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What are derivatives?

  • Concept:
  • Derivatives have become very important in the field finance. They are very important financial instruments for risk management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form of insurance. This shift of risk means that each party involved in the contract should be able to identify all the risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an underlying asset. This means that risks in trading derivatives may change depending on what happens to the underlying asset.

    A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate. The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be monitored constantly.

    The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.

    We will try and understand
    • What are derivatives?
    • Why have derivatives at all?
    • How are derivatives traded and used?

    In subsequent lessons we will try and understand how exactly will an underlying asset effect the movement of a derivative instrument and how is it traded and how one can profit from these instruments.

    What are forward contracts?

    Derivatives as a term conjure up visions of complex numeric calculations, speculative dealings and come across as an instrument which is the prerogative of a few ‘smart finance professionals’. In reality it is not so. In fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the derivative is based and a small investor can benefit immensely.

    A derivative security can be defined as a security whose value depends on the values of other underlying variables. Very often, the variables underlying the derivative securities are the prices of traded securities.

    Let us take an example of a simple derivative contract:
    • ‘X’ buys a futures contract.
    • He will make a profit of Rs 1000 if the price of TCS rises by Rs 1000.
    • If the price is unchanged he will receive nothing.
    • If the stock price of TCC falls by Rs 800 he will lose Rs 800.

    As we can see, the above contract depends upon the price of the TCS scrip, which is the underlying security. Similarly, future trading has already started in Sensex futures and Nifty futures. The underlying security in this case is the BSE Sensex and NSE Nifty. Derivatives and futures are basically of 3 types:
    • Forwards and Futures
    • Options
    • Swaps

  • Forward contract
  • A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered into.

  • Example 1:
  • Mohan wants to buy a Washing Machine, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3 months hence. He, however, fears that prices of Washing Machine will rise 3 months from now. So in order to protect himself from the rise in prices he enters into a contract with the Washing Machine dealer that 3 months from now he will buy the Washing Machine for Rs 10,000. What Mohan is doing is that he is locking the current price of a Washing Machine for a forward contract. The forward contract is settled at maturity. The dealer will deliver the asset to him at the end of three months and Mohan in turn will pay cash equivalent to the Washing Machine price on delivery.

  • Example 2:
  • Raj is an importer who has to make a payment for his consignment in six months time. In order to meet his payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the underlying security is the foreign currency. The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contract.

  • What is an Index?
  • To understand the use and functioning of the index derivatives markets, it is necessary to understand the underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A market index is very important for the market players as it acts as a barometer for market behavior and as an underlying in derivative instruments such as index futures.

  • The Sensex and Nifty
  • In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30 stocks comprising the index which are selected based on market capitalization, industry representation, trading frequency etc. It represents 30 large well-established and financially sound companies. The Sensex represents a broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex. While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of shares of 50 companies with each having a market capitalization of more than Rs 500 crore.

  • Futures and stock indices
  • For understanding of stock index futures a thorough knowledge of the composition of indexes is essential. Choosing the right index is important in choosing the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index. Choosing and understanding the right index is important as the movement of stock index futures is quite similar to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes. Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising. Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.

  • Options
  • Stock markets by their very nature are fickle. While fortunes can be made in a jiffy more often than not the scenario is the reverse. Investing in stocks has two sides to it –a) Unlimited profit potential from any upside (remember Infosys, HFCL etc) or b) a downside which could make you a pauper. Derivative products are structured precisely for this reason -- to curtail the risk exposure of an investor. Index futures and stock options are instruments that enable you to hedge your portfolio or open positions in the market. Option contracts allow you to run your profits while restricting your downside risk. Apart from risk containment, options can be used for speculation and investors can create a wide range of potential profit scenarios. We have seen in the Derivatives School how index futures can be used to protect oneself from volatility or market risk. Here we will try and understand some basic concepts of options.

  • What are options?
  • Some people remain puzzled by options. The truth is that most people have been using options for some time, because options are built into everything from mortgages to insurance. An option is a contract, which gives the buyer the right, but not the obligation to buy or sell shares of the underlying security at a specific price on or before a specific date. ‘Option’ , as the word suggests, is a choice given to the investor to either honor the contract; or if he chooses not to walk away from the contract. To begin, there are two kinds of options: Call Options and Put Options.
    Call Option is an option to buy a stock at a specific price on or before a certain date. In this way, Call options are like security deposits. If, for example, you wanted to rent a certain property, and left a security deposit for it, the money would be used to insure that you could, in fact, rent that property at the price agreed upon when you returned. If you never returned, you would give up your security deposit, but you would have no other liability. Call options usually increase in value as the value of the underlying instrument rises. When you buy a Call option, the price you pay for it, called the option premium, secures your right to buy that certain stock at a specified price called the strike price. If you decide not to use the option to buy the stock, and you are not obligated to, your only cost is the option premium. Put Options are options to sell a stock at a specific price on or before a certain date. In this way, Put options are like insurance policies If you buy a new car, and then buy auto insurance on the car, you pay a premium and are, hence, protected if the asset is damaged in an accident. If this happens, you can use your policy to regain the insured value of the car. In this way, the put option gains in value as the value of the underlying instrument decreases. If all goes well and the insurance is not needed, the insurance company keeps your premium in return for taking on the risk. With a Put Option, you can "insure" a stock by fixing a selling price. If something happens which causes the stock price to fall, and thus, "damages" your asset, you can exercise your option and sell it at its "insured" price level. If the price of your stock goes up, and there is no "damage," then you do not need to use the insurance, and, once again, your only cost is the premium. This is the primary function of listed options, to allow investors ways to manage risk. Technically, an option is a contract between two parties. The buyer receives a privilege for which he pays a premium. The seller accepts an obligation for which he receives a fee. We will delve further into the mechanics of call/put options in subsequent lessons.

  • Option styles
  • Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:

    European: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India index and stock options are European in nature. eg: Sam purchases 1 NIFTY AUG 11100 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.

    American: These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration. Options in stocks that have been recently launched in the Indian market are "American Options". eg: Sam purchases 1 ACC SEP 1450 Call --Premium 12

    Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

    American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.

    Option Class & Series
    Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".
    An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.
    eg: All Nifty call options are referred to as one class.
    An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.

    Calls

    Puts

     

    JUL

    AUG

    SEP

    JUL

    AUG

    SEP

    TCS

     

    1300

    45

    60

    75

    15

    20

    28

    1400

    35

    45

    65

    25

    28

    35

    1500

    20

    42

    48

    30

    40

    55

    eg: TCS JUL 1300 refers to one series and trades take place at different premiums

    All calls are of the same option type. Similarly, all puts are of the same option type. Options of the same type that are also in the same class are said to be of the same class. Options of the same class and with the same exercise price and the same expiration date are said to be of the same series

  • Important Terms
  • (Strike price, In-the-money, Out-of-the-Money, At-the-Money, Covered call and Covered Put)
    Strike price: The Strike Price denotes the price at which the buyer of the option has a right to purchase or sell the underlying. Different strike prices will be available at any point of time.For Nifty the strike price interval will be of 50. If the index is currently at 11400, the strike prices available will be 11300, 11350, 11400, 11450, 11500 and so on. The strike price is also called Exercise Price. This price is fixed by the exchange for the entire duration of the option depending on the movement of the underlying stock or index in the cash market.

  • In-the-money:
  • A Call Option is said to be "In-the-Money" if the strike price is less than the market price of the underlying stock. A Put Option is In-The-Money when the strike price is greater than the market price. eg: Raj purchases 1 TCS AUG 1900 Call --Premium 10
    In the above example, the option is "in-the-money", till the market price of TCS is ruling above the strike price of Rs 1900, which is the price at which Raj would like to buy 100 shares anytime before the end of August. Similarly, if Raj had purchased a Put at the same strike price, the option would have been "in-the- money", if the market price of TCS was lower than Rs 190 per share.

  • Out-of-the-Money:
  • A Call Option is said to be "Out-of-the-Money" if the strike price is greater than the market price of the stock. A Put option is Out-Of-Money if the strike price is less than the market price. eg: Sam purchases 1 INFTEC AUG 3500 Call --Premium 150
    In the above example, the option is "out-of- the- money", if the market price of INFTEC is ruling below the strike price of Rs 3500, which is the price at which SAM would like to buy 100 shares anytime before the end of August. Similary, if Sam had purchased a Put at the same strike price, the option would have been "out-of-the-money", if the market price of INFTEC was above Rs 3500 per share.

  • At-the-Money:
  • The option with strike price equal to that of the market price of the stock is considered as being "At-the-Money" or Near-the-Money. eg: Raj purchases 1 ACC AUG 1500 Call or Put--Premium 10
    In the above case, if the market price of ACC is ruling at Rs 1500, which is equal to the strike price, then the option is said to be "at-the-money". If the index is currently at 11400, the strike prices available will be 11300, 11350, 11400, 11450, and so on. The strike prices for a call option that are greater than the underlying (Nifty or Sensex) are said to be out-of-the-money in this case 11450 and 11500 considering that the underlying is at 14000. Similarly in-the-money strike prices will be 11300 and 11350, which are lower than the underlying of 11400.