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FINANCIAL DERIVATIVES AND RISK MANAGEMENTIntroduction to derivativesFinancial DerivativeA financial instrument whose payoff(price) is based on the price of an underlying asset, reference rate or an indexUsed by Mark Rubinstein for the first time in financial context(1976)Derivative is a generic term referring to forwards, futures, options and swapsA security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities(SCRA,1956)

Evolution of derivatives Most of the derivative markets had evolved from the basic commodity markets in the worldFirst organised futures market in India came up in1875 Bombay Cotton Trade association Ltd.Indian derivatives market commenced with the forex derivatives in 1997Currently the following contracts are allowed for trading in Indian markets:Indian Derivatives marketHistory of derivative trading at nseThe derivatives trading on the NSE commenced on June 12, 2000 with futures trading on S&P CNX Nifty IndexTrading in index options and options on individual securities commenced on June 4, 2001 and July 2, 2001. Single stock futures were launched on November 9, 2001. Now product base has increased to include trading in futures and options on CNX IT Index, Bank Nifty Index, Nifty Midcap 50 Indices etc. Today, both in terms of volume and turnover, NSE is the largest derivatives exchange in India.The derivatives contracts have a maximum of 3-month expiration cycles except for a long dated Nifty Options contract which has a maturity of 5 years.Three contracts are available for trading, with 1 month, 2 months and 3 months to expiry. A new contract is introduced on the next trading day following the expiry of the near month contract.Types of derivativesTypes of derivativesForwardsAgreement between the buyer and the seller in which the buyer has the right and obligation to buy a specified asset on a specified date and at a specified priceSeller is also under an obligation to perform as per terms of the contractUnderlying asset can be anything, Eg. stock, commodity, bondFuturesA kind of forwardsRepresent obligations on the part of the buyer and seller but the terms and conditions are of the contract are specified by the exchange where they are actually traded

Types of derivativesOptionsA form of forward contracts wherein the buyer will have a right but not an obligation and on the expiry of the contract he will decide whether or not to exercise his right to buy or sellSWAPS financial structures that allow the counterparties to exchange the obligations

Exchange traded Vs OTC traded derivativesDerivatives that trade on an exchange are called exchange traded derivatives, Privately negotiated derivative contracts are called OTC contracts. OTC derivatives are negotiated deals between the buyer and sellerThere is no specific place where this market exists.Forward contract is an example for OTC derivativePractically all the terms of the contract are negotiable between the counter parties such as quality of the asset, quantity of the asset, place of delivery, price of the asset and duration of the contractEg.On Jan 20,2004, A gold merchandiser enters into an agreement to buy2.15 kg of gold of 99% purity at a price of Rs.500 per gram at Baroda in 60 days timeFeatures of the OTC derivatives markets

The management of counter-party (credit) risk is decentralized and located within individual institutions,There are no formal centralized limits on individual positions, leverage, or margining,There are no formal rules for risk and burden-sharing, There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants, and The OTC contracts are generally not regulated by a regulatory authority and the exchanges self-regulatory organization.

Why derivativesDerivatives help in discovery of future as well as current prices.The derivatives market helps to transfer risks from those who have them but do not like them to those who have an appetite for them.With the introduction of derivatives, the underlying market witnesses higher trading volumes. This is because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.Speculative trades shift to a more controlled environment in derivatives market. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for new entrepreneurial activity. The derivatives have a history of attracting many bright, creative, well-educated people with an entrepreneurial attitude. In a nut shell, derivatives markets help increase savings and investment in the long run.Transfer of risk enables market participants to expand their volume of activity.Derivative trading in indiaIn India, derivatives are traded on:Bombay stock exchange(BSE)National stock exchange (NSE)National commodity and derivatives Exchange (NCDEX)Multi Commodity Exchange(MCX)Traders in derivative marketTraders in derivative marketArbitrageursSet of traders who are on look out for risk-free profits, interested in exploiting mispricing between spot market and the derivative marketEntails zero initial investment and zero riskSpeculatorsRisk seeking traders who believes that thy have some specialized knowledge about the market and can predict the direction of the markets movement If their forecast come true, they make profit, entails high riskHedgersRisk averse traders. They want to reduce risk in business operations. For reducing risk, they are even willing to pay a priceEg. A cotton farmer may expect his crop to face a decrease in price when it comes to the market. So he is entering into a futures contract to reduce risk and sells it now even before the arrival of the crop for delivery

Economic benefits of derivativesProvide risk management and mitigation toolsAssist in managerial decision making by providing some information on future prices that will help in production decisionsEquip firms in the economy with more effective tools to manage the exposure to interest rates, foreign exchange rates and commodity pricesIt helps in price discovery process of establishment of benchmark market prices

Exchange traded derivatives in IndiaFutures on indicesOptions on indicesFutures on individual securitiesOptions on individual stocksInterest rate futuresST future on a 91 day T BillLT future on a notional 10 year ZCBLT future on a notional 10 year 6% Coupon BondExchanges themselves do not trade in derivatives but they only facilitate trading, as per the eligibility criteria laid down by SEBI:

eligibility criteria laid down by SEBI: for exchange traded derivatives in IndiaThe stocks should figure in top 500 stocks in terms of average daily market capitalisation and average daily traded value in the previous six months on a rolling basisFor a stock to be eligible, the median quarter sigma order size over the last six months should not be less than Rs. 1 lakhQuarter sigma order size order size(in value terms) required to cause a change in the stock price equal to one-quarter of the standard deviationThe market-wide position limit in the stock should not be less than Rs.50 croresFutures and options contracts on an index can be issued only if 80% of the index constitutes are individually eligible for derivative trading

Median Quarter sigma RuleOrder size defined as the product of volume and price(volume x price) required for a stock price to change by one-fourth of its stand ard deviation should be at least Rs. 1 lakh.Aim is to ensure that derivatives will be introduced only on those stocks that are very liquidEg. If the SD () of a stock is 20%, the quarter sigma will be 5%. If average price of the stock is Rs.100, then quarter sigma price will be computed as 100 x 5% = Rs.5Median Quarter sigma RuleOrder size that will move the stock price by quarter sigma price is computed as:Quarter Sigma Order sizeQuarter Sigma Buy Price= Avg price - QSPQuarter Sigma Sell Price= Avg price + QSPQuarter Sigma Buy/Sell Order =Quarter Sigma Buy or Sell Price x No. of shares

Types of ordersLimit orderOrder for buying and selling at a limit priceMarket orderOrder to buy or sell at the best price in the market at the time of submission of orderStop lossOrder that becomes a limit order only when the market trades at a specified priceGood till cancelledOrder which remains in the system until the trader cancels itGood till days/dateOrder which remains till a specified number of days or till a specified date

Participants in the derivative marketParticipants in the derivative marketTrading memberOne who trades in his own behalf and on behalf of clientsClearing memberOne who undertakes to settle his own trades as well as that of other non-clearing membersSelf-clearing memberThose who clear and settle their own trades only

Other termsContract sizeUnit of trading represents the value of the security represented in the contract(SEBI stipulation minimum contract size of derivatives should not be less than Rs. 2 lakh)Contract multiplierPredetermined value used to arrive at the contract size(fixed by the concerned exchanges, for sensex futures Rs.50)Lot sizeNumber of underlying securities in one contractTick sizeMinimum price movement allowed(eg. Sensex futures tick size is 0.05 points or Rs.2.5)Clearing houseA separate legal entity from the exchangeAll concluded trades must be registered with the clearing house, margins are deposited with it, it administers settlement, takes responsibility in the event of defaultClearing house assures financial integrity of traded contracts by guaranteeing their settlementOnce deal is concluded, CH acts as a legal counterparty to both buyers as well as sellersNSCCL clearing house for NSE

marginsMoney indicating the capacity and willingness of the trader to meet the contractual termsThis reduce the risk of the CHIf the margins are too high derivative trading will not be attrativeIf the margins are too low, the CH will be exposed to very high riskSo setting up margins involves a trade off between these two requirementsInitial margins is linked to the risk of the underlying security.Whenever an investor instructs a broker to trade in derivatives, the investor has to deposit a margin initial marginmarginsNow CHs world wide use specialized margining systems SPAN Standard Portfolio Analysis of RiskTIMS Theoretical Intermarket Margin SystemOnce the contract is initiated, the trader faces mark to- market margins until the trader closes his position

Marking-to- marketRecording the value of a contract at the days settlement price to calculate profits and losses.Eg. Suppose an investor contacts his broker on June 5 to buy 2 Dec gold futures contracts on the NSECurrent future price is Rs.1400 per ounce, Contract size is 100, so the investor contracted to buy 200 ouncesThe broker will ask the investor to deposit margin in his account. The amount to be deposited at the time of contract is called initial margin suppose it is 2,000 per contract, i.e Rs.4,000 At the end of each trading day, the margin account is adjusted to reflect the investors gain or loss referred to as marking -to market the accountSuppose by the end of June5, the futures price dropped from Rs.1400 to Rs.1397, the investor has a loss of Rs.600(Rs.3 x 200) balance in the margin account is thus reduced by Rs.600 to Rs.3,400Suppose by the end of June5, the futures price increased from Rs.1400 to Rs.1403, the investor has a gain of Rs.600(Rs.3 x 200) so balance in the margin account is thus increased by Rs. 600 to Rs.4,600

Marking-to- market - exampleDaySettlement priceGain/2120lossOpeningAt close of day 0At close of day 1At close of day 2At close of day 3At close of day 4At close of day 5At close of day 6At close of day 7At close of day 8

2,100212019701930195019802010202021252080-20-150-4020303010105-35VALUE AT RISKVaR is a volatility based measure containing information on losses during normal market conditions and the probability in a single numberUsed for the first time by J.P MorganVaR = TP = critical value from standard normal distributionT = square root of the number of time periods = standard deviationP=estimate of initial value of portfolioFunctions of derivative marketEnable price discoveryFacilitate transfer of riskProvide leveragingOther benefits better portfolio management, curb hoarding etc.