India, commodity futures date back to 1875. The government banned futures trading in manyof the commodities in the sixties and seventies. Forward trading was banned in the 1960s by thegovernment despite the fact that India had a long tradition of forward markets. Derivatives werenot referred to as options and futures but as tezi-mandi.

In exercise of the power conferred on it under section 16 of the Securities Contracts (Regulation)Act, the government by its notification issued in 1969 prohibited all forward trading in securities.However, the forward contracts in the rupee dollar exchange rates (foreign exchange market) areallowed by the Reserve Bank and used on a fairly large scale. Futures trading is permitted in 41commodities. There are 18 commodity exchanges in India. The Forward Markets Commissionunder the Ministry of Food and Consumer Affairs acts as a regulator.

In the case of capital markets, the indigenous 125 year old badla system was very popular amongthe broking and investor community. The advent of foreign institutional investors in the ninetiesand a large number of scams led to a ban on badla. The foreign institutional investors (FIIs) werenot comfortable with this system and they insisted on adequate risk-management tools. Hence,the Securities and Exchange Board of India (SEBI) decided to introduce financial derivatives inIndia. However, there were many legal hurdles which had to be overcome before introducingfinancial derivatives. The preamble of the Securities Contract (Regulation) Act, states that theAct was to prevent undesirable transactions in Securities by regulating business of dealingtherein, by prohibiting options, and by providing for certain other matters connected therewith.Section 20 of the Act explicitly prohibits all options in securities. The first step therefore was to

withdraw all these prohibitions and make necessary amendments in the Act.


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Module II

Futures and forwards

Forwards are the simplest of the derivative instruments. A forward contract is an agreement to

buy, or sell, an asset at a certain time for a certain price.Features of Forwards

Forwards are transactions involving delivery of an asset or a financial instrument at afuture date, and therefore, are over-the-counter (OTC) contracts.

OTC products are customized contracts which are written across the counter or struck ontelephone, fax or any other mode of communication by financial institutions to suit theneeds of their customers.

Both the buyer and seller are committed to the contracts. They have to take delivery anddeliver respectively, the underlying asset on which the forward contract was entered into.

They are bilateral contracts & hence, exposed to counter party risk. One of the parties to the contract assumes a long position (buying of a security such as

stock, commodity or currency, with the expectation that the asset will rise in value) &agrees to buy the underlying asset on a certain specified date, for a certain specified price.

The other party assumes a short position & agrees to sell the asset on the same date forthe same price.

Forward contracts are normally traded outside the stock exchange. They are very useful in hedging & speculation. The contract price is generally not available on public demand.

Each contract is customer designed & hence, is unique in terms of contract size,expiration date & the asset type & quality.

FUTURE CONTRACTS

Future markets are designed to solve the problems that exist in forward markets. 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. It is an agreement to deliver (sell) or take delivery (buy) of a standardized quantity of an

underlying commodity/instrument, at a pre-established price agreed on a regulated

exchange at a specified future date.


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Features of Future Contract

1. Future contracts are standardized & stock exchange traded.2. The standardized items in a future contracts are: Quality of the underlying

Quantity of the underlying The date/month of delivery The units of price quotation & minimum price change Location of settlement

3. Both the parties pay a margin to the clearing association. This is used as a performance bondby contracting parties.

4. Each futures contract has an association month which represents the month of contractdelivery or final settlement. For example, a September T-bill, a March Euro etc.

VALUING FUTURES AND FORWARD CONTRACTS

Infinance,a futures contract (more colloquially, futures) is a standardizedcontractbetween twoparties to buy or sell a specified asset of standardized quantity and quality for a price agreedupon today (the futures price orstrike price)with delivery and payment occurring at a specifiedfuture date, the delivery date. The contracts are negotiated at a futures exchange,which acts asan intermediary between the two parties. The party agreeing to buy the underlying asset in thefuture, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset inthe future, the "seller" of the contract, is said to be "short"

Valuation of long and short forward contract

a forward contract or simply a forward is a non-standardized contract between two parties to buyor to sell an asset at a specified future time at a price agreed upon today.[1]This is in contrast to aspot contract,which is an agreement to buy or sell an asset today. The party agreeing to buy theunderlying asset in the future assumes along position,and the party agreeing to sell the asset inthe future assumes ashort position.The price agreed upon is called thedelivery price,which isequal to theforward price at the time the contract is entered into

Mechanics of buying & selling futures

Before you decide to buy and/or write (sell) options, you should understand the other costs

involved in the transactioncommissions and fees. Commission is the amount of money, peroption purchased or written, that is paid to the brokerage firm for its services, including theexecution of the order on the trading floor of the exchange. The commission charge increases thecost of purchasing an option and reduces the sum of money received from writing an option. Inboth cases, the premium and the commission should be stated separately.

Each firm is free to set its own commission charges, but the charges must be fully disclosed in amanner that is not misleading. In considering an option investment, you should be aware that:
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can be charged on a per trade or a round-turn basis, covering both the purchaseand sale.

charges can differ significantly from one brokerage firm to another.Some firms have fixed commission charges (so much per option transaction) and others

charge a percentage of the option premium, usually subject to a certain minimum charge.

charges based on a percentage of the premium can be substantial, particularly ifthe option is one that has a high premium.

charges can have a major impact on your chances of making a profit. A highcommission charge reduces your potential profit and increases your potential loss.

Margins

Margin Trading: Introduction

Imagine this: you're sitting at the blackjack table and the dealer throws you an ace. You'd love to

increase your bet, but you're a little short on cash. Luckily, your friend offers to spot you $50 andsays you can pay him back later. Tempting, isn't it? If the cards are dealt right, you can win bigand pay your buddy back his $50 with profits to spare. But what if you lose? Not only will yoube down your original bet, but you'll still owe your friend $50. Borrowing money at the casino islike gambling on steroids: the stakes are high and your potential for profit is dramaticallyincreased. Conversely, your risk is also increased.

Margin Trading: What Is Buying On Margin?

The Basics

Buying on margin is borrowing money from a broker to purchase stock. You can think of it as aloan from your brokerage. Margin trading allows you to buy more stock than you'd be able tonormally. To trade on margin, you need amargin account.This is different from a regularcashaccount,in which you trade using the money in the account. By law, your broker is required toobtain your signature to open a margin account.

You are more likely to lose lots of money (or make lots of money) when you invest on margin.

Now let's recap other key points in this tutorial:

Buying onmargin is borrowing money from a broker to purchase stock. Margin increases yourbuying power. An initial investment of at least $2,000 is required (minimum margin). You can borrow up to 50% of the purchase price of a stock (initial margin). You are required to keep a minimum amount of equity in your margin account that can

range from 25% - 40% (maintenance margin). Marginable securities act ascollateral for the loan. Like any loan, you have to pay interest on the amount you borrow. Not all stocks qualify to be bought on margin.
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You must read the margin agreement and understand its implications. If the equity in your account falls below the maintenance margin, the brokerage will issue

amargin call. Margin calls can result in you having toliquidate stocks or add more cash to the account. Brokers may be able to sell your securities without consulting you.

Margin meansleverage. The advantage of margin is that if you pick right, you win big. The downside of margin is that you can lose more money than you originally invested. Buying on margin is definitely not for everybody. Margin trading is extremely risky.

Hedging using futures:

Long & Short Hedges A long futures hedge is appropriate when you know you will purchase an asset in the

future and want to lock in the price

A short futures hedge is appropriate when you know you will sell an asset in the future &want to lock in the price

Commodity futuresAn agreement to buy or sell a set amount of a commodity at a predetermined price and date.Buyers use these to avoid the risks associated with the price fluctuations of the product or rawmaterial, while sellers try to lock in a price for their products. Like in all financial markets,others use such contracts to gamble on price movements.

Index futures

A futures contract on a stock or financial index. For each index there may be a different multiple

for determining the price of the futures contractInterest rates futures

Interest rates vary between countries based on their economic health, which creates anopportunity for investors. By purchasing a foreign currency and depositing it abroad, investorscan effectively capitalize on the difference in interest rates in some cases. While these bets are nolonger as popular as they used to be, they are still widely used in the financial markets.

Risks with Interest Rate Arbitrage

Despite the impeccable logic, interest rate arbitrage isn't without risk. The foreign exchangemarkets are fraught with risk, due to the lack of cohesive regulation and tax agreements. In fact,

some economists argue that covered interest rate arbitrage is no longer a profitable businessunless transaction costs can be reduced to below market rates.
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MODULE-3

SWAPS

The word swap literally means an exchange.

A financial swap may be defined as a contract whereby two parties, exchange two streams ofcash flows over a defined period of time, usually through an intermediary like a financialinstitution.

Types of Swaps

There are two major types of swap structures (I) Interest-rate swaps and (ii) currency swaps.Interest-rate swaps

An interest rate swap (IRS) is a contractual agreement between counter-parties to exchange a

series of interest payments for a stated period of time. The payments in a swap are similar tointerest payments on a borrowing. A typical IRS involves exchanging fixed and floating interestpayments in the same currency.

Features of IRS There is no exchange of principal Only the interest payments are exchanged. They are usually netted on the settlement dates

and only the net value is exchanged between counter parties. Any underlying loan or deposit is not affected by the swap. The swap is a separate

transaction.

(ii) Currency Swap

A currency swap is a contractual agreement between counter parties in which oneparty makes payments in one currency and other party makes payments in a different currencyfor a stated period of time.

Commodity Swap

A commodity swap is a contractual agreement between counter parties, wherein at least one setof payments involved is set by the price of the commodity or by the price of a commodity index.

Equity index Swap

An equity swap or an equity index swap is a contractual agreement between counterparties, wherein at least one party agrees to pay the other a rate of return based on a stock indexduring the life of the swap.


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Mechanics of Interest Rate Swaps

The most common type of a financial swap is an interest-rate swap. In this, one party, B,agrees to pay to the other party, A, cash flows equal to interest at a predetermined fixed rate on anotional principal for a number of years.

At the same time, party A agrees to pay party B cash flows equal to interest at a floatingrate on the same notional principal for the same period of time. The currencies of the two setsinterest cash flows are the same. The life of the swap can range from two years to over 15 years.

LIBOR

The floating rate in many interest rate swap agreements is the London Inter-bank OfferRate (LIBOR). LIBOR is the rate of interest offered by banks on deposits from other banks inEurocurrency markets. LIBOR rates are determined by trading between banks and changefrequently so that the supply of funds in the inter-bank market equals the demand for the funds in

that market.

MIBOR- Mumbai Inter-Bank Offer Rate

II. Currency Swap

A currency swapis a foreign-exchange agreement between two institutions to exchange aspects(namely theprincipal and/orinterestpayments) of aloan in one currency for equivalent aspectsof an equal in net present value loan in another currency; see foreign exchange derivative.Currency swaps are motivated by comparative advantage. A currency swap should be

distinguished from acentral bank liquidity swap.

Valuation of Interest Rate Swaps

Value of the swap is the difference between the value of fixed rate bondunderlying the swap (Bfix) and value of floating rate bond underlying the swap (B fl).

Thus, Vswap= Bfl-Bfix

Bfix = Ke-r1t1 + Pe-rntn

Where, r1= appropriate zero rate for a maturity t1

t1= time when ith payment are exchanedK = fixed receipt (payment) on each payment dateP = Notional principal amount.
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Currency swaps are over-the-counter derivatives,and are closely related to interest rate swaps.However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.There are three different ways in which currency swaps can exchange loans

The simplest currency swap structure is to exchange only the principal with thecounterparty at a

specified point in the future at a rate agreed now. Such an agreement performs a functionequivalent to aforward contract orfutures.The cost of finding a counterparty (either directly orthrough an intermediary), and drawing up an agreement with them, makes swaps more expensivethan alternative derivatives (and thus rarely used) as a method to fix shorter term forwardexchange rates. However for the longer term future, commonly up to 10 years, where spreads arewider for alternative derivatives, principal-only currency swaps are often used as a cost-effectiveway to fix forward rates. This type of currency swap is also known as an FX-swap.

Valuation of Currency Swaps

A currency swap can be decomposed into a position in two bonds: foreign bonds anddomestic currency bond. If Vs represents the value of swaps where foreign currency is receivedand domestic currency is paid.

Vs=EOBF-BD

Where BF is the value, measured in the foreign currency, of the foreign denominatedbond underlying the swap; BDis the value in rupees of the INR bond underlying the swap; andEOis the current spot exchange rate (expressed as no. of rupees per unit of foreign currency). Thevalue of a swap where the domestic currency is received and foreign currency is paid

Vs = BDEOBF

Prob:1 Suppose the term structure of LIBOR interest rates is flat in both India and United States.The US rates is 4% per annum and the rate is 9% per annum in India (both with continuouscompounding). A financial institution has entered into a currency swap where it receives 5% perannum in dollar and pays 8% per annum in rupees once a year. The principals in the twocurrencies are rupees 10 million and $2.5 million. The swap will last for another 3 years and thecurrency exchange rate is $1=Rs.39.5. What is the value of the swap
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Module 4

Options

Introduction

The trading in options began in Europe and the US as early the 18 thcentury. It was onlyin the early 1900s that a group of firms set up, what was known as the Put and Call Brokers andDealers Association, with the aim of providing a mechanism for bringing buyers and sellerstogether.

Suddenly the options market got a big boost in the year 1973 mainly for two reasons.First, Fisher Black and Myron Scholes developed an options valuation model which forms thebasis for pricing of options. Second, in April 1973, CBOE (Chicago Board Options Exchange)was set up specifically for the purpose of trading in options.

In India, NSE introduced trading in index options and options on individual securities onJune 4, 2001 and July 2, 2001 respectively.

MeaningOptions contract is a type of derivatives contract which gives the buyer or holder of the

contract the right (but not the obligation) to buy or sell the underlying asset at a predeterminedprice within or at the end of a specified period.

The buyer or holder of the option purchases the right from the seller or writer for aconsideration which is called the premium. The seller or writer of an option is obliged to settlethe option as per the terms of the contract when the buyer or holder exercises his right. Theunderlying asset could include securities, an index of prices of securities, currency, etc.

DefinitionUnder Securities Contracts (Regulations) Act 1956, option on securities has been defined

as option in securities means a contract for the purchase or sale of a right to buy or sell, or aright to buy and sell, securities in futures.

The NSE and BSE have introduced index based options and stock options which facilitatehedging of risk exposures and speculations with high leverage.


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Parties in Options Trading

There are three parties involved in the options trading: The option seller or option writer The option buyer

The broker

The Option Seller (writer) is a person who grants someone else the option to buy or sell.He receives a premium (option price) in return. The option writer is usually a skilledmarket player with an in-depth knowledge of the market. He is willing to take unlimitedrisk in return for a limited profit. The premium paid by the buyer of option is his limitedincome, but loss is unlimited.

The Option Buyer pays a price to the option writer to induce him to write the option. Thetrade between options writer and buyer is a zero-sum game. Writers profit is buyersloss.

The securities broker acts as an agent to find the option buyer and the seller, and receivesa commission or fee for it.

Players in the Option Market

Hedgers: The objective of many players in the options market is to reduce the risk. They arenot in the options market to make profits. They want to safeguard their existing positions.

Speculators: These are the traders whose objective is to make profits. They are willing totake risks and they bet upon whether the markets would go up or come down.

Arbitrageurs: Risk-less profit making is the prime goal of arbitrageurs. Buying in onemarket and selling in another market. They could be making profits even without putting in

their own money and such opportunities often come up in the market but they last for veryshort time frames.

Types of Options

Exercise Style A European Option contract may be exercised only on the contracts expiration date.(If the

option is exercised by the holder) An American Option contract can be exercised at any time prior to the contractsexpiration

date, at the holders discretion. Thus, the exercise date of an American option can bedifferent from its expiration date. In India, except stock index options, rest of the options are

American type options.


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II. Structure Call Options: The option to buy an asset is known as a call option Put Options: The option to sell an asset is called a put option.

The put or call options can further be categorized into equity options, index options,foreign currency options, option on futures and interest rate options.

1. Equity Options: The best known options are those that give their owner the right to buy or sellshares of stock. These are stock options, also commonly called equity options. With exchangetraded options, the underlying asset is 100 shares of the stock. A person who buys a call optionon the stock of a particular company, he is purchasing the right to buy 100 shares of stock.

2. Index Options: Where the underlying asset of an option is some market measure like theNIFTY 50 Index, such an option is called index option. While these are similar to equity options

in most respects, one important difference is that they are cash-settled.

3. Future Option: The underlying asset is a futures contract. An option on a futures contract islike other exchange traded options, except that holders acquire the right to buy or sell a futurescontract on an underlying asset, rather than the asset itself. When the holders of a call optionexercise, they acquire from the writers a long position in the underlying futures contract. Whenthe holders of a put option exercise, they acquire a short position in the underlying futurescontract.

4. Currency Option: It gives the buyer the right to buy or sell a fixed quantity of a specified

currency in exchange for a specific quantity of another currency, in a ratio determined by thestrike price of the option.

5. Interest Rate Option: They are the instruments whose payoffs are dependent in some way onthe level of interest rates. They are used to hedge interest rate risk exposure.

III. StandardStandard Options: They are traded on recognized stock exchanges world over and their volumeis growing at an astronomical rate.Exotic Options: Besides trading options on the exchanges, it is also possible to enter into privateoption arrangements with brokerage firms or other dealers. It is also called OTC option.


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Basic Option Positions

CALL PUT

BUY Right to buy Right to sell

WRITE Obligation to sell Obligation to buy

Payoff Profile for Buyer of Call Options:

A call option gives the buyer the right to buy the underlying asset at a strike pricespecified in the option. The profit/loss that the buyer makes on the option depends on the spotprice of the underlying.

If upon expiration the spot price exceeds the strike price, he makes a profit.

Higher the spot price, more is the profit he makes. On the other hand, If the spot price of theunderlying is less than the strike price, he lets his option expire un-exercised.

His loss in this case is the premium paid for buying the option.

For example, if an investor bought 1 month (March) HPCL stock call option witha strike price of Rs.500 on March 12 at a premium of Rs.16, the payoff profile for the buyer ofcall option is below:

Factors Affecting Option Prices

Factors Affecting Call Prices

1. The current share price

The higher the current (spot) share price, the greater is the probability that the share price willincrease above the exercise price in future, and therefore the higher the call price. If the currentshare price is low, the exercise price also will be low.

2. The exercise price

The higher the exercise price, the lower the option price I.e. the lower is the probability that theshare price will increase above the exercise price. For example, on Oct 20, the Nov-360 has aoption price of Rs.18, whereas the Nov-370 has a option price of only Rs.15.65.


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Prices of selected call options on Maruthi shares on Oct 20, 2004

Expiry Month Exercise Type of Option Price (Rs.)Price (Rs.)

October 350 American call 1 7.40

October 360 American call 9.35

November 360 American call 1 8.00

November 370 American call 15.65

3. The term to expiry

The longer the term to expiry, the greater is the probability that share price willincrease above the exercise price. Therefore, the longer the term to expiry, the greater is the callprice. For example, on October 20, the Oct-360 American call price is 9.35, whereas the Nov360 American Call price is 18.

4. The Volatility of the Share

The volatility of a share is the variability of the price over time. Consider a high volatilityshare, H, whose current price is Rs.5 and a low volatility share, L, whose current price is alsoRs.5. Consider call options on H and L, the expected values of the calls on shares H and L are:

E (call on H) = (0.2) (0.50) + (0.2) (1.00)= Rs.0.30

E (call on L) = (0.16) (0.50) + (0.04) (1.00)= Rs.0.12

The call on the low volatility share is less valuable than the call on the high-volatility share.

5. The risk-free interest rate

The buyer of a call option can defer paying for the shares. Because interest rates arepositive, money has a time value, so the right to defer payment is valuable. The higher the

interest rate, the more valuable is this right. Therefore, it is plausible to suggest that the higherthe risk-free interest rate, the higher is the price of a call.

6. Expected dividend

If a company pays a dividend to its ordinary shareholders the share price will fall on theex-dividend date. The price of a call will decrease if the price of the underlying share decreases.


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The calls on shares that pay high dividends during the life of the call are worth less thancalls on shares that pay low dividends during the life of the call.

To summarize, other things being equal, call option prices should higher:The higher the current share price

The lower the exercise price.The longer the term to expiryThe more volatile the underlying shareThe higher the risk-free interest rate andThe lower the expected dividend to be paid following an ex-dividend date that occurs during theterm of the call.

Factors Affecting Put Option Price

The buyer of the put option obtains the right to sell shares at the exercise price. The higher theexercise price, the buyer of the put option stands to gain. For example, the buyer of the put

option will prefer to sell, if the exercise price is Rs.100 than Rs.90. Therefore, for put options,the higher the exercise price, the higher the price of the option.

The buyer of the put option is willing the current share price should be low comparing with theexercise price. Then the option Price will go up. For example, the current market price is Rs.90and the exercise price is Rs.100. The current market price lower than the exercise price. So, theprice of the put option will be high.

If the term of the put option is shorter, the price of the put option will be high. For example, Nov350, American put option price is 8.00 but Dec 350 American put option price is 2.65.

Higher volatility implies a greater chance of large increases and large decreases in the shareprice. From the put holdersviewpoint, share price increases are bad news, while decreases aregood news. So, a put holder has a favorable view of share price volatility.

A higher interest rate reduces the present value of whatever future cash inflow received by theput option holder. If interest rate is low, the option price will be high.

Finally, dividend payments reduce share price, which benefits put holders, so higher expecteddividend payments increase put prices.


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Estimation of Equity Option Price

European Call OptionNon-Dividend paying stocksCE= SO-Ke-rT

Where CE = Price of Call option

SO= Stock priceK= Strike pricer= Risk free rate of interestT= Maturity period

European Call OptionDividend paying stocks

CE= SO-De-rT-Ke-rT

De-rT= Present value of dividends

European Put OptionNon-Dividend paying stocks

Formula: PE= Ke-rT- SO

Put-Call Parity

Put-call parity establishes that European call and put options values are identical. This meansthat:

CE+ Ke-rT= PE+SO

It shows that the value of European call with a certain exercise price and exercise date isequal to the value of a European put with the same exercise price and date.

Alternatively European call option price should be equal to the price of a put option withthe same strike price and expiration date plus a sum equal to the current price of the underlyingasset minus the present value of the options strike price.

CE= PE+SO -Ke-rT

If call prices are too high relative to put prices, an arbitrageur can lock in a risk less profit

by selling a call and simultaneously buying a put, borrowing the amount equal to Ke-rTat therisk-free interest rate and buying the underlying asset.


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Exotic option

An exotic optionis anoption which has features making it more complex than commonly tradedvanillaoptions.Like the more generalexotic derivatives they may have several triggers relating to determinationof payoff. An exotic option may also include non-standard underlying instrument, developed for a

particular client or for a particular market. Exotic options are more complex than options that trade on anexchange, and are generally tradedover the counter (OTC).

Valuation of option:

Binomial options pricing model

The binomial options pricing model (BOPM) provides a generalizablenumerical method for thevaluation of options. The binomial model was first proposed by Cox, Ross and Rubinstein in1979. Essentially, the model uses a discrete-time (lattice based) model of the varying priceover time of theunderlying financial instrument. In general, binomial options pricing models do

not have closed-form solutions.

The Binomial options pricing model approach is widely used as it is able to handle a variety ofconditions for which other models cannot easily be applied. This is largely because the BOPM isbased on the description of anunderlying instrument over a period of time rather than a singlepoint. As a consequence, it is used to valueAmerican options that are exercisable at any time in agiven interval as well as Bermudan options that are exercisable at specific instances of time.Being relatively simple, the model is readily implementable in computer software (including aspreadsheet).

The BlackScholes

BlackScholesMertonmodel is amathematical model of afinancial market containing certainderivative investment instruments. From the model, one can deduce the BlackScholes formula,which gives a theoretical estimate of the price of European-styleoptions.The formula led to aboom in options trading and legitimised scientifically the activities of theChicago Board OptionsExchange and other options markets around the world. lt is widely used, although often withadjustments and corrections, by options market participants. Many empirical tests have shownthat the BlackScholes price is "fairly close" to the observed prices, although there are well-known discrepancies such as the "option smile".

The BlackScholes was first published byFischer Black andMyron Scholes in their 1973 paper,

"The Pricing of Options and Corporate Liabilities", published in the Journal of PoliticalEconomy.They derived a stochasticpartial differential equation,now called theBlackScholesequation,which estimates the price of the option over time. The key idea behind the model is tohedge the option by buying and selling the underlying asset in just the right way and, as aconsequence, to eliminate risk. This type of hedge is called delta hedging and is the basis ofmore complicated hedging strategies such as those engaged in by investment banks and hedgefunds.
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Option Greeks

Inmathematical finance,the Greeksare the quantities representing the sensitivity of the price ofderivatives such as options to a change in underlying parameters on which the value of aninstrument orportfolio offinancial instruments is dependent. The name is used because the most

common of these sensitivities are often denoted by Greek letters.Collectively these have alsobeen called the risk sensitivities, risk measures or hedge parameters.

The Greeks are vital tools inrisk management.Each Greek measures thesensitivity of the valueof a portfolio to a small change in a given underlying parameter, so that component risks may betreated in isolation, and the portfolio rebalanced accordingly to achieve a desired exposure; seefor exampledelta hedging.

The Greeks in theBlackScholes model are relatively easy to calculate, a desirable property offinancialmodels,and are very useful for derivatives traders, especially those who seek to hedgetheir portfolios from adverse changes in market conditions. For this reason, those Greeks which

are particularly useful for hedging delta, theta, and vega are well-defined for measuring changesin Price, Time and Volatility. Although rho is a primary input into the BlackScholes model, theoverall impact on the value of an option corresponding to changes in therisk-free interest rate isgenerally insignificant and therefore higher-order derivatives involving the risk-free interest rateare not common.

The most common of the Greeks are the first order derivatives:Delta,Vega,Theta andRho aswell asGamma,a second-order derivative of the value function. The remaining sensitivities inthis list are common enough that they have common names, but this list is by no meansexhaustive

Delta

Delta, , measures the rate of change of option value with respect to changes in the underlyingasset's price. Delta is the first derivative of the value of the option with respect to theunderlying instrument's price .

Vega
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Vegameasures sensitivity tovolatility.Vega is the derivative of the option value with respect tothevolatility of the underlying asset.

Vega is not the name of any Greek letter. However, the glyph used is the Greek letter nu ( ).Presumably the name vegawas adopted because the Greek letter nulooked like a Latin vee, and

vegawas derived from veeby analogy with how beta, eta, and thetaare pronounced in AmericanEnglish. Another possibility is that it is named after Joseph De La Vega, famous for Confusion ofConfusions, a book about stock markets and which discusses trading operations that werecomplex, involving both options and forward trades.

The symbolkappa, , is sometimes used (by academics) instead of vega(as is tau( ) or capitalLambda ( ), though these are rare).

Vega is typically expressed as the amount of money per underlying share that the option's valuewill gain or lose as volatility rises or falls by 1%.

Vega can be an important Greek to monitor for an option trader, especially in volatile markets,since the value of some option strategies can be particularly sensitive to changes in volatility.The value of anoption straddle,for example, is extremely dependent on changes to volatility.

Theta

Theta, , measures the sensitivity of the value of the derivative to the passage of time (seeOption time value): the "time decay."

The mathematical result of the formula for theta (see below) is expressed in value peryear. By convention, it is usual to divide the result by the number of days in a year, to arrive atthe amount of money per share of the underlying that the option loses in one day. Theta is almostalways negative for long calls and puts and positive for short (or written) calls and puts. Anexception is a deep in-the-money European put. The total theta for a portfolio of options can bedetermined by summing the thetas for each individual position.

The value of an option can be analysed into two parts: the intrinsic value and the time

value. The intrinsic value is the amount of money you would gain if you exercised the optionimmediately, so a call with strike $50 on a stock with price $60 would have intrinsic value of$10, whereas the corresponding put would have zero intrinsic value. The time value is the valueof having the option of waiting longer before deciding to exercise. Even a deeply out of themoneyput will be worth something, as there is some chance the stock price will fall below thestrike before the expiry date. However, as time approaches maturity, there is less chance of thishappening, so the time value of an option is decreasing with time.
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Rho

Rho, , measures sensitivity to the interest rate: it is the derivative of the option value withrespect to the risk free interest rate (for the relevant outstanding term).

Except under extreme circumstances, the value of an option is less sensitive to changes in therisk free interest rate than to changes in other parameters. For this reason, rho is the least used ofthe first-order Greeks.

Rho is typically expressed as the amount of money, per share of the underlying, that the value ofthe option will gain or lose as the risk free interest rate rises or falls by 1.0% per annum (100basis points).

Lambda

Lambda, , omega, , or elasticity is the percentage change in option value per percentagechange in the underlying price, a measure ofleverage,sometimes calledgearing.

Arbitrage profits in options

Options arbitragetrades are commonly performed byfloor traders in theoptions market to earnsmall profits with very little or zero risk.

Traders perform conversions when options are relatively overpriced by purchasing stock andselling the equivalent options position. When the options are relatively underpriced, traders willdo reverse conversions or reversals. In practice, actionable option arbitrage opportunities havedecreased with the advent of automated trading strategies.
http://en.wikipedia.org/wiki/Rho_%28letter%29http://en.wikipedia.org/wiki/Rho_%28letter%29http://en.wikipedia.org/wiki/Lambdahttp://en.wikipedia.org/wiki/Lambdahttp://en.wikipedia.org/wiki/Omegahttp://en.wikipedia.org/wiki/Omegahttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Leverage_%28finance%29http://en.wikipedia.org/wiki/Gearing_%28finance%29http://en.wikipedia.org/wiki/Floor_traderhttp://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Option_%28finance%29http://en.wikipedia.org/wiki/Floor_traderhttp://en.wikipedia.org/wiki/Gearing_%28finance%29http://en.wikipedia.org/wiki/Leverage_%28finance%29http://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Percentagehttp://en.wikipedia.org/wiki/Omegahttp://en.wikipedia.org/wiki/Lambdahttp://en.wikipedia.org/wiki/Rho_%28letter%29


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Module V

Commodity derivatives

The Forward Markets Commission (FMC) is the chief regulator of forwards and futuresmarkets in India. As of March 2009, it regulates Rs 52 Trillion worth of commodity trade in

India. It is headquartered inMumbai and is overseen by theMinistry of Consumer Affairs, Foodand Public Distribution,Government of India.

History

Established in 1953 under the provisions of the Forward Contracts (Regulation) Act, 1952, itconsists of two to four members, all appointed by the Indian Government. Currently, theCommission allowscommodity trading in 22 exchanges in India, of which three are national.Uniquely the FMC falls under the Ministry of Consumer Affairs, Food and Public Distributionand not the finance ministry as in most countries. This is because futures, traded in India, aretraditionally on food commodities. However, this has been changing and there have been callsfor change in the industry and in regulation. One proposal is the merging the commodities

derivatives and securities regulation by including the Forward Market Commission within theSecurities and Exchange Board of India (SEBI), the primary securities regulator in India.However as of 2003 there is no clear consensus for this move.

Development of the Industry

India has a long history of trading commodities and considered the pioneer in some forms ofderivatives trading. The first derivative market was set up in 1875 in Mumbai, where cottonfutures was traded. This was followed by establishment of futures markets in edible oilseedscomplex, raw jute and jute goods and bullion. This became an active industry with volumesreported to be large.However, in 1935 a law was passed allowing the government to in part restrict and directly

control food production (Defence of India Act, 1935). This included the ability to restrict or banthe trading in derivatives on those food commodities. Post independence, in the 1950s, Indiacontinued to struggle with feeding its population and the government increasingly restrictingtrading in food commodities. Just at the time the FMC was established, the government felt thatderivative markets increased speculation which led to increased costs and price instabilities. Andin 1953 finally prohibited options and futures trading altogether.

The industry was pushed underground and the prohibition meant that development andexpansion came to a halt. In the 1970 as futures and options markets began to develop in the restof the world, Indian derivatives markets were left behind. The apprehensions about the role ofspeculation, particularly in the conditions of scarcity, prompted the Government to continue the

prohibition well into the 1980s.This left the India with a large number of small and isolated regional futures markets. Thefutures markets are dispersed and fragmented, with separate trading communities in differentregions with little contact with one another. The exchanges generally have yet to embracemodern technology or modern business practices.
http://en.wikipedia.org/wiki/Forward_contracthttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Indian_rupeehttp://en.wikipedia.org/wiki/Mumbaihttp://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Securities_and_Exchange_Board_of_Indiahttp://en.wikipedia.org/wiki/Securities_and_Exchange_Board_of_Indiahttp://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Commodityhttp://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Ministry_of_Consumer_Affairs,_Food_and_Public_Distribution_(India)http://en.wikipedia.org/wiki/Mumbaihttp://en.wikipedia.org/wiki/Indian_rupeehttp://en.wikipedia.org/wiki/Indiahttp://en.wikipedia.org/wiki/Futures_exchangehttp://en.wikipedia.org/wiki/Forward_contract


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Next to the officially approved exchanges, there are many havala markets. Most of theseunofficial commodity exchanges have operated for many decades. Some unofficial markets trade20-30 times the volume of the "official" futures exchanges. They offer not only futures, but alsooption contracts. Transaction costs are low, and they attract many speculators and the smallerhedgers. Absence of regulation and proper clearing arrangements, however, mean that these

markets are mostly "regulated" by the reputation of the main players.Responsibilities and functionsThe functions of the Forward Markets Commission are as follows:

To advise the Central Government in respect of the recognition or the withdrawal ofrecognition from any association or in respect of any other matter arising out of theadministration of the Forward Contracts (Regulation) Act 1952.

To keep forward markets under observation and to take such action in relation to them, asit may consider necessary, in exercise of the powers assigned to it by or under the Act.

To collect and whenever the Commission thinks it necessary, to publish informationregarding the trading conditions in respect of goods to which any of the provisions of theact is made applicable, including information regarding supply, demand and prices, andto submit to the Central Government, periodical reports on the working of forwardmarkets relating to such goods;

To make recommendations generally with a view to improving the organization andworking of forward markets;

To undertake the inspection of the accounts and other documents of any recognized

association or registered association or any member of such association whenever itconsiders it necessary.

It allows futures trading in 23 Fibers and Manufacturers,15 spices, 44 edible oils, 6 pulses, 4energy products, single vegetable, 20 metal futures, 33 others Futures.

FUTURES TRADING IN COMMODITY EXCHANGES AND FORWARD MARKETSCOMMISSION

1. Futures trading perform two important functions of price discovery and price risk management

with reference to the given commodity. It is useful to all segments of the economy. It is useful tothe producer because he can get an idea of the price likely to prevail at a future point of time andtherefore can decide between various competing commodities, the best that suits him. It enablesthe consumer in that he gets an idea of the price at which the commodity would be available at afuture point of time. He can do proper costing and also cover his purchases by making forwardcontracts.


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2. Forward/futures trading involves a passage of time between entering into a contract and itsperformance making thereby the contracts susceptible to risks uncertainties, etc. Hence the needfor the regulatory functions to be exercised by the Forward Markets Commission (FMC), whichis the Regulator established under the provisions of Forward Contracts (Regulation) Act, 1952.

3. At present, futures trading are permitted in 103 commodities (Annexure-I). Apart from thethree national level Exchanges, there are 21 other regional Exchanges recognized for commodityfutures trading (Annexure-II). The trading volume and value in the past two years have increasedmanifold. During 2005-06, permission to trade in furnace oil, crude oil, menthe oil, PVC,polypropylene and natural gas was granted. Onion has also been notified for futures trading on26.4.2006.

4. Overall growth during 2005-06, the total value of commodity futures trade was Rs. 21.34 lakhcrore as compared to Rs. 5.71 lakh crore during 2004-05 showing an increase of 274%. Thevolume of trade has also gone up to 6685 lakh tonnes during 2005-06 as compared to 1942 lakhtonnes during 2004-05. The trade volume has also gone up by 244% during 2005-2006.

5. The trading volume and value have increased manifold after the three national levelExchanges were set up. Department of Consumer Affairs granted recognition to these Exchangesas indicated below:National Multi-Commodity Exchange of India, Ahmedabad (NMCE), startedtrading in November 2002 and the other two national Exchanges viz. Multi CommodityExchange of India Ltd., Mumbai (MCX) and National Commodity and Derivatives ExchangeLtd., Mumbai (NCDEX) started trading in November 2003. The following table shows theincrease in volume and value of trading in commodity futures since the setting up of thesenational Exchanges.

Commodity Futures Trading Value and Volume since 2001-02

2002-03 2003-04 2004-05 2005-06

VolumeofTrading (in lakhtonnes)

314.4

(44.4)*

492.9

(57.7)*

1,942.1

(294)*

6,685.09

(244)*

Valueoftrading (Rs. incrore)

66,530

(92.8)*

1,29,363

(94.4)*

5,71,759

(341.9)*

21,34,471

(274)*


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6. The commodity futures market is regulated under the provisions of the Forward Contracts(Regulation) Act, 1952. In order to include some new features that are in tune with the latestdevelopments in the commodity futures market, this Department has proposed amendments inthe Forward Contracts (Regulation) Act, 1952. Accordingly, Forward Contracts (Regulation)Amendment Bill, 2006 has been introduced in the Lok Sabha on 21.03.2006. The Bill, inter-alia,

seeks to make the following amendments :-- increase the maximum number of members of FMCfrom four to nine out of which three to be whole time members and a Chairman; confer powerupon the FMC to levy fees; provide for constitution of FMC General Fund to which all grants,fees and all sums received by the FMC shall be credited except penalty and apply the funds formeeting the expenses of the Commission; make provisions for corporatization anddemutualization of recognized associations in accordance with the scheme to be approved by theFMC; make provisions for registration of members and intermediaries; allow trading in options;make provision for investigation, enforcement and penalty in case of contravention of theprovisions of the FCR Act, 1952;

7. Future prospect

Future prospect of commodity derivative trading is upbeat. Futures market size (bothcommodities and securities) relative to Gross Domestic Product (GDP at current prices) in theUS is about 90%, in China about 85%, and in Brazil about 200%. Commodities derivatives tradevalue relative to GDP (at current price) in India was 5.81 % in 2003-04, 20.14% in 2004-05 andit has gone up to 66 % during 2005-06. The commodity futures trade has taken a big leap in thepast two years. Likely participation of Banks, Mutual Funds and Foreign Institutional Investorsalong with introduction of options trading after amendments to FCR

Exchanges and Commodities in which futures contracts are traded.


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No. Exchange COMMODITY

1. India Pepper & Spice Trade Association, Kochi (IPSTA)Pepper (both domestic and international

contracts)

2.Vijai Beopar Chambers Ltd.,

MuzaffarnagarGur, Mustard seed

3. Rajdhani Oils & Oilseeds Exchange Ltd., Delhi Gur, Mustard seed its oil & oilcake

4.Bhatinda Om & Oil Exchange Ltd.,

BhatindaGur

5. The Chamber of Commerce, Hapur Gur , Potatoes and Mustard seed

6. The Meerut Agro Commodities Exchange Ltd., Meerut Gur

7. The Bombay Commodity Exchange Ltd., Mumbai

Oilseed Complex

* Castor oil international contracts

8. Rajkot Seeds, Oil & Bullion Merchants Association, Rajkot

Castor seed, Groundnut, its oil & cake,

cottonseed, its oil & cake, cotton (kapas) and

RBD palmolein.

9. The Ahmedabad Commodity Exchange, Ahmedabad Castorseed, cottonseed, its oil and oilcake

10. The East India Jute & Hessian Exchange Ltd., Calcutta Hessian & Sacking

11. The East India Cotton Association Ltd., Mumbai Cotton

12. The Spices & Oilseeds Exchange Ltd., Sangli. Turmeric

13. National Board of Trade, Indore

Soya seed, Soyaoil and Soya meals.

Rapeseed/Mustardseed its oil and

oilcake and RBD Palmolien

14. The First Commodities Exchange of India Ltd., Kochi Copra/coconut, its oil & oilcake

15. Central India Commercial Exchange Ltd., Gwalior Gur and Mustard seed

16. E-sugar India Ltd., Mumbai Sugar

**17 National Multi-Commodity Exchange of India Ltd., AhmedabadSeveral Commodities (Please see the site of

the Exchange at www.nmce.com)

18 Surendranagar Cotton Oil & Oilseeds , Surendranagar Cotton, Cottonseed, Kapas


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19 E-Commodities Ltd., New Delhi Sugar (trading yet to commence)

20** National Commodity & Derivatives Exchange Ltd., Mumbai

Several Commodities (Please see the

site of the Exchange at

www.ncdex.com)

21** Multi Commodity Exchange Ltd., Mumbai

Several Commodities (Please see the

site of the Exchange at

www.mcxindia.com)

22 Bikaner commodity Exchange Ltd., BikanerMustard seed its oil & oilcake, Gram.

Guar seed. Guar Gum

23 Haryana Commodities Ltd., Hissar Mustard seed complex

24 Bullion Association Ltd., Jaipur Mustard seed Complex

Commodity Derivatives Market in India:

Development Regulation and Future Prospects

Introduction

The Indian economy is witnessing a mini revolution in commodity derivatives and risk management.Commodity options trading and cash settlement of commodity futures had been banned since 1952 anduntil 2002 commodity derivatives market was virtually non-existent, except some negligible activity onan OTC basis. Now in September 2005, the country has 3 national level electronic exchanges and 21regional exchanges for trading commodity derivatives. As many as eighty (80) commodities have beenallowed for derivatives trading. The value of trading has been booming and is likely to cross the $ 1

Trillion mark in 2006 and, if all goes well, seems to be set to touch $5 Trillion in a few years. This paperanalyses questions such as: how did India pull it off in such a short time since 2002? Is this progresssustainable and what are the obstacles that need urgent attention if the market is to realize its fullpotential? Why are commodity derivatives important and what could other emerging economies learnfrom the Indian mistakes and experience

Why are Commodity Derivatives Required?

India is among the top-5 producers of most of the commodities, in addition to being a majorconsumer of bullion and energy products. Agriculture contributes about 22% to the GDP of the

Indian economy. It employees around 57% of the labor force on a total of 163 million hectaresof land. Agriculture sector is an important factor in achieving a GDP growth of 8-10%. All thisindicates that India can be promoted as a major center for trading of commodity derivatives. It isunfortunate that the policies of FMC during the most of 1950s to 1980s suppressed the verymarkets it was supposed to encourage and nurture to grow with times. It was a mistake otheremerging economies of the world would want to avoid.


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However, it is not in India alone that derivatives were suspected of creating too much speculationthat would be to the detriment of the healthy growth of the markets and the farmers. Suchsuspicions might normally arise due to a misunderstanding of the charac

Financial Derivaties -Notes

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