Derivatives

 Derivative is a contract or a product whose value is derived from value of

some other asset known as underlying.
 Derivatives are based on wide range of underlying assets.
 These include:
 • Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead etc.
 • Energy resources such as Oil (crude oil, products, cracks), Coal, Electricity,
 Natural Gas etc.
 • Agri commodities such as wheat, Sugar, Coffee, Cotton, Pulses etc, and
 • Financial assets such as Shares, Bonds and Foreign Exchange.
Some of the factors driving the growth of financial
derivatives are:

 Increased fluctuations in underlying asset prices in financial markets.

 Integration of financial markets globally.
 Use of latest technology in communications has helped in reduction of
transaction costs.
 Enhanced understanding of market participants on sophisticated risk
management tools to manage risk.
 Frequent innovations in derivatives market and newer applications of
products.
Products in Derivatives Market

 Forwards
 It is a contractual agreement between two parties to buy/sell an underlying asset
at a certain future date for a particular price that is pre-decided on the date of
contract.
 Both the contracting parties are committed and are obliged to honour the
transaction irrespective of price of the underlying asset at the time of delivery.
Since forwards are negotiated between two parties, the terms and conditions of
contracts are customized.
 These are Over-the-counter (OTC) contracts.
 Futures
 A futures contract is similar to a forward, except that the deal is made through an
organized and regulated exchange rather than being negotiated directly between
two parties. Indeed, we may say futures are exchange traded forward contracts.
 Options
 An Option is a contract that gives the right, but not an obligation, to buy or sell
the underlying on or before a stated date and at a stated price.
 While buyer of option pays the premium and buys the right, writer/seller of
option receives the premium with obligation to sell/ buy the underlying asset, if
the buyer exercises his right.
 Swaps
 A swap is an agreement made between two parties to exchange cash flows in
the future according to a prearranged formula.
 Swaps are, broadly speaking, series of forward contracts.
 Swaps help market participants manage risk associated with volatile interest
rates, currency exchange rates and commodity prices.
Market Participants

 There are broadly three types of participants in the derivatives market -

hedgers, traders (also called speculators) and arbitrageurs.
 An individual may play different roles in different market circumstances.
 Hedgers
 They face risk associated with the prices of underlying assets and use
derivatives to reduce their risk.
 Corporations, investing institutions and banks all use derivative products to
hedge or reduce their exposures to market variables such as interest rates ,
share values, bond prices, currency exchange rates and commodity prices.
 Speculators/Traders
 They try to predict the future movements in prices of underlying assets and based on the
view, take positions in derivative contracts.
 Derivatives are preferred over underlying asset for trading purpose, as they offer
leverage, are less expensive (cost of transaction is generally lower than that of the
underlying) and are faster to execute in size (high volumes market).
 Arbitrageurs
 Arbitrage is a deal that produces profit by exploiting a price difference in a product in
two different markets.
 Arbitrage originates when a trader purchases an asset cheaply in one location and
simultaneously arranges to sell it at a higher price in another location.
 Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in
to these transactions, thus closing the price gap at different locations.
Types of Derivatives Market

 They are either traded on organized exchanges (called exchange traded derivatives)
or agreed directly between the contracting counterparties over the telephone or
through electronic media (called Over-the-counter (OTC) derivatives).
 Few complex products are constructed on simple building blocks like forwards,
futures, options and swaps to cater to the specific requirements of customers.
 OTC derivative markets have witnessed a substantial growth over the past few years,
very much contributed by the recent developments in information technology.
 The OTC derivative markets have banks, financial institutions and sophisticated
market participants like hedge funds, corporations and high net-worth individuals.
 OTC derivative market is less regulated market because these transactions occur in
private among qualified counterparties, who are supposed to be capable enough to
take care of themselves.
 As the word suggests, derivatives that trade on an exchange are called exchange traded
derivatives,
 whereas privately negotiated derivative contracts are called OTC contracts.
 The OTC derivatives markets have witnessed rather sharp growth over the last few years,
which has accompanied the modernization of commercial and investment banking and
globalization of financial activities.
 The recent developments in information technology have contributed to a great extent to
these developments.
 While both exchange-traded and OTC derivative contracts offer many benefits, the former
have rigid structures compared to the latter.
 It has been widely discussed that the highly leveraged institutions and their OTC derivative
positions were the main cause of turbulence in financial markets in 1998.
 These episodes of turbulence revealed the risks posed to market stability originating in
features of OTC derivative instruments and markets.
 The OTC derivatives markets – transactions among the dealing counterparties, have following
features compared to exchange traded derivatives:
 • Contracts are tailor made to fit in the specific requirements of dealing counterparties.
 • 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 or mechanisms for risk management to ensure market stability and
integrity, and for safeguarding the collective interest of market participants.
 • Transactions are private with little or no disclosure to the entire market.
 On the contrary, exchange-traded contracts are standardized, traded on organized exchanges
with prices determined by the interaction of buyers and sellers through anonymous auction
platform.
 A clearing house/ clearing corporation, guarantees contract performance (settlement of
transactions).
 The following features of OTC derivatives markets can give rise to instability in
institutions, markets, and the international financial system:
 (i) the dynamic nature of gross credit exposures;
 (ii) information asymmetries;
 (iii) the effects of OTC derivative activities on available aggregate credit;
 (iv) the high concentration of OTC derivative activities in major institutions; and
 (v) the central role of OTC derivatives markets in the global financial system.
Instability arises when shocks, such as counter-party credit events and sharp
movements in asset prices that underlie derivative contracts occur, which significantly
alter the perceptions of current and potential future credit exposures.
 When asset prices change rapidly, the size and configuration of counter-party
exposures can become unsustainably large and provoke a rapid unwinding of positions.
 There has been some progress in addressing these risks and perceptions.
 However, the progress has been limited in implementing reforms in risk
management, including counterparty, liquidity and operational risks, and OTC
derivatives markets continue to pose a threat to international financial stability.
 The problem is more acute as heavy reliance on OTC derivatives creates the
possibility of systemic financial events, which fall outside the more formal
clearing house structures.
 Moreover, those who provide OTC derivative products, hedge their risks through
the use of exchange traded derivatives.
 In view of the inherent risks associated with OTC derivatives, and their
dependence on exchange traded derivatives, Indian law considers them illegal.
Significance of Derivatives

 Like other segments of Financial Market, Derivatives Market serves following

specific functions:
 • Derivatives market helps in improving price discovery based on actual
valuations and expectations.
 • Derivatives market helps in transfer of various risks from those who are
exposed to risk but have low risk appetite to participants with high risk appetite.
 For example hedgers want to give away the risk where as traders are willing to
take risk.
 • Derivatives market helps shift of speculative trades from unorganized market
to organized market. Risk management mechanism and surveillance of activities
of various participants in organized space provide stability to the financial
system.
Various risks faced by the participants in
derivatives
 Market Participants must understand that derivatives, being leveraged instruments, have
risks like counterparty risk (default by counterparty), price risk (loss on position because
of price move), liquidity risk (inability to exit from a position), legal or regulatory risk
(enforceability of contracts), operational risk (fraud, inadequate documentation,
improper execution, etc.) and may not be an appropriate avenue for someone of limited
resources, trading experience and low risk tolerance.
 A market participant should therefore carefully consider whether such trading is suitable
for him/her based on these parameters.
 Market participants, who trade in derivatives are advised to carefully read the Model Risk
Disclosure Document, given by the broker to his clients at the time of signing agreement.
 Model Risk Disclosure Document is issued by the members of Exchanges and contains
important information on trading in Equities and F&O Segments of exchanges.
 All prospective participants should read this document before trading on Capital
Market/Cash Segment or F&O segment of the Exchanges.
Economy & Capital Markets

 There is a greater need to develop and strengthen capital markets, as they can help to mobilize
private financing.
 The role that capital markets can have in channeling financing to the corporate sector as well as
to other strategic sectors such as infrastructure, and SMEs are increasingly being highlighted in
the G20 agenda.
 The Capital Markets product line assists countries in developing deep and resilient capital
markets that can contribute to economic growth and financial stability. This support includes
assistance for the development of deep and liquid government bond markets, the development
of products and markets for corporate financing (i.e. equity, corporate bonds), as well as the
development of products and solutions to mobilize financing to strategic sectors, such as
infrastructure, housing and SMEs including financing for innovation (including through the
development of a PE and VC ecosystem), and the development of derivatives markets as a key
tool for risk management.
 Well-functioning capital markets require an enabling policy and regulatory framework, and
synchronization of robust regulatory framework with institutional capacity. In addition, in many
cases different de-risking tools and/or incentives are needed to crowd in private capital.
Economic Function of the Derivative
Market
 Prices in an organized derivatives market reflect the perception of the market
participants about the future and lead the prices of underlying to the
perceived future level.
 The prices of derivatives 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.
 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.
 Derivatives, due to their inherent nature, are linked to the underlying cash
markets.
 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.
 In the absence of an organized derivatives market, speculators trade in the
underlying cash markets.
 Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets
 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.
 They often energize others to create new businesses, new products and new
employment opportunities, the benefit of which are immense.
 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.
Derivatives Market – History & Evolution

 History of Derivatives may be mapped back to the several centuries. Some of the specific milestones in
evolution of Derivatives Market Worldwide are given below:
 12th Century- In European trade fairs, sellers signed contracts promising future delivery of the items
they sold.
 13th Century- There are many examples of contracts entered into by English Cistercian Monasteries, who
frequently sold their wool up to 20 years in advance, to foreign merchants.
 1634-1637 - Tulip Mania in Holland: Fortunes were lost in after a speculative boom in tulip futures burst.
 Late 17th Century - In Japan at Dojima, near Osaka, a futures market in rice was developed to protect
rice producers from bad weather or warfare.
 In 1848, The Chicago Board of Trade (CBOT) facilitated trading of forward contracts on various
commodities.
 In 1865, the CBOT went a step further and listed the first ‘exchange traded” derivative contract in the
US. These contracts were called ‘futures contracts”.
 In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was reorganized to allow futures trading.
Later its name was changed to Chicago Mercantile Exchange (CME).
 In 1972, Chicago Mercantile Exchange introduced International Monetary
Market (IMM), which allowed trading in currency futures.
 In 1973, Chicago Board Options Exchange (CBOE) became the first
marketplace for trading listed options.
 In 1975, CBOT introduced Treasury bill futures contract. It was the first
successful pure interest rate futures.
 In 1977, CBOT introduced T-bond futures contract. In 1982, CME introduced
Eurodollar futures contract.
 In 1982, Kansas City Board of Trade launched the first stock index futures.
 In 1983, Chicago Board Options Exchange (CBOE) introduced option on stock
indexes with the S&P 100® (OEX) and S&P 500® (SPXSM) Indexes.
Indian Derivatives Market

 As the initial step towards introduction of derivatives trading in India, SEBI set
up a 24– member committee under the Chairmanship of Dr. L. C. Gupta on
November 18, 1996 to develop appropriate regulatory framework for
derivatives trading in India.
 The committee submitted its report on March 17, 1998 recommending that
derivatives should be declared as ‘securities’ so that regulatory framework
applicable to trading of ‘securities’ could also govern trading of derivatives.
 Subsequently, SEBI set up a group in June 1998 under the Chairmanship of Prof.
J. R. Verma, to recommend measures for risk containment in derivatives
market in India. The committee submitted its report in October 1998.
 It worked out the operational details of margining system, methodology for
charging initial margins, membership details and net-worth criterion, deposit
requirements and real time monitoring of positions requirements.
 In 1999, The Securities Contract Regulation Act (SCRA) was amended to include “derivatives”
within the domain of ‘securities’ and regulatory framework was developed for governing
derivatives trading.
 In March 2000, government repealed a three-decade old notification, which prohibited
forward trading in securities.
 The exchange traded derivatives started in India in June 2000 with SEBI permitting BSE and
NSE to introduce equity derivative segment.
 To begin with, SEBI approved trading in index futures contracts based on CNX Nifty and BSE
Sensex, which commenced trading in June 2000.
 Later, trading in Index options commenced in June 2001 and trading in options on individual
stocks commenced in July 2001.
 Futures contracts on individual stocks started in November 2001.
 MCX-SX started trading in all these products (Futures and options on index SX40 and
individual stocks) in February 2013
Introduction to Index

 Index is a statistical indicator that measures changes in the economy in general or in

particular areas.
 In case of financial markets, an index is a portfolio of securities that represent a particular
market or a portion of a market.
 Each Index has its own calculation methodology and usually is expressed in terms of a change
from a base value.
 The base value might be as recent as the previous day or many years in the past. Thus, the
percentage change is more important than the actual numeric value.
 Financial indices are created to measure price movement of stocks, bonds, T-bills and other
type of financial securities.
 More specifically, a stock index is created to provide market participants with the
information regarding average share price movement in the market.
 Broad indices are expected to capture the overall behaviour of equity market and need to
represent the return obtained by typical portfolios in the country.
Understanding the Stock Index

 An index is a number which measures the change in a set of values over a

period of time.
 A stock index represents the change in value of a set of stocks which
constitute the index.
 More specifically, a stock index number is the current relative value of a
weighted average of the prices of a pre-defined group of equities.
 A stock market index is created by selecting a group of stocks that are
representative of the entire market or a specified sector or segment of the
market.
 It is calculated with reference to a base period and a base index value.
 The beginning value or base of the index is usually set to a number such as
100 or 1000.
 For example, the base value of the Nifty was set to 1000 on the start date of
November 3, 1995. Stock market indices are meant to capture the overall
behavior of equity markets.
 Stock market indices are useful for a variety of reasons.
 Some uses of them are:
 1. As a barometer for market behaviour,
 2. As a benchmark for portfolio performance,
 3. As an underlying in derivative instruments like Index futures, Index options,
and
 4. In passive fund management by index funds/ETFs
Significance of Index

 A stock index is an indicator of the performance of overall market or a

particular sector.
 It serves as a benchmark for portfolio performance - Managed portfolios,
belonging either to individuals or mutual funds; use the stock index as a
measure for evaluation of their performance.
 It is used as an underlying for financial application of derivatives – Various
products in OTC and exchange traded markets are based on indices as
underlying asset.
Economic Significance of Index
Movements
 Index movements reflect the changing expectations of the stock market about future
dividends of the corporate sector.
 The index goes up if the stock market perceives that the prospective dividends in the
future will be better than previously thought. When the prospects of dividends in the
future become pessimistic, the index drops.
 The ideal index gives us instant picture about how the stock market perceives the
future of corporate sector. Every stock price moves for two possible reasons:
 1. News about the company- micro economic factors
 (e.g. a product launch, or the closure of a factory, other factors specific to a company)
 2. News about the economy – macro economic factors
 (e.g. budget announcements, changes in tax structure and rates, political news such as
change of national government, other factors common to all companies in a country)
 The index captures the second part, the movements of the stock market as a
whole (i.e. news about the macroeconomic factors related to entire economy).
This is achieved by averaging.
 Each stock contains a mixture of two elements - stock news and index news.
 When we take an average of returns on many stocks, the individual stock news
tends to cancel out and the only thing left is news that is common to all stocks.
 The news that is common to all stocks is news about the economy.
 The correct method of averaging is that of taking a weighted average, giving each
stock a weight proportional to its market capitalization.
 Example: Suppose an index contains two stocks, A and B. A has a market
capitalization of Rs.1000 crore and B has a market capitalization of Rs.3000 crore.
Then we attach a weight of 1/4 to movements in A and 3/4 to movements in B.
Types of Stock Market Indices

 Indices can be designed and constructed in various ways. Depending upon

their methodology, they can be classified as under:
 Market capitalization weighted index
 Free-Float Market Capitalization Index
 Price-Weighted Index
 Equal Weighted Index
Market capitalization weighted index

 In this method of calculation, each stock is given weight according to its

market capitalization.
 So higher the market capitalization of a constituent, higher is its weight in
the index.
 Market capitalization is the market value of a company, calculated by
multiplying the total number of shares outstanding to its current market
price.
 For example, ABC company with 5,00,00,000 shares outstanding and a share
price of Rs 120 per share will have market capitalization of 5,00,00,000 x 120
= Rs 6,00,00,00,000 i.e. 600 Crores.
 Let us understand the concept with the help of an example: There are five
stocks in an index. Base value of the index is set to 100 on the start date
which is January 1, 1995. Calculate the present value of index based on
following information.
Free-Float Market Capitalization Index

 In various businesses, equity holding is divided differently among various

stake holders – promoters, institutions, corporates, individuals etc.
 Market has started to segregate this on the basis of what is readily available
for trading or what is not.
 The one available for immediate trading is categorized as free float.
 And, if we compute the index based on weights of each security based on free
float market cap, it is called free float market capitalization index.
 Indeed, both Sensex and Nifty, over a period of time, have moved to free
float basis.
 SX40, index of MCX-SX is also a free float market capitalization index.
Price-Weighted Index

 A stock index in which each stock influences the index in proportion to its
price.
 Stocks with a higher price will be given more weight and therefore, will have
a greater influence over the performance of the Index.
 Let us take the same example for calculation of price-weighted index.
Equal Weighted Index

 An equally-weighted index makes no distinction between large and small

companies, both of which are given equal weighting.
 The value of the index is generated by adding the prices of each stock in the
index and dividing that by the total number of stocks.
 Let us take the same example for calculation of equal weighted index.
 Base level of this index would be (150+300+450+100+250)/5 = 250.
 We equate this to 100.
 Current level of this index would be (650+450+600+350+500)/5 = 510.
 It means current level of index on the base of 100 would be (510/250)*100 =
204
Attributes of an Index

 A good market index should have following attributes:

 • It should reflect the market behaviour
 • It should be computed by independent third party and be free from
influence of any market participant
 • It should be professionally maintained
Impact Cost

 Liquidity in the context of stock market means a market where large orders
are executed without moving the prices. Let us understand this with help of
an example. The order book of a stock at a point in time is as follows:
 In the order book given above, there are four buy orders and four sell orders.
 The difference between the best buy and the best sell orders is 0.50 - called bid-ask
spread.
 If a person places a market buy order for 100 shares, it would be matched against the
best available sell order at Rs. 4.50. He would buy 100 shares for Rs. 4.50.
 Similarly, if he places a market sell order for 100 shares, it would be matched against the
best available buy order at Rs. 4 i.e. the shares would be sold at Rs.4.
 Hence, if a person buys 100 shares and sells them immediately, he is poorer by the bid-
ask spread i.e. a loss of Rs 50.
 This spread is regarded as the transaction cost which the market charges for the privilege
of trading (for a transaction size of 100 shares).
 Now, suppose a person wants to buy and then sell 3000 shares.
 The sell order will hit the following buy orders:
 There is increase in the transaction cost for an order size of 3000 shares in comparison to the
transaction cost for order for 100 shares. The “bid-ask spread” therefore conveys transaction cost for
small trade
 Now, we come across the term called impact cost. We have to start by defining the ideal price as the
average of the best bid and offer price. In our example it is (4+4.50)/2, i.e. Rs. 4.25.
 In an infinitely liquid market, it would be possible to execute large transactions on both buy and sell
at prices that are very close to the ideal price of Rs.4.25.
 However, while actually trading, you will pay more than Rs.4.25 per share while buying and will
receive less than Rs.4.25 per share while selling.
 Percentage degradation, which is experienced vis-à-vis the ideal price, when shares are bought or
sold, is called impact cost.
 Impact cost varies with transaction size. Also, it would be different for buy side and sell side.
 To buy 1500 shares, Ideal price = (9.8+9.9)/ 2 = Rs.9.85
 Actual buy price = [(1000*9.9)+(500*10.00)]/1500 = Rs.9.93
 Impact cost for (1500 shares) = {(9.93 - 9.85)/9.85}*100 = 0.84 %
Index management

 Index construction, maintenance and revision process is generally done by

specialized agencies.
 For instance, all NSE indices are managed by a separate company called “India
Index Services and Products Ltd. (IISL)”, a joint venture between Standard and
Poor’s (S&P), National Stock Exchange (NSE) and CRISIL Ltd. (Now a part of
Standard & Poor’s).
 Index construction is all about choosing the index stocks and deciding on the
index calculation methodology.
 Maintenance means adjusting the index for corporate actions like bonus issue,
rights issue, stock split, consolidation, mergers etc.
 Revision of index deals with change in the composition of index as such i.e.
replacing some existing stocks by the new ones because of change in the trading
paradigm of the stocks / interest of market participants.
Index Construction

 A good index is a trade-off between diversification and liquidity. A well diversified

index reflects the behaviour of the overall market/ economy.
 While diversification helps in reducing risk, beyond a point it may not help in the
context.
 Going from 10 stocks to 20 stocks gives a sharp reduction in risk. Going from 50 stocks
to 100 stocks gives very little reduction in risk. Going beyond 100 stocks gives almost
zero reduction in risk.
 Hence, there is little to gain by diversifying beyond a point.
 Stocks in the index are chosen based on certain pre-determined qualitative and
quantitative parameters, laid down by the Index Construction Managers.
 Once a stock satisfies the eligibility criterion, it is entitled for inclusion in the index.
 Generally, final decision of inclusion or removal of a security from the index is taken
by a specialized committee known as Index Committee.
Index Maintenance and Index Revision

 Maintenance and Revision of the indices is done with the help of various
mathematical formulae.
 In order to keep the index comparable across time, the index needs to take
into account corporate actions such as stock splits, share issuance, dividends
and restructuring events.
 While index maintenance issue gets triggered by a corporate action, index
revision is an unabated phenomenon to ensure that index captures the most
vibrant lot of securities in the market and continues to correctly reflect the
market.
Major Indices in India

 These are few popular indices in India.

 • BSE Sensex • BSE Midcap • BSE-100 • BSE-200 • BSE-500
 • CNX Nifty • CNX Nifty Junior • CNX Defty • CNX Midcap • CNX 500 • SX 40
Application of Indices

 Traditionally, indices were used as a measure to understand the overall

direction of stock market.
 However, few applications on index have emerged in the investment field.
 Few of the applications are explained below.
 Index Funds: These types of funds invest in a specific index with an objective
to generate returns equivalent to the return on index.
 These funds invest in index stocks in the proportions in which these stocks
exist in the index.
 For instance, Sensex index fund would get the similar returns as that of
Sensex index. Since Sensex has 30 shares, the fund will also invest in these 30
companies in the proportion in which they exist in the Sensex.
 Index Derivatives : Index Derivatives are derivative contracts which have the index as the
underlying asset.
 Index Options and Index Futures are the most popular derivative contracts worldwide.
 Index derivatives are useful as a tool to hedge against the market risk.
 Exchange Traded Funds: Exchange Traded Funds (ETFs) is basket of securities that trade like
individual stock, on an exchange.
 They have number of advantages over other mutual funds as they can be bought and sold on the
exchange.
 Since, ETFs are traded on exchanges intraday transaction is possible.
 Further, ETFs can be used as basket trading in terms of the smaller denomination and low
transaction cost.
 The first ETF in Indian Securities Market was the Nifty BeES, introduced by the Benchmark Mutual
Fund in December 2001.
 Prudential ICICI Mutual Fund introduced SPIcE in January 2003, which was the first ETF on Sensex
Introduction to forward and futures
Contracts
 Forward contract is an agreement made directly between two parties to buy or sell an asset on a
specific date in the future, at the terms decided today.
 Forwards are widely used in commodities, foreign exchange, equity and interest rate markets.
 Let us understand with the help of an example. What is the basic difference between cash market
and forwards?
 Assume on March 9, 2009 you wanted to purchase gold from a goldsmith. The market price for
gold on March 9, 2009 was Rs. 15,425 for 10 gram and goldsmith agrees to sell you gold at market
price. You paid him Rs.15, 425 for 10 gram of gold and took gold. This is a cash market transaction
at a price (in this case Rs.15, 425) referred to as spot price.
 Now suppose you do not want to buy gold on March 9, 2009, but only after 1 month. Goldsmith
quotes you Rs.15, 450 for 10 grams of gold. You agree to the forward price for 10 grams of gold
and go away. Here, in this example, you have bought forward or you are long forward, whereas
the goldsmith has sold forwards or short forwards. There is no exchange of money or gold at this
point of time. After 1 month, you come back to the goldsmith pay him Rs. 15,450 and collect your
gold. This is a forward, where both the parties are obliged to go through with the contract
irrespective of the value of the underlying asset (in this case gold) at the point of delivery.
 Essential features of a forward are:
 • It is a contract between two parties (Bilateral contract).
 • All terms of the contract like price, quantity and quality of underlying, delivery terms like place,
settlement procedure etc. are fixed on the day of entering into the contract.
 In other words, Forwards are bilateral over-the-counter (OTC) transactions where the terms of the
contract, such as price, quantity, quality, time and place are negotiated between two parties to the
contract.
 Any alteration in the terms of the contract is possible if both parties agree to it.
 Corporations, traders and investing institutions extensively use OTC transactions to meet their specific
requirements.
 The essential idea of entering into a forward is to fix the price and thereby avoid the price risk.
 Thus, by entering into forwards, one is assured of the price at which one can buy/sell an underlying asset.
 In the above-mentioned example, if on April 9, 2009 the gold trades at Rs. 15,500 in the cash market, the
forward contract becomes favourable to you because you can then purchase gold at Rs. 15,450 under the
contract and sell in cash market at Rs. 15,500 i.e. net profit of Rs. 50. Similarly, if the spot price is 15,390
then you incur loss of Rs. 60 (buy price – sell price).
Major limitations of forwards

 1) Liquidity Risk: Liquidity is nothing but the ability of the market

participants to buy or sell the desired quantity of an underlying asset.
 As forwards are tailor made contracts i.e. the terms of the contract are
according to the specific requirements of the parties, other market
participants may not be interested in these contracts.
 Forwards are not listed or traded on exchanges, which makes it difficult for
other market participants to easily access these contracts or contracting
parties.
 The tailor made contracts and their nonavailability on exchanges creates
illiquidity in the contracts.
 Therefore, it is very difficult for parties to exit from the forward contract
before the contract’s maturity.
 2) Counterparty risk: Counterparty risk is the risk of an economic loss from the failure of
counterparty to fulfil its contractual obligation.
 For example, A and B enter into a bilateral agreement, where A will purchase 100 kg of rice
at Rs.20 per kg from B after 6 months.
 Here, A is counterparty to B and vice versa. After 6 months, if price of rice is Rs.30 in the
market then B may forego his obligation to deliver 100 kg of rice at Rs.20 to A.
 Similarly, if price of rice falls to Rs.15 then A may purchase from the market at a lower price,
instead of honouring the contract.
 Thus, a party to the contract may default on his obligation if there is incentive to default.
 This risk is also called default risk or credit risk. In addition to the illiquidity and
counterparty risks, there are several issues like lack of transparency, settlement
complications as it is to be done directly between the contracting parties.
 Simple solution to all these issues lies in bringing these contracts to the centralized trading
platform. This is what futures contracts do.
Futures contract

 Futures markets were innovated to overcome the limitations of forwards.

 A futures contract is an agreement made through an organized exchange to
buy or sell a fixed amount of a commodity or a financial asset on a future
date at an agreed price.
 Simply, futures are standardized forward contracts that are traded on an
exchange.
 The clearinghouse associated with the exchange guarantees settlement of
these trades.
 A trader, who buys futures contract, takes a long position and the one, who
sells futures, takes a short position.
 The words buy and sell are figurative only because no money or underlying
asset changes hand, between buyer and seller, when the deal is signed.
Features of futures contract In futures
market
 exchange decides all the contract terms of the contract other than price.
 Accordingly, futures contracts have following features:
 • Contract between two parties through Exchange
 • Centralized trading platform i.e. exchange
 • Price discovery through free interaction of buyers and sellers
 • Margins are payable by both the parties
 • Quality decided today (standardized )
 • Quantity decided today (standardized)
Limitations of Futures Contract

 As futures are standardized contracts introduced by the exchanges, they too

have certain limitations in the context of
 limited maturities,
 limited underlying set,
 lack of flexibility in contract design and
 increased administrative costs on account of MTM settlement, etc.
Contract specifications of futures
contracts
 The exchange decides all terms and conditions of futures contracts other than the price of the
futures contract.
 These terms and conditions are known as ‘contract specifications.
 Contract specifications include the salient features of a derivatives contract like contract
maturity, contract multiplier or contract size, tick size, etc.
 Let us understand these contract specifications with an example of a Nifty futures contract
traded on the NSE.
 Quotes given on the NSE website for Nifty futures as on September 21, 2021
 1. Instrument type : Index futures 2. Underlying asset : Nifty 50
 3. Expiry date : September 30, 2021 4. Open price (in Rs.) : 17378.00
 5. High price (in Rs.) : 17569.55 6. Low price (in Rs.) : 17335.50
 7. Closing price (in Rs.) : 17559.30 8. No of contracts traded : 1,89,312
 9. Turnover (in Rs. Lakhs) : 16,51,808.89 10. Underlying value (in Rs.) : 17562.00
 Underlying instrument and underlying price: The underlying instrument
refers to the index or stock on which the futures contract is traded.
 In the above example, the underlying asset is the Nifty 50 index.
 The underlying price is the spot price or the price at which the underlying
asset trades in the cash market.
 In this example, the underlying price is the value of the Nifty index on
September 21, 2021 which is 17562.00.
 Contract multiplier or Contract Size: Futures contracts are traded in lots.
The lot size or contract size for the index and stock futures is determined by
the exchange.
 Contract sizes are different for each stock and index traded in the derivatives
segment.
 The contract size can be changed by the exchange from time to time,
depending upon the changes in the index level and stock prices.
 To arrive at the contract value, we have to multiply the futures price with the
contract multiplier (i.e., multiply the futures price with the lot size).
 The contract size for the Nifty futures contract is currently 50. In the above
example, the value of a Nifty futures contract can be calculated by
multiplying the lot size with the closing futures price on September 21, 2021
i.e., 50 * 17559.30 which works out to Rs.8,77,965
 Contract Cycle: It is a period over which a contract trades. Index and stock
futures contracts follow a three-month trading cycle.
 Thus, on September 21, 2021, index and stock futures contracts are available
for trading for the near month (September 2021), the next month (October
2021) and the far month (November 2021).
 Most of the futures contracts traded on Indian exchanges expire on the last
Thursday of the respective month (or the day before if the last Thursday is a
trading holiday) and a new contract (in this example - December 2021) is
introduced on the trading day following the expiry day of the near month
contract.
 However, the monthly futures contracts on the Nifty Financial Services Index
expire on the last Tuesday of their expiry month.
 Expiration Day: This is the day on which a derivative contract ceases to exist. It
is the last trading day of the contract.
 Generally, it is the last Thursday of the expiry month (with some exceptions as
mentioned in the above paragraph). If the last Thursday is a trading holiday, the
contracts expire on the previous trading day.
 On expiry date, all the contracts are compulsorily settled.
 If a position is to be continued, then it must be rolled over to another futures
contract of the same underlying. For a long position, this means selling the
expiring contract and buying the next contract. Both the sides of a roll over
should be executed at the same time.
 In the above example, the September Nifty futures contract will cease to trade
on September 30, 2021 and all open positions of the September series will be
compulsorily settled by the exchange.
 Tick Size: It is the minimum move allowed in the price quotations.
 Exchanges decide the tick sizes on traded contracts as part of contract specification.
 Tick size for Nifty futures is 5 paisa.
 Bid price is the price the buyer is willing to pay and ask price is the price at which the seller is
willing to sell.
 Daily settlement price: The exchange follows a daily settlement procedure for open positions
in equity index and stock futures contracts.
 All open positions are settled daily based on the daily settlement price of the futures
contracts, which is calculated by the exchange on the basis of the last half-an-hour weighted
average price of that futures contract.
 Thus, the daily settlement price is different for each futures contract of a different expiry
month.
 In the above example, the daily settlement price of the September Nifty futures contract on
September 21 is its closing price which is 17559.30.
 Final settlement price: This is the price at which all open positions in the near-month futures
contracts are finally settled on the expiration day of the near-month futures contract.
 The final settlement price is the closing price of the relevant underlying index or stock in the
cash segment on the last trading day of the futures contract.
 In the above example, the final settlement price for the September Nifty futures contract will
be the closing spot value of Nifty on the expiration date, i.e., on September 30, 2021 which is
the last Thursday of the expiry month.
 Trading hours: The equity futures contracts can be traded during the normal market hours
between 9.15 am and 3.30 pm from Monday to Friday.
 The exchange publishes a list of annual trading holidays and clearing holidays for the
information of the market participants.
 Trading holidays are days on which no trading is possible as the exchanges are closed
 while clearing holidays are days on which the exchanges are open and trading is possible but
no clearing and settlement takes place as banks are closed.
 Basis: The difference between the spot price and the futures price is called
basis.
 If the futures price is greater than spot price, basis for the asset is negative.
 Similarly, if the spot price is greater than futures price, basis for the asset is
positive.
 On September 21, 2021, spot price > futures price, thus basis for Nifty futures
is positive (i.e., 17562 – 17559.30 = 2.70).
 Importantly, basis for one-month contract would be different from the basis for two or three month
contracts.
 Therefore, definition of basis is incomplete until we define the basis vis-a-vis a futures contract i.e.
basis for one month contract, two months contract etc.
 It is also important to understand that the basis difference between say one month and two months
futures contract should essentially be equal to the cost of carrying the underlying asset between first
and second month.
 Indeed, this is the fundamental of linking various futures and underlying cash market prices together.
 During the life of the contract, the basis may become negative or positive, as there is a movement in
the futures price and spot price.
 Further, whatever the basis is, positive or negative, it turns to zero at maturity of the futures
contract i.e. there should not be any difference between futures price and spot price at the time of
maturity/ expiry of contract.
 This happens because final settlement of futures contracts on last trading day takes place at the
closing price of the underlying asset.
 It may be noted that we also have global indices being traded on BSE and NSE
denominated in Indian Rupees.
 For example, NSE has derivative contracts on S&P 500, Dowjones & FTSE100
whereas BSE has derivative contracts on iBovespa (Brazilian index), MICEX
(Russian index), Hang Seng (Hongkong index) & FTSE / JSE Top40 (South
African index).
 The National Stock Exchange has also launched future contracts on India
Volatility Index (VIX) enabling traders to hedge market risk arising out of
volatility in Feb. 2014. Other exchanges are also working on introducing
derivative contracts on volatility index
Cost of Carry

 Cost of Carry is the relationship between futures prices and spot prices.
 It measures the storage cost (in commodity markets) plus the interest that is paid to
finance or ‘carry’ the asset till delivery, less the income earned on the asset during
the holding period.
 For equity derivatives, carrying cost is the interest paid to finance the purchase less
(minus) dividend earned.
 For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A
person wishes to buy the share, but does not have money. In that case he would
have to borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this
share for one year and in that year, he expects the company to give 200% dividend
on its face value of Rs. 1 i.e., dividend of Rs. 2. Thus his net cost of carry = Interest
paid – dividend received = 6 – 2 = Rs. 4. Therefore, break even futures price for him
should be Rs.104. It is important to note that cost of carry may be different for
different participants.
Margin Account

 Margin Account : As the exchange guarantees the settlement of all the trades, to protect itself against default by
either counterparty, it charges various margins from brokers.
 Brokers in turn charge margins from their clients.
 Margins are briefly explained as follows:
 Initial Margin: The amount one needs to deposit in the margin account at the time of entering into a futures contract
is known as the initial margin.
 Let us take an example - On September 21, 2021 a person decided to enter into a futures contract. He expects the
market to go up and so he takes a long Nifty Futures position for September expiry at Rs.17400.
 The contract value = Nifty futures price * lot size = 17400 * 50 = Rs 8,70,000.
 This is the contract value of the investor’s long position in one Nifty Future contract expiring on September 30, 2021.
 Assuming that the broker charges 10% of the contract value as initial margin, the investor has to give him Rs. 87,000
as initial margin.
 Both buyers and sellers of futures contract pay initial margin, as there is an obligation on both the parties to honour
the contract.
 The initial margin is dependent on price movement of the underlying asset.
 As high volatility assets carry more risk, the exchange would charge higher initial margin on them.
Marking to Market (MTM)

 In futures market, while contracts have maturity of several months, profits and losses
are settled on day-to-day basis – called mark to market (MTM) settlement.
 The exchange collects these margins (MTM margins) from the loss-making participants
and pays to the gainers on day-to-day basis.
 Suppose a person bought a futures contract on September 21, 2021 when the Nifty
futures contract was trading at 17400.
 He paid an initial margin of Rs. 87,000 as calculated above.
 At the end of that day, Nifty futures contract closes at17559.30.
 This means that he/she benefits due to the 159.30 points gain on Nifty futures
contract.
 Thus, his/her MTM gain for the day is Rs 159.30 x 50 = Rs 7965. This money will be
credited to his account and next day his/her position will start from 17559.30 (for the
purpose of MTM computation).
 Open Interest and Volumes Traded: The open interest is the total number of
contracts outstanding (yet to be settled) for an underlying asset.
 It is important to understand that number of long futures as well as number of
short futures is equal to the Open Interest.
 This is because total number of long futures will always be equal to total
number of short futures.
 Only one side of contracts is considered while calculating/mentioning open
interest.
 The level of open interest indicates depth in the market
 Volumes traded give us an idea about the market activity with regards to
specific contract over a given period – volume over a day, over a week or
month or over entire life of the contract. The following example explains the
difference between open interest and traded volume
Price band

 Price Band is essentially the price range within which a contract is permitted to trade
during a day.
 The band is calculated with regard to previous day’s closing price of a specific contract.
 For example, previous day closing price of a contract is Rs.100 and price band for the
contract is 10%, then the contract can trade between Rs.90 and Rs.110 for next trading
day.
 On the first trading day of the contract, the price band is decided based on the closing
price of the underlying asset in cash market.
 For example, if today is first trading day of a futures contract for an underlying asset
i.e., company A, the price band for the contract is decided on the previous day’s closing
price of company ‘A’ stock in cash market.
 Price band is clearly defined in the contract specifications so that all market participants
are aware of the same in advance. Sometimes, bands are allowed to be expanded at the
discretion of the exchanges with specific trading halts.
Positions in derivatives market

 As a market participant, you will always deal with certain terms like long, short and open
positions in the market.
 Let us understand the meanings of commonly used terms:
 Long position: Outstanding / unsettled buy position in a contract is called “Long Position”.
 For instance, if Mr. X buys 5 contracts on Sensex futures, then he would be long on 5
contracts of Sensex futures.
 If Mr. Y buys 4 contracts on Nifty futures, then he has a long position in 4 contracts of Nifty
futures.
 Short Position: Outstanding / unsettled sell position in a contract is called “Short Position”.
 For instance, if Ms. P sells 5 contracts on Sensex futures, then she would be short on 5
contracts on Sensex futures.
 If Ms. Q sells 4 contracts on Nifty futures, then she would be short on 4 contracts of Nifty
futures.
Open position

 Outstanding / unsettled either long (buy) or short (sell) position in various

derivative contracts is called “Open Position”.
 For instance, if Mr. X shorts 5 contracts on Infosys futures and goes long on 3
contracts of Reliance futures, he is said to be having open position, which is
equal to short on 5 contracts of Infosys and long on 3 contracts of Reliance.
 If on the next day, he buys 2 Infosys contracts of same maturity, his open
position would be – short on 3 Infosys contracts and long on 3 Reliance
contracts.
 Naked and calendar spread positions:
 Naked position in futures market simply means a long or short position in any futures
contract without having any position in the underlying asset.
 Calendar spread position is a combination of two positions in futures on the same
underlying - long on one maturity contract and short on a different maturity contract.
 For instance, a short position in near month contract coupled with a long position in far
month contract is a calendar spread position.
 Calendar spread position is computed with respect to the near month series and
becomes an open position once the near month contract expires or either of the
offsetting positions is closed.
 A calendar spread is always defined with regard to the relevant months i.e., spread
between August contract and September contract, spread between August contract and
October contract, or spread between September contract and October contract, etc.
 Opening a position: Opening a position means either buying or selling a
contract, which increases client’s open position (long or short).
 Closing a position: Closing a position means either buying or selling a
contract, which essentially results in reduction of client’s open position (long
or short).
 A client is said to be closed a position if he sells a contract which he had
bought before, or he buys a contract which he had sold earlier
Pay off Charts for Futures contract

 Pay off Charts: Pay off on a position is the likely profit/loss that would accrue to a market
participant with change in the price of the underlying asset at expiry.
 The pay off diagram is a graphical representation showing the price of the underlying asset on the
X-axis and profits/losses on the Y-axis.
 Pay off charts for futures In case of futures contracts, long as well as short position has unlimited
profit or loss potential.
 This results into linear pay offs for futures contracts.
 Pay off for buyer of futures: Long futures
 Let us say a person goes long in a futures contract at Rs.100. This means that he has agreed to buy
the underlying at Rs. 100 on expiry. Now, if on expiry, the price of the underlying is Rs. 150, then
this person will buy at Rs. 100, as per the futures contract and will immediately be able to sell the
underlying in the cash market at Rs.150, thereby making a profit of Rs. 50.
 Similarly, if the price of the underlying falls to Rs. 70 at expiry, he would have to buy at Rs. 100,
as per the futures contract, and if he sells the same in the cash market, he would receive only Rs.
70, translating into a loss of Rs. 30.
 This potential profit/loss at expiry when expressed graphically, is known as a
pay off chart.
 The X Axis has the market price of the underlying at expiry. It increases on
the Right Hand Side (RHS).
 We do not draw the X Axis on the Left Hand Side (LHS), as prices 30 cannot go
below zero. The Y Axis shows profit & loss.
 In the upward direction, we have profits and in the downward direction, we
show losses in the chart. The below table and pay off chart show long futures
pay offs:
 Short Futures pay off As one person goes long, some other person has to go
short, otherwise a deal will not take place. The profits and losses for the
short futures position will be exact opposite of the long futures position. This
is shown in the table and chart below:
Futures pricing

 Pricing of a futures contract depends on the characteristics of underlying

asset.
 There is no single way to price futures contracts because different assets
have different demand and supply patterns, different characteristics and cash
flow patterns.
 This makes it difficult to design a single methodology for calculation of prices
of futures contracts.
 Market participants use different models for pricing futures.
 Here, our discussion is limited to only two popular models of futures pricing -
Cost of Carry model and Expectations model.
Cost of Carry Model for Futures Pricing

 Cost of Carry model is also known as the no-arbitrage model.

 This model assumes that in an efficient market, arbitrage opportunities cannot exist.
 In other words, the moment there is an opportunity to make money in the market due to mispricing in the
asset price and its replicas, arbitrageurs will start trading to profit from these mispricing and thereby
eliminating these opportunities.
 This trading continues until the prices are aligned across the products/markets for replicating assets.
 Let us understand the entire concept with the help of an example. Practically, forward/ futures position in
a stock can be created in the following manner:
  Enter into a forward/futures contract, or
  Create a synthetic forward/futures position by buying that stock in the cash market and carrying it to the
future date.
 The price of acquiring the asset by a future date should be the same in both the cases i.e., cost of
synthetic forward/futures contract ( = spot price + cost of carrying the asset from today to the future date)
should be equivalent to the present price of the forward/ futures contract.
 If these prices are not the same, then it will trigger arbitrage and will continue until prices in both the
markets are aligned.
 The cost of creating a synthetic futures position is the fair price of futures contract.
 Fair price of futures contract is nothing but the sum of spot price of underlying asset
and cost of carrying the asset from today until delivery.
 Cost of carrying a financial asset from today to the future date would entail
different costs like transaction cost, custodial charges, financing cost, etc.
 whereas for commodities, it would also include costs like warehousing cost,
insurance cost, etc. Let us take an example from Bullion Market.
 Assume that the spot price of gold is Rs 49,950 per 10 grams. The cost of financing,
storage and insurance for carrying the gold for a period of three months is Rs 100
per 10 grams.
 Now you purchase 10 grams of gold from the market at Rs 49,950 and hold it for
three months. We may now say that the value of the gold after 3 months would be
Rs 50,050 per 10 grams.
 Assume the 3-month futures contract on gold is trading at Rs 50,150 per 10
grams. What should one do?
 Apparently, one should attempt to exploit the arbitrage opportunity present
in the gold market by buying gold in the cash market and sell 3- month gold
futures simultaneously.
 We borrow money to take delivery of gold in cash market today, hold it for 3
months and deliver it in the futures market on the expiry of our futures
contract. Amount received on settling the futures contract could be used to
repay the financier of our gold purchase.
 The net result will be a profit of Rs 100 without taking any risk. (Please note
that we have not considered any transaction costs in this example).
 Because of this mispricing, as more and more people come to the cash market to buy gold
and sell in futures market, spot gold price will go up and gold futures price will come down.
 This arbitrage opportunity continues until the prices between cash and futures markets are
aligned.
 Therefore, if futures price is more than the fair futures price, it will trigger “cash and carry
arbitrage”, which will continue until the prices in both the markets are aligned.
 Similarly, if the futures price is less than the fair futures price, it will trigger “reverse cash
and carry arbitrage” i.e., market participants will start buying gold in futures markets and
sell gold in cash market.
 To do this, traders will borrow gold and deliver it to honour the contract in the cash market
and earn interest on the cash market sales proceeds.
 After three months, they give gold back to the lender on receipt of the same in futures
market. This reverse arbitrage will result in reduction of gold’s spot price and increase of its
futures price, until these prices are aligned and there is no further arbitrage left.
 Cost of transaction and no-arbitrage bound Cost components of futures
transaction like margins, transaction costs (commissions), taxes etc.
 create distortions and take markets away from equilibrium. In fact, these cost
components create a no-arbitrage bound in the market i.e., if the futures
price is within that bound around the fair futures price, arbitrage will not
take place.
 In other words, because of the frictions in the market, for arbitrage to get
triggered, it is important for the futures price to fall outside the no-arbitrage
bounds in either direction for the arbitragers to make profit from the
arbitrage opportunities.
 Practically, every component of carrying cost contributes towards widening of these
noarbitrage bounds.
 Here, we should appreciate that wider the no-arbitrage bounds, farther the markets are
from the equilibrium. In other words, for markets to be efficient, different costs of
operating in the markets should be as low as possible.
 Lower costs would narrow the no-arbitrage bound, which in turn would ensure the efficient
price alignment across the markets.
 Extension of Cost of Carry model to the assets generating returns Let us extend the Cost of
Carry model by adding the inflows during the holding period of underlying assets.
 For instance, underlying asset like securities (equity or bonds) may have certain inflows, like
dividend on equity and interest on debt instruments, during the holding period.
 These inflows are adjusted in the computation of the fair futures price. Thus, modified
formula of fair futures price or synthetic futures price is: Fair futures price = Spot price +
Cost of carry - Inflows
 In mathematical terms, F = S (1+r-q)T Where F is fair price of the futures contract, S is the Spot price of the
underlying asset, q is expected return during holding period T (in years) and r is cost of carry. If we use the
continuous compounding,
 we may rewrite the formula as: F= Se(r-q)*T
 Let us apply the above formula to the index futures market to find the fair futures price of an index.
Suppose, you buy an index in cash market at 17500 level i.e., purchase of all the stocks constituting the index
in the same proportion as they are in the index, cost of financing is 12% and the return on index is 4% per
annum (spread uniformly across the year).
 Given this data, fair price of index three months down the line should be: = Spot price * (1 + cost of financing
– holding period return) ^ (time to expiration / 365) = 17500 * (1+0.12-0.04) ^ (90/365) = Rs. 17835.26
 [Alternatively, we could use exponential form for calculating the futures value as: Spot Price * e(r-q)T.
 Value in that case would have been: 17500*e((0.12-0.04)*90/365) = Rs. 17848.63].
 If the index futures is trading above 17848.63, we can buy index stocks in cash market and simultaneously
sell index futures to lock the gains equivalent to the difference between futures price and fair futures price.
 Note that the cost of transaction, taxes, margins, etc. are not considered while calculating the fair futures
price.
 Note: Cost of borrowing of funds and securities, return expectations on the
held asset, etc. are different for different market participants.
 The number of fair values of futures can be as many as the number of market
participants in the market.
 Perhaps the difference among the fair values of futures contracts and no-
arbitrage bounds for different market participants is what makes the market
and trading take place on a continuous basis.
Assumptions of the Cost of Carry model

 This model of futures pricing works under certain assumptions.

 The important assumptions are stated below (*):
  Underlying asset is available in abundance in cash market.
  Demand and supply in the underlying asset is not seasonal.
  Holding and maintaining of underlying asset is easy and feasible.
  Underlying asset can be sold short.
  There are no transaction costs.
  There are no taxes.
  There are no margin requirements.
 [*This is not an exhaustive list of the assumptions of the model but is the list of important assumptions]
 The assumption that underlying asset is available in abundance in the cash market means that we can
buy and/or sell as many units of the underlying assets as we want. This assumption does not work
especially when underlying asset has seasonal pattern of demand and supply. The prices of seasonal
assets (especially commodities) vary drastically in different demand-supply environments.
 For example, in case of agricultural commodities, when new supplies arrive in the market place, prices
tend to fall, whereas prices tend to be high just before the arrival of that new supply.
 When an underlying asset is not storable i.e., the asset is not easy to hold/maintain, then one cannot
carry the asset to the future. The Cost of Carry model is not applicable to these types of underlying
assets.
 Similarly, many a time, the underlying may not be sold short. This is true in case of seasonal commodities.
 Even though this simple model does not discount for transaction cost, taxes, etc., we can always upgrade
the formula to reflect the impact of these factors in the model.
 Margins are not considered while computing the fair value/ synthetic futures value. That is why this model
is suitable for pricing forward contracts rather than futures contracts.
 Thus, no generalized statement can be made with regard to the use of Cost of Carry model for pricing
futures contracts.
 Assumptions of the model and characteristics of underlying asset can help us in deciding whether a
specific asset can be priced with the help of this model or not.
 Further, suitable adjustments are made in the model to fit in the specific requirements of the underlying
assets.
Other Models

 Convenience Yield: These values may be in the form of convenience or

perceived mental comfort by holding the asset. For instance, in case of
natural disaster like flood in a particular region, people start storing essential
commodities like grains, vegetables and energy products (heating oil), etc. As
a human tendency, we store more than what is required for our real
consumption during a crisis. If every person behaves in similar way, then
suddenly a demand is created for an underlying asset in the cash market.
 Expectations model of futures pricing : According to the expectations
hypothesis, it is not the relationship between spot and futures prices, but
that of expected spot and futures prices, which moves the market, especially
in cases when the asset cannot be sold short or cannot be stored. It also
argues that futures price is nothing but the expected spot price of an asset in
the future.
Uses of futures

 Hedgers : Corporations, Investing Institutions, Banks and Governments all use

derivative products to hedge or reduce their exposures to market variables
such as interest rates, share values, bond prices, currency exchange rates and
commodity prices.
 The classic example is the farmer who sells futures contracts to lock into a
price for delivering a crop on a future date. The buyer might be a food-
processing company, which wishes to fix a price for taking delivery of the crop
in the future.
 Another example could be that of an investor with a diversified equity
portfolio, who wants to protect his portfolio from any temporary correction in
the stock market. Such an investor could sell index futures for this purpose.
 Speculators/Traders : Futures contracts are very well suited to trading on the
prices of financial assets and commodities. It is much less expensive to create
a speculative position using futures than by actually trading the underlying
asset. As a result, the potential returns are much greater.
 A classic application is the trader who believes that the announcement of
better than expected quarterly results of a company will boost the stock price
of that company.
 He has two options:
 The first alternative is to buy and hold the equity shares of the company
whereas
 the other alternative is to go long the futures contracts of that stock.
 If the trader chooses the second option to go long futures contract on the
underlying stock and the stock price increases, the value of the contract will
also rise and he can square-off the position to book his profit.
 Of course, if the trader takes a long position and the stock price falls, the
futures price will also fall, leaving the trader with a large loss.
 Leverage acts as a ‘double-edged’ sword. Therefore, positions in futures
contracts, which are basically leveraged instruments, are riskier in nature
than buying or selling the underlying asset itself.
 Arbitrageurs: An arbitrage is a deal that produces risk-free profits by exploiting
a mispricing in the market.
 A simple arbitrage occurs when a trader purchases an asset cheaply in one
location/ exchange and simultaneously arranges to sell it at another location/
exchange at a higher price.
 Such opportunities are unlikely to persist for very long, since arbitrageurs would
rush in to buy the asset in the cheaper market and simultaneously sell it in the
expensive market, thus reducing the pricing gap.
 As mentioned above, there are three major players in derivatives market –
Hedgers, Traders, and Arbitrageurs.
 Hedgers aim to hedge their risk, traders take the risk which hedgers plan to
offload from their exposure and arbitrageurs establish an efficient link between
different markets.
 Traders take naked positions in the futures market i.e., they go long or short
in various futures contracts available in the market.
 Indeed, the capacity of derivatives market to absorb buying/selling by
hedgers is directly dependent upon availability of traders, who act as
counter-party to hedgers.
 Thus, traders form one of the most important participants of the derivatives
market, providing depth to the market.
 Hedgers may not be able to hedge, if traders were not present in the system.
Therefore, the presence of both hedgers and traders is essential for the
growth of the futures market.
 For instance, assume, a farmer expects the price of wheat to fall in near future. He
wants to hedge his price risk on wheat produce for next 3 months till the time he
has actual produce in his hands and so would like to lock in the forward/ futures
price now.
 Accordingly, the farmer can sell futures contracts on the expected quantity of
produce. In order to sell this futures contract, he needs a buyer.
 This buyer may be someone who needs wheat after three months, may be a flour
mill or a bakery. However, most of the times, there is a demand supply mismatch in
the market and the trader fills the gap between demand and supply.
 Here the trader, who is a counterparty to the farmer, has a contrary view i.e., this
buyer would buy only if he thinks that the actual price of wheat three months down
the line is going to be higher than the three-month futures price today. Further, the
profit of the trader would depend upon actual wheat price being more than the
contracted futures price at the maturity of futures contract.
 If that happens, the trader would make money, else he would lose money.
 In addition to hedgers and traders, to establish a link between various
markets like spot and derivatives, we need a third party called arbitrageurs.
 These arbitragers continuously hunt for the profit opportunities across the
markets and products and seize those by executing trades in different
markets and products simultaneously.
 Importantly, arbitrageurs generally lock in their profits unlike traders who
trade naked contracts.
 For example, at the end of day (1st January 2021):
 Market price of underlying asset (in Rs.) 100 March futures 110 Lot size 50
 Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the
Futures market at Rs. 110, thereby locking Rs. 10 as his profit on each share.
On the expiration date, suppose price (in Rs.) of the underlying asset is 108.
 Cash Market Futures
 Buy 100 Sell 110
 Sell 108 Buy 108
 +8 +2
 Total profit would be Rs 2 + Rs 8 = Rs 10 per unit and Rs 10 * 50 = Rs 500 for
the lot.
 Suppose price (in Rs.) of the underlying asset is 95 on the expiration date.
 Cash Market Futures
 Buy 100 Sell 110
 Sell 95 Buy 95
 -5 +15
 Total profit would be Rs 15 - Rs 5 = Rs 10 per unit and Rs 10 * 50 = Rs 500 for
the lot.
 Transaction costs and impact cost have not been considered in the above
example.
 In real life, the transaction costs such as brokerage, Service Tax, Securities
Transaction Tax, etc. have to be considered.
 Here, it may be interesting to look at the risks these arbitrageurs carry.
 As seen before, arbitrageurs are executing positions in two or more markets/products
simultaneously.
 Even if the systems are seamless and electronic and both the legs of transaction are liquid, there
is a possibility of some gap between the executions of both the orders.
 If either leg of the transaction is illiquid then the risk on the arbitrage deal is huge as only one
leg may get executed and another may not, which would open the arbitrager to the naked
exposure of a position.
 Similarly, if contracts are not cash settled in both or one of the markets, it would need reversal
of trades in the respective markets, which would result in additional risk on unwinding position
with regard to simultaneous execution of the trades.
 These profit focused traders and arbitrageurs fetch enormous liquidity to the products traded on
the exchanges.
 This liquidity in turn results in better price discovery, lesser cost of transaction and lesser
manipulation in the market.
Important terms in hedging

 Long hedge: Long hedge is the transaction when we hedge our position in cash
market by going long in futures market.
 For example, we expect to receive some funds in future and want to invest
the same amount in the securities market.
 We have not yet decided the specific company/companies, where investment
is to be made. We expect the market to go up in near future and bear a risk
of acquiring the securities at a higher price.
 We can hedge by going long index futures today. On receipt of money, we may
invest in the cash market and simultaneously unwind corresponding index
futures positions.
 Any loss due to acquisition of securities at higher price, resulting from the
upward movement in the market over this intermediate period, would be
partially or fully compensated by the profit made on our position in index
futures.
 Further, while investing, suitable securities at reasonable prices may not be
immediately available in sufficient quantity. Rushing to invest all money is
likely to drive up the prices to our disadvantage.
 This situation can also be taken care of by using the futures. We may buy
futures today, gradually invest money in the cash market and unwind
corresponding futures positions.
 Short hedge: Short Hedge is a transaction when the hedge is accomplished by going
short in futures market.
 For instance, assume, we have a portfolio and want to liquidate it in near future
but we expect the prices to go down in near future. This may go against our plan
and may result in reduction in the portfolio value.
 To protect our portfolio’s value, today, we can short index futures of equivalent
amount. The amount of loss made in cash market will be partly or fully
compensated by the profits on our futures positions.
 Cross hedge: When futures contract on an asset is not available, market
participants look for an asset that is closely associated with their underlying and
trades in the futures market of that closely associated asset, for hedging purpose.
 They may trade in futures of this related asset to protect the value of their actual
asset. This is called cross hedge.
 For instance, if futures contracts on jet fuel are not available in the
international markets then hedgers may use contracts available on other
energy products like crude oil, heating oil or gasoline due to their close
association with jet fuel for hedging purpose.
 This is an example of cross hedge. Indeed, in a crude sense, we may say that
when we use index futures to hedge against the market risk on a portfolio, we
are essentially establishing a cross hedge because we are not using the exact
underlying to hedge the risk.
 Hedge contract month: Hedge contract month is the maturity month of the
contract through which we hedge our position.
 The thumb rule is to select that futures contract which expires just after the
date on which we wish to unwind our exposure.
 For example, suppose that on September 25, an investor decides to sell his
portfolio on December 20 to meet some financial obligation. He wants to
hedge the market risk of his portfolio by shorting index futures. In this case,
the investor should short the index futures contract expiring in December
2021, and not in September 2021 or in October 2021.
Trading in futures market

 Traders are risk takers in the derivatives market. And they take positions in the futures
market without having position in the underlying cash market.
 These positions are based upon their expectations on price movement of underlying asset.
 Traders either take naked positions or spread positions. A trader takes a naked long
position when he expects the market to go up.
 Money comes by reversing the position at higher price later.
 Similarly, he takes a short position when he expects the market to go down to book profit
by reversing his position at lower price in the future.
 For instance, if one month Sensex futures contract is trading at 61000 and a trader
expects the spot index at the maturity of the one month contract would settle at a level
higher than this, he would take a long position in index futures at a level of 61000. If his
expectation comes true and index on maturity settles beyond 61000, this trader will make
money to the extent of the difference between buy price and sell price (or, between buy
price and settlement price) of the index.
 Traders may also take long/short positions in single stock futures. When they expect
the market to go up, they may take long position in these futures and when they
expect the market to go down, they may take short position in single stock futures.
 If the market or the stock moves in the expected direction, the trader would end up
making profit.
 Here, it may be noted that if the market or stock does not move in the expected
direction, trader may also incur a loss. A futures position is as exposed to loss as to
profit.
 Naked position is long or short in any of the futures contracts
 but in case of a spread, two opposite positions (one long and one short) are taken
either in two contracts with same maturity on different products, or in two
contracts with different maturities on the same product.
 .
 The former is termed an inter-commodity or inter-product spread and
 the latter is known as calendar spread/time spread or horizontal spread.
 Exchanges need to provide the required inputs to the system for it to
recognize any kind of spread.
 At present, in equity market, the system recognizes only calendar spreads.
 In commodities market, system recognizes inter-commodity spread between
specific commodities like Gold and Silver; Soybean, Soybean meal and
Soybean oil, etc
 Calendar spread position is always computed with respect to the near month series.
 For instance, if Mr. A has say 3 contacts short in one-month futures contract,
 2 contracts long in two-months futures contract and
 3 contracts long in three-months futures contract,
 he would be said to have 2 calendar spreads between first and second months and
 1 calendar spread between first and third month.
 Further, his position in remaining 2 three-months contracts would be treated as naked.
 A calendar spread becomes a naked/open position, when the near month contract
expires or either of the legs of spread is closed.
 As spread positions are hedged to a large extent because they are combinations of two
opposite positions, they are treated as conservatively speculative positions.
 The objective of arbitragers is to make profits without taking risk, but the complexity
of activity is such that it may result in losses as well.
 Well-informed and experienced professional traders, equipped with powerful
calculating and data processing tools, normally undertake arbitrage trades.
 Arbitrage in the futures market can typically be of three types:
  Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the
cash or underlying market and a short position in futures market.
  Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long
position in futures market and short position in the underlying or cash market.
  Inter-Exchange arbitrage: This arbitrage entails two positions on the same contract
in two different markets/exchanges.
 In the language of simple mathematics, Fair futures price F = S + C where S stands for
Spot price and C stands for Holding costs/carrying costs.
 If cost of carry is defined in the percentage terms,
 we may redefine the formula as:
 F = S(1+r)T
 Where r is the carrying cost (in percentage) and T is the Time to expiration (in
years).
 If we use continuous compounding for computation of the cost, the same
formula reduces to: F= SerT
 If futures price is higher than fair/theoretical price, there would exist a
profitable, risk free, cash and carry arbitrage opportunity.
 On the other hand, if the futures price is lower than the fair futures price,
there could be a profitable opportunity for reverse cash-carry arbitrage.
 Thus, unless there are obstacles to such arbitrage, the activities of the
arbitrageurs would cause spot-futures price relationships to conform to that
described by the cost of carry formula.
 On rare occasions, however, there is an arbitrage opportunity that exists for
some time.
 Practically, an arbitrage is feasible and will be undertaken only if it provides
net cash inflow after transaction costs, brokerage, margin deposits, etc.
Inter-market Arbitrage

 This arbitrage opportunity arises because of some price differences existing in the same
underlying at two different exchanges.
 If August futures on stock Z are trading at Rs. 101 at NSE and Rs. 100 at BSE, the trader
can buy a contract at BSE and sell at NSE.
 The positions could be reversed over a period of time when difference between futures
prices squeeze. This would be profitable to an arbitrageur.
 It is important to note that the cost of transaction and other incidental costs involved in
the deal must be analyzed properly by the arbitragers before entering into the
transaction.
 In the light of above, we may conclude that futures provide market participants with a
quick and less expensive mode to alter their portfolio composition to arrive at the desired
level of risk.
 As they could be used to either add risk to the existing portfolios or reduce risk of the
existing portfolios, they are essentially risk management and portfolio restructuring tools.
BETA

 Beta is a measure of how sensitive a particular stock (or a particular portfolio of stocks) is with
respect to a general market index.
 For example, if Reliance has a beta of 1.15 with respect to the Sensex, the implication is that
Reliance fluctuations will be 1.15 times the fluctuations in the Sensex.
 If the Sensex moves up by 10%, Reliance will move up by 11.5%.
 Beta is widely used for hedging purposes.
 If you have Reliance shares worth Rs 10 lakhs and you want to hedge your portfolio using Sensex
Futures, you will typically sell Rs 11.50 lakhs of Sensex Futures. Thus if Sensex moves down by
10%, Reliance will move down by 11.5%. On the Sensex Futures, you will gain Rs 1.15 lakhs (10%
of Rs 11.50 lakhs), while on Reliance, you will lose Rs 1.15 lakhs (11.5% of Rs 10 lakhs).
 High beta stocks are termed aggressive stocks, while low beta stocks are termed defensive
stocks.
 Hedge Ratio is related to beta and can be understood as the number of Futures contracts
required to be sold to create a perfect hedge.
VOLATILITY

 Derivative markets create risks, however, it will be more correct to say that Derivative Markets
redistribute risks.
 There are some participants who want to take on risk (speculators) while some participants want to
reduce risk (hedgers).
 Derivative Markets align the risk appetites of such players and thus redistribute risks. Volatility is the
extent of fluctuation in stock prices (or prices of other items like commodities and foreign exchange).
 Volatility is not related to direction of the movement.
 Thus, volatility can be high irrespective of whether the stock price is moving up or down. A market
index (like the Sensex) would generally be less volatile than individual stocks (like Satyam).
 The level of Volatility will dictate the level of Margins. Higher volatility will result in higher margins and
vice-versa. Daily Volatility, if known, can be used to calculate volatility for any given period.
 For example, Periodic Volatility will be Daily Volatility multiplied by the square root of the number of
days in that period.
 For example, Annual Volatility is generally taken as the square root of 256 (working days
approximately) i.e. 16 times the Daily Volatility.
Central counterparty clearing houses (CCPs)

 Central counterparty clearing houses (CCPs) perform two primary functions as the
intermediary in a transaction: clearing and settlement.
 A CCP acts as a counterparty to both sellers and buyers, collecting money from each,
which allows it to guarantee the terms of a trade.
Introduction to Clearing and Settlement
System
 Clearing Corporation/ Clearing House is responsible for clearing and
settlement of all trades executed on the F&O Segment of the Exchange.
 Clearing Corporation acts as a legal counterparty to all trades on this segment
and also guarantees their financial settlement.
 The Clearing and Settlement process comprises of three main activities, viz.,
Clearing, Settlement and Risk Management.
 Clearing and settlement activities in the F&O segment are undertaken by
Clearing Corporation with the help of the following entities: Clearing
Members and Clearing Banks
 Clearing Members Broadly speaking there are three types of clearing members
1. Self clearing member: They clear and settle trades executed by them only,
either on their own account or on account of their clients.
 2. Trading member–cum–clearing member: They clear and settle their own
trades as well as trades of other trading members and custodial participants.
3. Professional clearing member: They clear and settle trades executed by
trading members.
 Both trading-cum-clearing member and professional clearing member are
required to bring in additional security deposits in respect of every trading
member whose trades they undertake to clear and settle.
 Clearing Banks: Funds settlement takes place through clearing banks.
 For the purpose of settlement all clearing members are required to open a
separate bank account with Clearing Corporation designated clearing bank for
F&O segment.
 Clearing Member Eligibility Norms • Net-worth of at least Rs.300 lakhs.
 The Net-worth requirement for a Clearing Member who clears and settles only
deals executed by him is Rs. 100 lakhs.
 • Deposit of Rs. 50 lakhs to clearing corporation which forms part of the
security deposit of the Clearing Member.
 • Additional incremental deposits of Rs.10 lakhs to clearing corporation for
each additional TM, in case the Clearing Member undertakes to clear and
settle deals for other TMs.
 Clearing Mechanism The first step in clearing process is calculating open positions and
obligations of clearing members.
 The open positions of a CM is arrived at by aggregating the open positions of all the
trading members (TMs) and all custodial participants (CPs) clearing though him, in the
contracts which they have traded.
 The open position of a TM is arrived at by adding up his proprietary open position and
clients’ open positions, in the contracts which they have traded.
 While entering orders on the trading system, TMs identify orders as either proprietary
(Pro) or client (Cli).
 Proprietary positions are calculated on net basis (buy-sell) for each contract and that
of clients are arrived at by summing together net positions of each individual client.
 A TM’s open position is the sum of proprietary open position, client open long position
and client open short position.
Settlement Mechanism In India

 Settlement Mechanism In India, SEBI has given the stock exchanges the
flexibility to offer:
 a) Cash settlement (settlement by payment of differences) for both stock
options and stock futures; or
 b) Physical settlement (settlement by delivery of underlying stock) for both
stock options and stock futures; or
 c) Cash settlement for stock options and physical settlement for stock
futures; or
 d) Physical settlement for stock options and cash settlement for stock futures.
 A Stock Exchange may introduce physical settlement in a phased manner.
 On introduction, however, physical settlement for all stock options and/or all
stock futures, as the case may be, must be completed within six months.
 The settlement mechanism shall be decided by the Stock Exchanges in
consultation with the Depositories.
 On expiry / exercise of physically settled stock derivatives, the risk
management framework (i.e., margins and default) of the cash segment shall
be applicable.
 Settlements of cash and equity derivative segments shall continue to remain
separate.
 The Stock Exchanges interested to introduce physical settlement should:
 a. Put in place proper systems and procedures for smooth implementation of physical
settlement.
 b. Make necessary amendments to the relevant bye-laws, rules and regulations for
implementation of physical settlement.
 c. Bring the provisions of this circular to the notice of all categories of market participants,
including the general public, and also to disseminate the same on their websites.
 The Stock Exchanges interested to offer physical settlement should submit to SEBI for
approval, a detailed framework for implementation of physical settlement of stock derivatives.
 After opting for a particular mode of settlement for stock derivatives, a Stock Exchange may
change to another mode of settlement after seeking prior approval of SEBI.
 At present, derivative contracts on both individual stocks and on stock indices are cash settled
on NSE and MCX-SX but on BSE, derivative contracts on stock indices are cash settled while
those on individual stocks are delivery based.
 Settlement Schedule The settlement of trades is on T+1 working day basis.
 Members with a funds pay-in obligation are required to have clear funds in
their primary clearing account on or before 10.30 a.m. on the settlement day.
 The payout of funds is credited to the primary clearing account of the
members thereafter.
 Settlement of Futures Contracts on Index or Individual Securities In Futures
contracts, both the parties to the contract have to deposit margin money
which is called as initial margin.
 Futures contract have two types of settlements, the MTM settlement which
happens on a continuous basis at the end of each day, and the final
settlement which happens on the last trading day of the futures contract.
 Mark to Market (MTM) Settlement Mark to Market is a process by which
margins are adjusted on the basis of daily price changes in the markets for
underlying assets.
 The profits/ losses are computed as the difference between:
 1. The trade price and the day's settlement price for contracts executed
during the day but not squared up.
 2. The previous day's settlement price and the current day's settlement price
for brought forward contracts.
 3. The buy price and the sell price for contracts executed during the day and
squared up.
 The clearing member who suffers a loss is required to pay the MTM loss
amount in cash which is in turn passed on to the clearing member who has
made a MTM profit.
 The pay-in and pay-out of the mark-to-market settlement are affected on the
day following the trade day (T+1) where trading member is responsible to
collect/ pay funds from/ to clients by the next day.
 Clearing Members are responsible to collect and settle the daily MTM
profits/losses incurred by the TMs and their clients clearing and settling
through them.
 After completing day’s settlement process, all the open positions are reset to
the daily settlement price. These positions become the open positions for the
next day.
 Final Settlement: On expiration day of the futures contracts, after the close
of trading hours, clearing corporation marks all positions of a clearing
member to the final settlement price and the resulting profit/ loss is settled
in cash.
 Final settlement loss/profit amount is debited/ credited to the relevant
clearing member’s clearing bank account on the day following expiry day of
the contract.
 All long positions are automatically assigned to short positions in option
contracts with the same series, on a random basis.
 Settlement of Options Contracts on Index or Individual Securities Options contracts have two
types of settlements.
 These are as follows
 1) Daily premium settlement, 2) Final settlement
 Daily Premium Settlement: In options contract, buyer of an option pays premium while seller
receives premium. The amount payable and receivable as premium are netted to compute the
net premium payable or receivable amount for each client for each option contract.
 The clearing members who have a premium payable position are required to pay the premium
amount to clearing corporation which in turn passed on to the members who have a premium
receivable position.
 This is known as daily premium settlement.
 The pay-in and pay-out of the premium settlement is on T+1 day (T=Trade day).
 The premium payable amount and premium receivable amount are directly credited/ debited to
the clearing member’s clearing bank account.
 Final Exercise Settlement: All the in the money stock options contracts shall
get automatically exercised on the expiry day.
 All the unclosed long/ short positions are automatically assigned to short/
long positions in option contracts with the same series, on the random basis.
 Profit/ loss amount for options contract on index and individual securities on
final settlement is credited/debited to the relevant clearing members
clearing bank account on T+1 day i.e. a day after expiry day.
 Open positions, in option contracts, cease to exist after their expiration day.
The pay-in/ pay-out of funds for a clearing member on a day is the net
amount across settlements and all trading members/ clients, in Future &
Option Segment
 Settlement of Custodial Participant (CP): Deals Clearing corporation provides a facility to
entities like institutions to execute trades through any trading member, which may be
cleared and settled by their own CM.
 Such 111 entities are called Custodial Participants (CP).
 A CP is required to register with clearing corporation through this clearing member,
which allots them a unique CP code. The CP and the CM are required to enter into an
agreement.
 All trades executed by such CP through any TM are required to have the CP code in the
relevant field on the F&O trading system at the time of order entry.
 Without confirmation from CM, the responsibility of settlement of such trade vests with
the CM of the TM while such trades form part of the obligations of the CM of the CP
when they are confirmed from CM.
 They shall be responsible for all obligations arising out of such trades including the
payment of margins and settlement of obligations.
Risk Management

 For the F&O segment, a comprehensive risk containment mechanism has been
developed by clearing corporation.
 The salient features of risk containment measures on the F&O segment are:
 • Stringent requirements of capital adequacy for membership (Financial
strength of a member) helps in risk management.
 • Clearing corporation charges an upfront initial margin for all the open
positions of a Clearing Member (CM).
 It specifies the initial margin requirements for each futures/ options contract
on a daily basis and also follows Value-At-Risk (VAR) based margining. Clearing
member collects initial margin from the trading members (TMs) and their
respective clients.
 The open positions of the members are settled on an MTM basis for each contract at
the end of the day. The difference is settled in cash on a T+1 basis.
 • Clearing corporation’s on-line position monitoring system monitors a CM’s open
position on a real-time basis. It sets limit for each CM based on his effective deposits
and simultaneously generates alert messages whenever a CM reaches certain pre-
determined benchmarks of the limit.
 Clearing corporation monitors the CMs for Initial Margin violation, Exposure margin
violation, while TMs are monitored for Initial Margin violation and position limit
violation.
 • A trading terminal helps the CMs to monitor the open positions of all the TMs
clearing and settling through him.
 A CM may set limits for a TM clearing and settling through him. Clearing corporation
assists the CM to monitor the intraday limits set up by a CM and whenever a TM
exceed the limits, it stops that particular TM from further trading.
 The most critical component of risk containment mechanism for F&O segment is the
margining system and on-line position monitoring.
 The actual position monitoring and margining is carried out on-line through Parallel
Risk Management System (PRISM) using SPAN® (Standard Portfolio Analysis of Risk)
system for the purpose of computation of on-line margins, based on the parameters
defined by SEBI.
 In order to manage risk efficiently in the Indian securities market, exchanges have
adopted SPAN (Standard Portfolio Analysis of Risk), a risk management and margining
product designed by Chicago Mercantile Exchange (CME), Chicago, USA.
 This software was developed for calculating initial margins on the various positions of
market participants. The objective of SPAN is to identify overall potential risk in a
portfolio.
 The program treats futures and options uniformly, while recognizing the unique
exposures associated with options portfolios.
Comparison between Futures and
Options
 Options are different from futures in several interesting senses.
 At a practical level, the option buyer faces an interesting situation. He pays for the option
in full at the time it is purchased.
 After this, he only has an upside. There is no possibility of the options position generating
any further losses to him (other than the funds already paid for the option).
 This is different from futures, which is free to enter into, but can generate very large
losses.
 This characteristic makes options attractive to many occasional market participants, who
cannot put in the time to closely monitor their futures positions. Table 5.1 presents the
comparison between the futures and options.
 Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance
which reimburses the full extent to which Nifty drops below the strike price of the put
option. This is attractive to many people, and to mutual funds creating “guaranteed
return products”.
 More generally, options offer “nonlinear payoffs” whereas futures only have “linear
payoffs”.
 By combining futures and options, a wide variety of innovative and useful payoff
structures can be created.
 Options Payoffs :
 The optionality characteristic of options results in a non-linear payoff for options.
 It means that the losses for the buyer of an option are limited;
 however the profits are potentially unlimited.
 For a writer, the payoff is exactly the opposite. Profits are limited to the option
premium; and losses are potentially unlimited.
 These non-linear payoffs are fascinating as they lend themselves to be used to
generate various payoffs by using combinations of options and the underlying.