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UNDERSTANDING DERIVATIVES
Sampath Kariyawasam

Derivatives
Definition

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The Financial Dictionary Definition A financial contract whose value is based on, or derived from, a traditional security (such as a stock or bond), an asset (such as a commodity), or a market index.

Derivatives
Party A Party B

Assets

What are Derivatives?


Underlying's to a derivative product, are subject to change

in value.
Risk of change in value of a Stock.

Derivative contracts seek to transfer these risks from an

individual who is not comfortable with the risk to one who is.

Why Use Derivatives


Derivatives make future risks tradable.

Can eliminate uncertainty by exchanging market risks,

commonly known as hedging. Corporates and financial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc., 92 percent of the worlds 500 largest companies manage their price risks using derivatives.

Derivatives Types
Derivative Financial Market

Over the Counter(OTC)


Traded directly Between Two parties. Privately Negotiated. Unregulated. Swaps, Forwards, Floors,

Exchange Traded(ETD)
Traded via Specialized Derivatives Exchange. Individuals Trade Standardized contracts by the exchange. Regulated.

Common Derivatives Types

Financial Derivatives

Futures

Options

Forward

Swap

Participants in the Derivative Markets


Hedgers

People who buy or sell to minimize their losses.

An importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50 /$ from Rs 48/$, then the importer can minimize his losses by buying a currency future at Rs 49/$

Participants in the Derivative Markets


Speculators

People who buy or sell in the market to make profits.

If you will the stock price of ABC is expected to go up to Rs.400 in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make profits

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Participants in the Derivative Markets


Arbitrageurs

People who buy or sell to make money on price differentials in different markets.

A futures price is simply the current price plus the interest cost. If there is any change in the interest, it presents an arbitrage opportunity.

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Functions in derivatives trading


Pre Trading Derivatives Trading Clearing
Payment and Delivery
The origination and channeling of derivatives orders to marketplaces for the execution of transactions.

matching of buyers and sellers in derivatives contracts. The buyer and the seller respectively enter into the derivatives contract.

Position Management of open contracts. Termination of Contracts( canceling ,giving up, exercise and expiry)

Final Stage of the Derivative Trading

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Main Service Providers in the Derivatives Value Chain


Broker Dealers ( Large investment or universal

banks) Exchanges Clearing houses

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Futures
An agreement between two parties a buyer and a

seller wherein the former agrees to purchase from the latter, a number of shares or an index at a certain time in the future (expiry date) for a pre-determined price, which is agreed upon when the transaction takes place.

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Futures
As futures contracts are standardized in terms of expiry

dates and contract sizes, they can be freely traded on exchanges. A buyer may not know the identity of the seller and vice versa. Every contract is guaranteed and honored by the stock exchange, or more precisely, the clearing house or the clearing corporation of the stock exchange, which is an agency designated to settle trades of investors on the stock exchanges.

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Futures...

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Futures- Lot Size


Consists of a fixed lot of the underlying share.

Determined by the exchange on which it is traded and

differs from stock to stock.

ABC Ltd. (ABC) futures contract has a lot of 600 ABC shares, i.e., when you buy one futures contract of ABC, you are actually buying 600 shares of ABC.

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Futures...
Spot Price The current market price of Stock Future Price The price at which the futures contract trades in the futures market

Tenure The period for which the future is traded


Expiry date The date on which the futures contract will be settled

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The Clearing House


To minimize counterparty risk to traders, trades executed

on regulated futures exchanges are guaranteed by a clearing house. The clearing house becomes the buyer to each seller, and the seller to each Buyer, so that in the event of a counterparty default the clearer assumes the risk of loss. This enables traders to transact without performing due diligence on their counterparty.

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Futures - Pricing
Value is largely derived from the price of the underlying

stock or index. The difference between the spot price and the futures price. Models Used
The cost of carry model The expectancy model

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Futures - Buying
Similar to buying a number of shares of the same

underlying stock but without taking delivery of the same.


Can trade in index and stock contracts in just the same

way as you would trade in shares.

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Futures - Trading
Current price of XYZ is Rs. 200 per stock.

Interested in buying 500 shares of XYZ.


find someone, say John, who has 500 shares you tell

John that you will buy 500 shares at Rs. 200, but not now, at a later point of time, say on the last Thursday of this month. Agreed strike price is Rs. 202 for the end of the month Total Contract size : 202* 500= Rs.101000 Risk involvement Find a common friend to put a margin of Rs. 25000

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Futures Trading
On expiry date:

Share price : Rs. 230


John pays the balance amount : 230 202 =Rs. 28 You can then purchase the shares from the Stock Market

at Rs. 230. Since you will get Rs. 28 per share from John, you will effectively be able to buy the shares at Rs. 202 , the agreed strike price of the futures contract.
John can directly sell his 500 shares in the market at Rs.

230 and give you Rs 28 (per share) which means he effectively sold each share at Rs. 202, the agreed price.

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Futures - Margins
Required to deposit only a percentage of the value of your

outstanding position with the stock exchange, irrespective of whether you buy or sell futures. This mandatory deposit, which is called margin money, covers an initial margin and an exposure margin. These margins act as a risk containment measure for the exchanges and serve to preserve the integrity of the market. Typically 5%-15% of the contract's value.

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Margins...
This initial margin is adjusted daily depending upon the

market value of your open positions. The exposure margin is used to control volatility and excessive speculation in the futures markets. Have to maintain Mark-to-Market (MTM) margins, which cover the daily difference between the cost of the contract and the closing price on the day the contract is purchased. Thereafter, the MTM margin covers the differences in closing price from day to day.

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Futures -Example
ABC Shares Future Contract Price : Rs. 50/=

Margin Percentage 5%
200 Shares = ABC Future Contract

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Futures Example
Margin Money :@ 5% = Rs. 4568 * 50 * 5% =Rs. 11420 Marking to Market 1st day Loss (4568 to 4535= Rs. 33 Total Loss = 33* 50 = Rs. 1650 2nd day Gain (4535 to 4590) =Rs. 65 Total Gain = 65* 50 = Rs. 2750 3rd day Loss (4590 to 4570) =Rs. 20 Total Loss = 20* 50 = Rs. 1000 4th day Gain (4570 to 4600) = Rs. 30 Total Gain = 30 * 50 = Rs. 1500

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Futures -Example
Margin (At the beginning) = Rs. 11420

1st day less(-) : 1650


2nd day add(+) : 2750 3rd day loss(-) : 1000 4th day add(+) : 1500 Margin at EOD 4th day : Rs. 13020 Total Gain : 13020-11420 = Rs. 1600

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Settling stock futures contracts


On expiry

Buying a stock futures contract does not result in delivery of the underlying shares. The futures contract has to be settled (sold off if purchased or bought back if sold, as the case maybe) on the expiry day at the closing price of the underlying stock in the cash market.

Once your contract expires, you receive profits, the

margins that you have deposited to keep this position open will be added to these and if you gave made a loss, you are required to payoff the loss, net of the margins that you have deposited.

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Selling Stock futures


Before expiry Although futures expire on a particular date, most traders

do not hold on to their positions until the expiry date of the contract. They usually exit much before the expiry date by offsetting or cancelling their position

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Using Futures
By Speculators Speculators take long or short positions in index and stock futures, depending on their perceptions of the market. Lets take the case of stock futures of RIL; Contract size: 600 shares; Price of Future: 960; Spot Price: 955; Margin Required: 10 per cent of the contract value. In the above case, any movement in the stock prices to say Rs 980 would make the futures buyer richer by Rs 12,000 (600 x 20) for each contract. Similarly in the case of a fall in prices to say Rs 950, the investor would lose Rs 6,000 (600x10) for each contract. The seller, on the other hand, would lose when the buyer gains and gain when the buyer loses, to the same extent.

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The Futures for Speculators


Speculation using spot and futures contracts. One futures

contract is on $ 62,500. Initial margin on four futures contracts = $20,000. Possible Trades
Buy $ 250,000 Spot Price =2.0470 Investment Profit if April Spot =2.1000 Profit if April Spot =2.0000 511,750 13,250 -11,750 Buy 4 Futures Contracts, Future Price =2.0470 20,000 14,750 -10,250

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