Term papers on financial derivatives
Introduction
In the present state of the economy, there is an imperative need for the corporate clients to protect their operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.
In this context, derivatives occupy an important place as a risk reducing machinery. Derivatives are useful to reduce many of the risks discussed above. In fact, the financial service companies can play a very dynamic role in dealing with such risks. They can ensure that the above risks are hedged by using derivatives like forwards, futures, options, swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to the financial service companies. This really protects the clients from unforeseen risks and helps them to get their due operating profits or to keep the project well within the budgeted costs. To hedge the various risks that one faces in the financial market today, derivatives are absolutely essential.
Meaning:
In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For instance, equity share itself is a derivative, since, it derives its value from the firm’s underlying assets. Similarly, one takes an insurance against his house covering all risks. This insurance is also a derivative instruments on the house. Again, if one signs a contract with a building contractor stipulating a condition, that, if the cost of materials goes up by 15%, the contract price will also go up by 10%. This is also a kind of derivative contract. Thus, derivatives cover a lot of common transactions.
Definition
It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this field in recent years. Moreover, many innovative instruments have been created by combining two or more of these financial derivatives so as to cater to the specific requirements of users, depending upon the circumstances. In spite of this, some attempts have been made to define the term ‘derivative’.
One such definition is, ‘Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal’.
According to another definition, ‘Derivatives are a special type of off- balance sheet instruments in which no principal is ever paid’.
Yet another definition runs as follows: ‘Derivatives are instruments which make payments calculated using price of interest rates derived from on balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments’.
Kind of Financial DERIVATIVES
As already discussed, the important financial derivatives are the following:
(i) Forwards,
(ii) Futures,
(iii) Options, and
(iv) Swaps
Forwards: are the oldest of all the derivatives. A forward contra t refers to an agreement between two parties to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc.
Example: On June 1, X enters into an agreement to buy 50 bales of cotton on December 1 at Rs. 1,000/- per bale from Y, a cotton dealer. It is a case of a forward contract where X has to pay Rs. 50,000 on December 1 to Y and Y has to supply 50 bales of cotton.
In a forward contract, a user (holder) who promises to buy the specified asset at an agreed price at a fixed future date is said to be in the ‘Long position’. On the other hand, the user (holder) who promises to sell at an agreed price at a future date is said to be in ‘Short position’. Thus, ‘long position’ and ‘short position’ take the form of ‘buy’ and ‘sell’ in a forward contract.
Features of Forward Contracts
In a forward contract, the supply of an asset is promised at a future date. This contract is usually referred to as ‘Forward Rate Contract’ (FRC).
Over the Counter Trading (OTC): These contracts are purely privately arranged agreements and hence, they are not at all standardized ones. They are traded ‘over the counter’ (OTC) and not in exchanges.
No down Payment: There must be a promise to supply or receive a specified asset at an agreed price at a future date. The contracting parties need not pay any down payment at the time of agreement.
Settlement at Maturity: The important feature of a forward contract is that no money or commodity changes hand when the contract is signed. Invariably, it takes place on the date of maturity only as given in the contract.
Linearity: Another special feature of a forward rate contract is linearity. It means symmetrical gains or losses due to price fluctuation of the underlying asset. When the spot price in future exceeds the contract price, the, forward buyer stands to gain. The gain will be equal to spot price minus contract price.
No Secondary Market: A forward rate contract is a purely private contract, and hence, it cannot be traded on an organised stock exchange. So, there is no secondary market for it.
Necessity of a Third Party: There is a need for an intermediary to enable the parties to enter into a forward rate contract. This intermediary maybe any financial institution like bank or any other third party.
Delivery: The delivery of the asset which is the subject matter of the contract is essential on the date of the maturity of the contract.
FINANCIAL FORWARDS
Forward rate contracts for commodities are commonly found in
Forward Rate Currency Contract
It is a contract where exchange of currencies is promised at an agreed exchange rate at a specified future date. The important feature of this contract is that the payoff is proportional to the difference between the rate specified in the Forward Rate Contract and the price of the currency prevailing in the market at the time of settlement.
Forward Rate Contract on Interest Rate
The extension of the forwards to the interest market is an important innovation. This type of contract is called Forward Rate Agreement (FRA). It is a contract where parties enter into a forward interest rate agreement at a specified future date. On the date of maturity, the difference between the forward interest rate as mentioned in the agreement and the interest rate prevailing in the market at that time (Spot rate) is paid/received (as the case may be) on a notional principal.
Futures
A futures contract is very similar to a forward contract in all respects excepting the fact that it is completely a standardised one. Hence, it is rightly said that a futures contract is nothing but a standardised forward contract. It is legally enforceable and it is always traded on an organised exchange.
As in a forward contract, the trader who promises to buy is said to be in ‘Long position’ and the one who promises to sell is said to be in ‘Short position’ in futures also.
Features of Futures
Highly Standardized: Futures are standardised and legally enforceable. Hence, they are traded only in organised Future exchanges. It contracting parties. However, many variants of Futures are available. But, once the agreement is entered into, the chances of modifying it are very remote.
Down Payment: The contracting parties need not pay any down payment at the time of agreement. However, they deposit a certain percentage of the contract price with the exchange and it is called initial ma5.gin. This gives a guarantee that the contract will be honoured.
Settlements: Though future contracts can be held till maturity. They are not so in actual practice. Futures instruments are marked to the market’ and the exchange records profit and loss on them on daily basis. That is, once a futures contract is entered into, profits or losses to both the parties are calculated on a daily basis. The difference between the futures price and the spot price on that clay constitutes either profit or loss depending upon the prevailing spot prices. The spot price is nothing but the1qarket price prevailing then.
For example, on Monday morning X enters into a futures agreement with Y to buy 50 bales of cotton at Rs. 100/- per bale on Friday afternoon. At the close of trading on Monday, the futures price goes up by Rs. 10/- per bale. Now, X will get a cash profit of Rs. 500/- for 50 bales at the rate of Rs. 10/- per bale. X can also cancel the existing futures contract with the price Rs. 100/- per bale or he can enter into a new futures contract at Rs.110/Jper bale.
Hedging of Price Risks: The main feature of a futures contract is to hedge against price fluctuations. The buyers of a futures contract hope to protect themselves from future spot price increases and the sellers from future spot price decreases. Parties enter into futures agreements on the basis of their expectations of the future price in the spot market for the assets in question.
Linearity: As stated earlier, futures contract is nothing but a standardised forward contract. Therefore, it also possesses the property of linearity. Parties to the contract get symmetrical gains or losses due to price fluctuation of the underlying asset on either direction.
Secondary Market: Futures are dealt in organised exchanges, and as such, they have secondary market too.
Non-delivery of the Asset: The delivery of the asset in question is not-essential on the date of maturity of the contract in the case of a futures contract. Generally, parties simply exchange the difference between the future and spot prices on the date of maturity.
TYPES OF FUTURES
Like forwards, futures may also be broadly divided into two types namely:
(i) Commodity Futures
(ii) Financial Futures)
Commodity Futures
A commodity future is a futures contract in commodities like agricultural products, metals and minerals etc. In organised commodity future markets, contracts are standardised with standard quantities. Of course, this standard varies from commodity to commodity. They also have fixed delivery dates in each month or a few months in a year. In
Some of the well established commodity exchanges are as follows:
(i) London Metal Exchange (LME) to deal in gold.
(ii) Chicago Board of Trade (CDT) to deal in soyabean oil.
(iii) New York Cotton Exchange (CTN) to deal in cotton.
(iv) Commodity Exchange,
(v) International Petroleum Exchange of London (IPE) to deal in crude oil.
Financial Futures
Financial futures refer to a futures contract in foreign exchange or financial instruments like treasury bill, commercial paper, stock market index or interest rate. It is an area where financial service companies can play a very dynamic role. Financial futures are very popular in Western countries as hedging instruments to protect against exchange rate/interest rate fluctuations and for ensuring future interest rates on loans.
Some of the well established financial futures exchanges are the following:
(i) International Monetary Market (IMM) to deal in
(ii) London International Financial Futures Exchange (LIFFE) to deal in Euro dollar deposits.
(iii) New York Futures Exchange (NYFE) to deal in sterling, Euro dollar deposits etc.
Options
In the volatile environment, risk of heavy fluctuations in the prices of assets is very heavy. Option is yet another tool to manage such risks.
As the very name implies, an option contract gives the buyer an option to buy or sell an underlying asset (stock, bond, currency, commodity etc.) at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.
Writer
In an options contract, the seller is usually referred to as a “writer” since he is said to write the contract. It is similar to the seller who is said to be in ‘Short position’ in a forward contract. However, in a put option, the writer is in a different position. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contract for enjoying the right to buy or sell.
American Option Vs European Option
In an Option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On the other hand, if it can be exercised only at the time of maturity, it is termed as European option.
Types of Options:
Options may fall under any one of the following main categories:
(i) Call Option
(ii) Put Option
(iii) Double Option
Call Option
A call option is one which gives the option holder the right to buy a underlying asset (commodities, foreign exchange, stocks, shares etc.) at a predetermined price called ‘exercise price’ or strike price on or before a specified date in future. In such a case, the writer of a call option is under an obligation to sell the asset at the specified price. In case the buyer exercises his option to buy. Thus, the obligation to sell arises only when the option is exercised.
Put Option
A put option is one which gives the option holder the right to sell an underlying asset at a predetermined price on or before a specified date in future. It means that the writer of a put option is under an obligation to buy the asset at the exercise price provided the option holder exercises his option to sell.
Double Option
A double option is one which gives the option holder both the rights either to buy or to sell an underlying asset at a predetermined price on or before a specified date in future.
Option Premium
In an option contract, the option writer agrees to buy or sell an underlying asset at a future date for an agreed price from/to the option buyer/seller at his option. This contract, like any other contract must be supported by consideration. The consideration for this contract is a sum of money called ‘premium’. The premium is nothing but the price which is required to be paid for the purchase of ‘right to buy or self.
Options Market
Options market refers to the market where option contracts are brought and sold. Once an option contract is written, it can be bought or sold on the options market. The first option market namely the Chicago Board of Options Exchange was set up in 1973. Thereafter, several options markets have been established.
Features of Option Contract
(i) Highly Flexible: On one hand, option contracts are highly standardised and so they can be traded only in organised exchanges. Such option instruments cannot be made flexible according to the requirements of the writer as well as the user. On the other hand, there are also privately arranged options which can be traded ‘over the counter.
(ii) Down Payment: The option holder must pay a certain amount called ‘premium’ for holding the right of exercising the option. This is considered to be the consideration for the contract. If the option holder does not exercise his option, he has to forego this premium. Otherwise, this premium will be deducted from the total payoff in calculating the net payoff due to the option holder.
(iii) Settlement: No money or commodity or share is exchanged when the contract is written. Generally this option contract terminates either at the time of exercising the option by the option holder or maturity whichever is earlier. So, settlement is made only when the option holder exercises his option. Suppose the option is not exercised till maturity, then the agreement automatically lapses and no settlement is required.
(iv) Non-Linearity: Unlike futures and forward, an option contract doe not possess the property of linearity. It means that the option holder’s profit, when the value of the underlying asset moves in one direction is not equal to his loss when its value moves in the opposite direction by the same amount. In short, profits and losses are not symmetrical under an option contract. This can be illustrated by means of an illustration:
Mr. X purchases a two month call option on rupee at Rs. 100 3.35 $. Suppose, the rupee appreciates within two months by 0.05 $per one hundred rupees, then the market price would be Rs.l00 = 3.40 $. If the option holder Mr. X exercises his option, he can purchase at the rate mentioned in the option ie., Rs. 100 = 3.35 $. He gets a payoff at the rate of 0.05 $ per every one hundred rupees. On the other hand, if the exchange rate moves in the opposite direction by the same amount and reaches a level of Rs.I00 = 3.30 $. The option holder will not exercise his option. Then, his loss will be zero. Thus, in an option contract, the gain is not equal to the loss.
(v) No Obligation La Buy or Sell: In all option contracts, the option holder has a right to buy or sell an underlying asset. He can exercise this right at any time during the currency of the contract. But, in no case, he is under an obligation to buy or sell. If he does not buy or sell, the contract will be simply lapsed.
Trading in Shares and Stocks
When option contract is entered into with an option to buy or sell shares or stocks, it is known as ‘share option’. Share option transactions are generally index-based. All calculations are based on the change in index value. For example, the present value of an index is 300. A person Mr. X buys a 3 month call option for an index value of 350 by paying 10% of the present index value in points at the rate of Rs.10 per point. Now, the option price is taken as Rs.300 and the strike price or exercise price is Rs. 350.
SWAP
Swap is yet another exciting trading instrument. Infact, it is a combination of forwards by two counterparties. It is arranged to reap the benefits arising from the fluctuations in the market either currency market or interest rate market or any other market for that matter.
Features
The following are the important features of swap:
(i) Basically a forward: A swap is nothing but a combination of forwards. So, it has all the properties of a forward contract discussed above.
Double coincidence of wants: Swap requires that two parties with -equal and opposite needs must come into contact with each other. As stated earlier, it is a combination of forwards by two counterparties with opposite but matching needs. For instance, the rate of interest differs from market to market and within the market itself. It varies from borrowers to borrowers due to the relative credit worthiness of borrowers.
(lii) Necessity of an intermediary: Swap requires the existence of two counterparties with opposite but matching needs. This has created a necessity for an intermediary to connect both the parties. By arranging swaps, these Intermediaries can earn income also. Financial companies, particularly banks can play a key role in this innovative field by virtue of their special position in the financial market and their knowledge of the diverse needs of the customers.
(iv) Settlement: Though a specified principal amount is mentioned in the swap agreement, there is no exchange of principal. On the other hand, a stream of fixed rate interest is exchanged for a floating rate of interest, and tints, there are streams of cash flows rather than single payment. For Instance, one party agrees to pay a fixed rate interest to another party, at the same time, he agrees to receive a floating rate interest from the same party. Both these rates are calculated on a notional principal and there is a continuous exchange of interest rates during the currency of the agreement. There is no such thing as single payment on the due date.
(v) long-term agreement: Generally, forwards are arranged for short period only Long dated forward rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate fluctuations etc. But, swaps are in the nature of long term agreement and they are just like lung dated forward rate contracts. The exchange of a fixed rate for a floating rate requires a comparatively longer period.
Kinds of Swap
A swap can be arranged for the exchange of currencies, interest rates etc. A swap in which two currencies are exchanged is called cross-currency swap. A swap in which a fixed rate of interest is exchanged for a floating rate is called interest rate swap. This interest rate swap can also be arranged in multi-currencies. A swap in which one stream of floating interest rate is exchanged for another stream of floating interest rate is called ‘Basis swap’. Thus, swap can be arranged according to the requirements of the parti5 concerned and many innovative swap instruments can be evolved like this.
Advantages
The following advantages can be derived by a systematic use of swap:
(i) Borrowing at Lower Cost: Swap facilitates borrowing at lower cost. It works on the principle of the theory of comparative cost as propounded by Ricardo. One borrower exchanges the comparative advantage possessed by him with the comparative advantage possessed by the other borrower the net result is that both the parties are able to get funds at cheaper rates.
(ii) Access to New Financial Markets: Swap is used to have access to new financial markets for funds by exploring the comparative advantage possessed by the other party in that market. Thus, the comparative advantage possessed by parties is fully exploited through swap. Hence, funds can be obtained from the best possible source at cheaper rates.
(iii) Hedging of Risk: Swap can also be used to hedge risk. For instance, a company has issued fixed rate bonds. It strongly feels that the interest rate will decline in future due to some changes in the economic scene. So, to get the benefit in future from the fall in interest rate, it has to exchange the fixed rate obligation with floating rate obligation.
(iv) Tool to correct Asset-Liability Mismatch: Swap can be profitably used to manage asset-liability mismatch. For example, a bank has acquired a fixed rate interest bearing asset on the one hand and a floating rate interest bearing liability on the other hand. In case the interest rate goes up, the bank would be much affected because with the increase in interest rate, the bank has to pay more interest. This is so because, the interest payment is based on the floating rate. But, the interest receipt will not go up, since, the receipt is based on the fixed rate.
(V) Additional Income: By arranging swaps, financial intermediaries can earn additional income in the form of brokerage.
Importance of Derivatives
Thus derivatives are becoming increasingly important in world markets as a tool for risk management the kind of hedging that can be obtained by using derivatives is cheaper aril more convenient than what could be obtained by using cash instruments. Derivatives do not create any new risk. They simply manipulate risks and transfer them to those who are willing to bear these risk.
Derivatives also offer high liquidity.
iNHIBITING FACTORS
Though derivatives are very useful for managing various risks, there are certain inhibiting factors which stand in their way. They are as follows:
(i) Misconception of Derivatives
There is a wrong feeling that derivatives would bring in financial collapse. There is an enormous negative publicity in the wake of a few incidents of financial misadventure. For instance, Barings had its entire net worth wiped out as a result of its trading and options writing on the Nikkie index futures. There are some other similar incidents like this. To quote a few: Procter and Gamble, Indah Kiat, Showa Shell etc. However, it must be understood that derivatives are not the root cause for all these troubles.
(ii) Leveraging
One of the important characteristic features of derivatives is that they lend Themselves to leveraging. That is, they are ‘high risk - high reward vehicles’. There is a prospect of either high return or huge loss in all derivative instruments. So, there is a feeling that only a few can play this game. There is no doubt that derivatives create leverage and leverage creates increased risk or return. At the same time, one should keep in mind that the very same derivatives, if properly handled, could be used as an efficient tool to minimize risks.
Derivatives in
In
Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on a stock index. They are really the risk management tools. Since derivates are permitted legally, one can e them to insulate his equity portfolio against the vagaries of the market.
There are no derivatives based on interest rates in
REcent DEVELOPMENTS
At present Derivative Trading has been permitted by the SEBI on the derivative segment of the BSE and the F & 0 segment of the NSE. The natures of derivative contracts permitted are:
i) Index Futures contracts introduced in June, 2000,
(ii) Index options introduced in June, 2001, and
(iii) Stock options introduced in July, 2001.
The minimum contract size for a derivative contract in Ks. 2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the under lying individual security should be in multiples of 100 and tractions, if any should be rounded of to the next higher multiple of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of a contract.
Apart from the above, there are market wide limits also. The wide Limit for index products in NIL. For stock specific products it is open positions. But, for option and futures the following wide limits have been fixed:
(i) 30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the exchange.
Or
(ii) 10% of the number of shares held by non-promote1S i.e., 10% of the free float in terms of number of shares of a company.
The SEBI down some eligibility conditions for Derivative Exchange/Segment and its clearing Corporation/House. They are as follows:
• The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation.
• The Derivatives Exchange/segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through at least two information vending networks, which are easily accessible to investors across the country.
• The Derivatives Exchange/segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.
• The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.
• The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
• The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades
• The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both.
• The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.
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