Derivatives Project Report

Derivatives – Indian Scenario

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Visit mbafin.blogspot.com for more 1.0 Introduction to derivatives The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves themselves against uncertainties uncertainties arising out of fluctuatio fluctuations ns in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivat Derivative ive product productss initia initially lly emerged emerged,, as hedgin hedgingg devices devices against against fluctu fluctuati ations ons in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post-1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives derivatives has grown tremendously tremendously both in terms of variety variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives visvis derivative products based on individual securities is another reason for their growing use.


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The following factors have been driving the growth of financial derivatives: 1. Increased Increased volatili volatility ty in in asset prices in financia financiall markets, markets, 2. Increased Increased integration integration of national national financial financial markets markets with with the internat international ional markets, markets, 3. Marked improvem improvement ent in communic communication ation facili facilities ties and sharp sharp decline decline in their their costs, costs, 4. Develo Developme pment nt of more sophist sophistica icated ted risk manageme management nt tools, providin providingg economi economicc agents a wider choice of risk management strategies, and 5. Innovat Innovation ionss in the derivativ derivatives es markets, markets, which which optimall optimallyy combine combine the risks and returns over a large number of financial assets, leading to higher returns, reduced risk as well as trans-actions costs as compared to individual financial assets.

1.1 Derivatives defined Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative. The price of this derivative is driven by the spot price of wheat which is the “underlying”. In the Indian context the Securities Securities Contracts Contracts (Regulation) (Regulation) Act, 1956 (SC(R) A) defines defines “equity derivative” to include – 1. A secu securi rity ty deri derive vedd from from a debt debt inst instru rume ment nt,, shar share, e, loan loan whet whethe herr secu secure redd or unsec unsecure ured, d, risk risk inst instru rume ment nt or cont contrac ractt for diff differe erenc nces es or any other other form form of security. 2. A cont contra ract ct,, whic whichh deri derive vess its its valu valuee from from the the pric prices es,, or inde indexx of pric prices es,, of underlying securities. The derivatives are securities under the SC(R) A and hence the trading of derivatives is governed by the regulatory framework under the SC(R) A. A.1

1.2 Types of derivatives The most commonly used derivatives contracts are forwards, futures and options which we shall discuss in detail later. Here we take a brief look at various derivatives contracts that have come to be used. 1

Source: www.nse-india.com


Forwards :

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A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at today’s pre-agreed price. Futures :

A futures contract is an agreement between two parties to buy or sell an asset at

a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchange-traded contracts. Options: Options are of two

types types - calls and puts. Calls give the buyer the right but not

the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. Swaps:

Swaps are private agreements between two parties to exchange cash flows in the

future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are: •

Interest rate swaps:

These entail swapping only the interest related cash flows

between the parties in the same currency. •

Currency swaps:

These entail swapping both principal and interest between the

parties, with the cash flows in one direction being in a different currency than those in the opposite direction. Warrants :

Options generally have lives of upto one year, the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter. LEAPS:

The acronym LEAPS means Long-Term Equity Anticipation Securities. These

are options having a maturity of upto three years. Baskets:

Basket options are options on portfolios of underlying assets. The underlying

asset is usually a moving average or a basket of assets. Equity index options are a form of basket options.


Swaptions :

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Swaptions are options to buy or sell a swap that will become operative at the

expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.2

1.3 Participants and Functions Three broad categories of participants - hedgers, speculators, and arbitrageurs - trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs are in business to take advantage of a discrepancy between between prices in two different markets. markets. If, for example, they see the futures futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit. The derivative market performs a number of economic functions. First, prices in an organized derivatives market reflect the perception of 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 derivative contract. Thus derivatives help in discovery of future as well as current prices. Second, the derivatives market helps to transfer risks from those who have them but may not like them to those who have appetite appetite for them. Third, derivatives, derivatives, due to their inherent nature, nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk. Fourth, speculative trades shift to a more controlled controlled environment environment of derivatives market. In the absence of an organi organize zedd deri deriva vati tives ves marke market,t, specu specula lato tors rs trade trade in the the under underly lyin ingg cash cash mark market ets. s. Margining, monitoring and surveillance of the activities of various participants become 2

Source: Options Futures & Other Derivatives John C Hull


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extremely difficult in these kind of mixed markets. Fifth, 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 people with with an entrepr entrepreneu eneuria riall attitu attitude. de. They often energiz energizee others others to create create new businesses, new products and new employment opportunities, the benefit of which are immense. Sixth, derivatives markets help increase savings and investment in the long run. Transf Transfer er of risk risk enabl enables es marke markett parti partici cipan pants ts to expan expandd thei theirr volu volume me of acti activi vity ty.. Derivatives thus promote economic development to the extent the later depends on the rate of savings and investment.

1.4 Development of exchange-traded derivatives Derivatives Derivatives have probably been around for as long as people have been trading with one another. Forward contracting dates back at least to the 12th century, and may well have been around before then. Merchants entered into contracts with one another for future delivery of specified amount of commodities at specified price. A primary motivation for prearranging prearranging a buyer or seller for a stock of commodities commodities in early forward contracts was to lessen the possibility that large swings would inhibit marketing the commodity after a harvest. Althoug Althoughh early early forward forward contract contractss in the US addresse addressedd mercha merchants nts’’ concern concernss about about ensuring that there were buyers and sellers for commodities, “credit risk” remained a serious problem. To deal with this problem, a group of Chicago businessmen formed the Chicago Board of Trade

(CBOT) in 1848. The primary intention of the CBOT was to

provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first “exchange traded” derivatives 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. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest “financial” exchanges of any kind in the world today.


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The first stock index futures contract was traded at Kansas City Board of Trad e. Currently the most popular index futures contract in the world is based on S&P 500 index, traded on Chicago Mercantile Exchange. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England, DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, etc.3 Table 1.1 The global derivatives industry: Outstanding contracts, (in $ billion)

1995 9283 Exchange traded instruments Interest rate futures and options 8618 Currency futures and options 154 Stock Index futures and options 511 17713 Some OTC instruments Interest rate swaps and options 16515 Currency swaps and options 1197 Other instruments -

1 996 1 0018 9 257 1 71 5 91 2 5453 2 3894 1 560 -

1 997 1 2403 1 1221 1 61 1 021 2 9035 2 7211 1 824 -

19 98 13 932 12 643 81 12 08 80 317 44 259 59 48 30 110

19 99 13 522 11 669 59 17 93 88 201 53 316 47 51 30 134

26996

3 5471

4 1438

94 249

10 1723

Total

Table 1.2 Chronology of instruments

1 874 1972 1972 1 973 197 1975 1 981 1982 1982

Commodity fut futures Fore Foreig ignn cur curre renc ncyy futu future ress Equity op options Treasu asury bond futu utures res Currency swaps Intere Interest st rate rate swap swaps, s, T note note future futures, s, Eurodol Eurodolla larr future futures, s, Equity Equity index index future futures, s,

1983

Options on T bond futures, Exchange listed currency options Option Optionss on equit equityy index, index, Opti Options ons on on T-note T-note futur futures, es, Optio Options ns on curre currency ncy futu futures, res,

1985 1985 1987 1987 1989 1989 1 990 199 1991 1993 1993 1994 1994

Options on equity index futures, interest rate caps and floors Euro Eu rodo doll llar ar opti option ons, s, Swap Swap opti option onss OTC OTC com compo pound und opti option ons, s, OTC OTC aver averag agee opt optio ions ns Future Futuress on inte interes restt rate rate swaps, swaps, Quan Quanto to optio options ns Equity in index sw swaps Differe erential swa swaps Capt Captio ions, ns, excha exchang ngee list listed ed FL FLEX EX opti option onss Cred Crediit defa defaul ultt opti option onss

3

Source: Derivatives in India FAQ Ajay Shah & Susan Thomas


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1.5 Exchange-traded vs. OTC derivatives markets 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 globalisati globalisation on of financial financial activitie activities. s. The recent developments developments in information 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 derivatives markets have the following features compared to exchange-trade exchange-tradedd derivatives: 1. The management management of counter counter-party -party (credit) (credit) risk risk is decentrali decentralized zed and located located within within individual institutions, 2. Th Ther eree are are no forma formall cent central raliz ized ed limi limits ts on indi indivi vidua duall posi positi tions ons,, lever leverag age, e, or margining, 3. There There are no formal formal rules rules for for risk and and burden-sh burden-shari aring, ng, 4. Th Ther eree are are no formal formal rule ruless or mecha mechani nism smss for for ensuri ensuring ng marke markett stab stabil ilit ityy and and integrity, and for safeguarding the collective interests of market participants, and 5. The OTC contract contractss are general generally ly not regulate regulatedd by a regulator regulatoryy authorit authorityy and the exchange’s exchange’s self-regulato self-regulatory ry organization, organization, although they are affected affected indirectly indirectly by national legal systems, banking supervision and market surveillance. Some of the features of OTC derivatives markets embody risks to financial market stability. Thee follo Th followi wing ng featu features res of OTC OTC deriv derivat ativ ives es marke markets ts can can give give rise rise to inst instabi abili lity ty 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


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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 configuration of counter-party 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 progres progresss has been limit limited ed in implem implement enting ing reforms reforms in risk risk manage management ment,, includ including ing counter-party, 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.

2.0 Indian Derivatives Market


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Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of India’s (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India Table 2.1 Chronology of instruments

1991 Liberalisation process initiated 14 Decem December ber 1995 1995 NSE asked asked SEBI SEBI for for permi permissio ssionn to trade trade inde indexx futures futures.. 18 November November 1996 1996 SEBI setup L.C.Gup L.C.Gupta ta Commit Committee tee to to draft a policy policy framework framework for 11 May 1998 7 Jul Julyy 199 1999

index futures. L.C.Gupta Committee submitted report. RBI gav gave pe permi rmissi ssion fo for OT OTC forwa rward rate ag agreeme ements (F (FRAs) and

24 May May 2000 2000

interest rate swaps. SIM SIMEX chos chosee Ni Nifty fty for for tra tradi ding ng fut futures ures and and opt optiions ons on on an an Ind Indiian

index. 25 May May 2000 2000 SEBI SE BI gave gave perm permiissi ssion to NSE NSE and and BSE BSE to do inde indexx fut futur ures es tradi rading ng.. 9 Ju n e 2 0 0 0 Trading of BSE Sensex futures commenced at BSE. 12 Ju June 20 2000 Trading of of Ni Nifty fu futures co commenced at at NS NSE. 25 Septem September ber 2000 2000 Nifty Nifty futur futures es tradi trading ng commen commenced ced at SGX. SGX. 2 Ju n e 2 0 0 1 Individual Stock Options & Derivatives

2.1 Need for derivatives in India today In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Today, derivatives have become part and parcel of the day day-to-day day life for for ordi rdinary peo people in major par part of the world rld. Until the advent of NSE, the Indian capital market had no access to the latest trading methods and was using traditional out-dated methods of trading. There was a huge gap between the investors’ aspirations of the markets and the available means of trading. The opening of Indian economy has precipitated the process of integration of India’s financial markets markets with with the interna internati tional onal financ financial ial market markets. s. Introdu Introducti ction on of risk manage managemen mentt instruments in India has gained momentum in last few years thanks to Reserve Bank of India’s efforts in allowing forward contracts, cross currency options etc. which have developed into a very large market.


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2.2 Myths and realities about derivatives In less than three decades of their coming into vogue, derivatives markets have become the most important markets in the world. Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970, when US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations including stock index futures. Today, derivatives have become part and parcel of the day-to-day life for ordinary people in major parts of the world. While this is true for many countries, there are still apprehensions about the introduction of derivatives. There are many myths about derivatives but the realities that are different especially for Exchange traded derivatives, which are well regulated with all the safety mechanisms in place. What are these myths behind derivatives?

•

Derivatives increase speculation and do not serve any economic purpose Indian Market is not ready for derivative trading Disas Disaste ters rs prove prove that that deriv derivat ativ ives es are are very very risky risky and and highl highlyy lever leverag aged ed

•

instruments Derivatives are complex and exotic instruments that Indian investors will find

•

difficulty in understanding Is the existing capital market safer than Derivatives?

• •

2.2.1 Derivatives increase speculation and do not serve any economic purpose

While the fact is... Numerous studies of derivatives activity have led to a broad consensus, both in the private and public sectors that derivatives provide numerous and substantial benefits to the users. Derivatives are a low-cost, effective method for users to hedge and manage thei theirr expo exposu sure ress to inter nteres estt rate rates, s, comm commod odiity pri prices, ces, or exch exchan ange ge rat rates. es. The need for derivatives as hedging tool was felt first in the commodities market. Agricultural futures and options helped farmers and processors hedge against commodity price risk. After the fallout of Bretton wood agreement, the financial markets in the world started undergoing radical changes. This period is marked by remarkable innovations in the financial markets such as introduction of floating rates for the currencies, increased trading in variety of derivatives instruments, on-line trading in the capital markets, etc.


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As the complexity of instruments increased many folds, the accompanying risk factors grew in gigantic proportions. This situation led to development derivatives as effective risk management tools for the market participants. Looking at the equity market, derivatives allow corporations and institutional investors to effectively manage their portfolios of assets and liabilities through instruments like stock index futures and options. An equity fund, for example, can reduce its exposure to the stock market quickly and at a relatively low cost without selling off part of its equity assets by using stock index futures or index options. By providing investors and issuers with a wider array of tools for managing risks and raising capital, capital, derivatives derivatives improve improve the allocation allocation of credit and the sharing sharing of risk in the global economy, lowering the cost of capital formation and stimulating economic growth. Now that world markets markets for trade and finance finance have become more integrated, integrated, derivatives derivatives have strengthened these important linkages between global markets, increasing market liquid uidity and effi fficiency and and facilitating the flow of trade and finan nance.4

2.2.2 Indian Market is not ready for derivative trading

While the fact is... Often the argument put forth against derivatives derivatives trading is that the Indian capital market is not ready for derivatives trading. Here, we look into the pre-requisites, which are needed for the introduction of derivatives and how Indian market fares:

Table 2.2

PRE-REQUISITES Large Large marke markett Capital Capitalisa isatio tionn

4

Source: www.nse-india .com

INDIAN SC SCENARIO India India is one of the largest largest market-c market-capi apital talise isedd countr countries ies in Asia with a market capitalisation of more than Rs.765000 crores.


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High Liquidity in the underlying

The daily average traded volume in Indian capital market today is around 7500 crores. Which means on an average every month 14% of the country’s Market capitalisation gets traded. These are clear indicators of high liquidity in the underlying.

Trade guarantee

The first clearing corporation guaranteeing trades has become fully functional from July 1996 in the form of Nat Natio iona nall Secur Securit itie iess Clear Clearin ingg Corpo Corporat ratio ionn (NSCC (NSCCL) L).. NSCCL is responsible for guaranteeing all open positions on the National Stock Exchange (NSE) for which it does the clearing.

A Stron rong Deposit sitory

National Securi urities Deposit sitorie ries Limited (NS (NSDL) which started functioning in the year 1997 has revolutionalised the security settlement in our country.

A Goo Goodd leg legal al guar guardi dian an

In the the Ins Insttitut tution ion of SEB SEBII (Sec (Secur uriities ies and and Exch Exchan ange ge Boa Board rd of India) today the Indian capital market enjoys a strong, independent, and innovative legal guardian who is helping the market to evolve to a healthier place for trade practices.

2.2. 2.2.3 3 Disa Disast ster erss prov provee that that deri deriva vati tive vess are are very very risk risky y and and high highly ly leve levera rage ged d instruments

While the fact is... Disasters can take place in any system. The 1992 Security scam is a case in point. Disas Disaste ters rs are are not neces necessar saril ilyy due due to deal dealin ingg in deri deriva vati tive ves, s, but deri deriva vati tive vess make make headlines... Here I have tried to explain some of the important issues involved in disasters related to derivatives. Careful observation will tell us that these disasters have occurred due to lack lack of inte interna rnall cont contro rols ls and/ and/or or outr outrig ight ht fraud fraud eith either er by the the empl employ oyee eess or promoters. Barings Collapse

1. 233 year year old old British British bank goes goes bankrupt bankrupt on 26th 26th February February 1995 1995 2. Downfall Downfall attribute attributedd to a single trader, 28 year year old Nichol Nicholas as Leeson 3. Loss arose arose due due to large exposure exposure to the Japanese Japanese futures market 4. Leeson, chief trader trader for Barings Barings futures futures in Singapore, Singapore, takes huge huge position position in index index futures of Nikkei 225


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5. Market falls falls by more than than 15% in the the first two months months of ’95 and Barings Barings suffers suffers huge losses 6. Bank Bank looses looses $1.3 $1.3 billio billionn from deriva derivativ tivee trading trading 7. Loss Loss wipes wipes out the the entire entire equity equity capit capital al of Barings Barings The reasons for the collapse: •

Leeson was supposed to be arbitraging between Osaka Securities Exchange and SIMEX -- a risk less strategy, while in truth it was an unhedged position.

•

Leeson was heading both settlement and trading desk -- at most other banks the functions are segregated, this helped Leeson to cover his losses -- Leeson was unsupervised.

•

Lack of independent risk management unit, again a deviation from prudential norms. There were no proper internal control mechanisms leading to the discrepancies going unnoticed – Internal audit report which warned of "excessive concentration of power in Leeson’s hands" was ignored by the top management.

The conclusion as summarised by Wall Street Journal article " Bank of England officials said they did not regard the problem in this case as one peculiar to derivatives. In a case where a trader is taking unauthorised positions, they said, the real question is the strength of an investment houses’ internal controls and the external monitoring done by Exchanges and Regulators. " Metallgesellschaft

1. Meta Metall llge gesel sells lsha haft ft (MG) -- a hedg hedgee that that went went bad to the tune of $1.3 $1.3 billi billion on Germany’s 14th largest industrial group nearly goes bankrupt from losses suffered through its American subsidiary - MGRM 2. MGRM MGRM offered offered long term contract contractss to supply supply 180 millio millionn barrels barrels of oil product productss to its clients -- commitment commitmentss were quite large, equivalent equivalent to 85 days of Kuwait’s oil output 3. MGRM MGRM created created a hedge hedge positio positionn for these long term term contract contractss with short term term futures market through rolling hedge --, As there was no viable long term contracts available 4. Compan Companyy was exposed exposed to basis risk risk -- risk of short short term oil prices prices tempora temporaril rilyy deviating from long term prices.


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5. In 1993, 1993, oil prices prices crashed, crashed, leadi leading ng to billion billion dollar dollarss of margin margin call to be met in cash. The Company was faced with temporary funds crunch. 6. New manage managemen mentt team decides decides to liquida liquidate te the remainin remainingg contracts contracts,, leading leading to a loss of 1.3 billion. 7. Liq Liquid uidati ation on has been criticise criticised, d, as the losses losses could could have decreased decreased over time. time. Auditors’ report claims that the losses were caused by the size of the trading exposure. Reasons for the losses: •

The transactions carried out by the company were mainly OTC in nature and hence lacked transparency and risk management system employed by a derivative exchange

•

Large exposure

•

Temporary funds crunch

•

Lack of matching long-term contracts, which necessitated the company to use rolling short term hedge -- problem arising from the hedging strategy

•

Basis risk leading to short term loss

2.2.4 Derivatives are complex and exotic instruments that Indian investors will have difficulty in understanding

While the fact is... Trading in standard derivatives such as forwards, futures and options is already prevalent in India and has a long history. Reserve Bank of India allows forward trading in RupeeDollar forward contracts, contracts, which has become a liquid market. Reserve Bank of India also allows Cross Currency options trading. Forwar Forwardd Marke Markets ts Comm Commis issi sion on has has allo allowe wedd trad tradin ingg in Comm Commod odit ityy Forwa Forward rdss on Comm Commod odit itie iess Ex Exch chan ange ges, s, whic whichh are, are, call called ed Futu Future ress in inte intern rnat atio iona nall mark market ets. s. Commod Commoditi ities es futures futures in India India are availab available le in turmer turmeric, ic, black black pepper, pepper, coffee, coffee, Gur (jaggery), hessian, castor seed oil etc. There are plans to set up commodities futures exchanges in Soya bean oil as also in Cotton. International markets have also been allowed (dollar denominated contracts) in certain commodities. Reserve Bank of India also allows, the users to hedge their portfolios through derivatives exchanges abroad.


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Detailed guidelines have been prescribed by the RBI for the purpose of getting approvals to hedge the user’s exposure in international markets. Derivatives in commodities markets have a long history. The first commodity futures exchange was set up in 1875 in Mumbai under the aegis of Bombay Cotton Traders Association (Dr.A.S.Naik, 1968, Chairman, Forwards Markets Commission, India, 196368). A clearinghouse for clearing and settlement of these trades was set up in 1918. In oilseeds, a futures market was established in 1900. Wheat futures market began in Hapur in 1913. Futures market in raw jute was set up in Calcutta in 1912. Bullion futures market was set up in Mumbai in 1920. History and existence of markets along with setting up of new markets prove that the concept of derivatives is not alien to India. In commodity markets, there is no resistance from the users or market participants to trade in commodity futures or foreign exchange markets. Government of India has also been facilitating the setting up and operations of these these market marketss in India India by providi providing ng approva approvals ls and definin definingg appropri appropriate ate regulat regulatory ory frameworks for their operations. Approval for new exchanges in last six months by the Government of India also indicates that Government of India does not consider this type of trading to be harmful albeit within proper regulatory framework. This amply proves that the concept of options and futures has been well ingrained ingrained in the Indian equities market for a long time and is not alien as it is made out to be. Even today, complex strategies of options are being traded in many exchanges which are called tejimandi, jota-phatak, bhav-bhav at different places in India (Vohra and Bagari,1998) In that sense, the derivatives are not new to India and are also currently prevalent in various markets including equities markets. 2.2.5 Is the existing capital market more safer than Derivatives?

While the fact is...


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World over, the spot markets in equities are operated on a principle of rolling settlement. In this kind of trading, if you trade on a particular day (T), you have to settle these trades on the third working day from the date of trading (T+3). Futures market allow you to trade for a period of say 1 month or 3 months and allow you to net the transaction taken place during the period for the settlement at the end of the period. In India, most of the stock exchanges allow the participants to trade during oneweek period for settlement in the following week. The trades are netted for the settlement for the entire one-week period. In that sense, the Indian markets are already operating the futu future ress styl stylee sett settle leme ment nt rath rather er than than cash cash mark market etss prev preval alen entt inte intern rnat atio iona nall lly. y. In this system, additionally, many exchanges also allow the forward trading called badla in Gujarati and Contango in English, which was prevalent in UK. This system is prevalent currently in France in their monthly settlement markets. It allowed one to even further increase the time to settle for almost 3 months under the earlier regulations. regulations. This way, a curious mix of futures style settlement with facility to carry the settlement obligations forward creates discrepancies. The more efficient way from the regulatory perspective will be to separate out the derivatives derivatives from the cash market i.e. introduce rolling rolling settlement settlement in all exchanges and at the same time allow futures and options to trade. This way, the regulators will also be able to regulate both the markets easily and it will provide more flexibility to the market participants. In addition, the existing system although futures style, does not ask for any margins from the clients. Given the volatility of the equities market in India, this system has become quite prone to systemic collapse. This was evident in the MS Shoes scandal. At the time of default taking place on the BSE, the defaulting member of the BSE Mr.Zaveri had a position close to Rs.18 crores. However, due to the default, BSE had to stop trading for a period of three days. At the same time, the Barings Bank failed on Singapore Monetary Exchange Exchange (SIMEX) for the exposure of more than US $ 20 billion (more than Rs.84,000 crore) with a loss of approximately US $ 900 million ( around Rs.3,800 crore). Although,


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the exposure was so high and even the loss was also very big compared to the total exposure on MS Shoes for BSE of Rs.18 crores, the SIMEX had taken so much margins that they did not stop trading for a single minute.

2.3 Comparision of New System with Existing System5 Many people and brokers in India think that the new system of Futures & Options and banning of Badla is disadvantageous and introduced early, but I feel that this new system is very useful especially to retail investors. It increases the no of options investors for investment. In fact it should have been introduced much before and NSE had approved it but was not active because of politicization in SEBI. The figure 2.1 –2.4

6

shows how advantages of new system (implemented from June

20001) v/s the old system i.e.before June 2001

New System Vs Existing System for Market Players Figure 2.1

Speculators Existing

5 6

SYSTEM

New

Source: Mr. Rajesh Gajra Senior writer- Intelligent Investor ([email protected]) Source: Invest Monitor (Magazine) July 2001


Approach &Prize

- 18 -

Peril &Prize Approach

1) Deliver based 1) Both profit & Trading, margin loss to extent of trading& carry price change. forward transactions. 2) Buy Index Futures hold till expiry.

1)Buy &Sell stocks on delivery basis 2) Buy Call &Put by paying premium

Peril 1)Maximum loss possible to premium paid

Advantages Greater Leverage as to pay only the premium. Greater variety of strike price options at a given time. •

•

Figure 2.2

Arbitrageurs Existing Approach &Prize

SYSTEM Peril &Prize Approach

1) Buying Stocks in 1) Make money one and selling in whichever way the another exchange. Market moves. forward transactions. 2) If Future Contract more or less than Fair price •

New Peril

1) B Group more 1) Risk free promising as still game. in weekly settlement 2) Cash &Carry arbitrage continues

Fair Price = Cash Price + Cost of Carry.

Figure 2.3

Hedgers Existing

SYSTEM

New


Approach &Prize

- 19 -

Peril &Prize

Approach

Peril

1) Difficult to 1) No Leverage 1)Fix price today to buy 1) Additional offload holding available risk latter by paying premium. cost is only during adverse reward dependant 2)For Long, buy ATM Put premium. market conditions on market prices Option. If market goes up, as circuit filters long position benefit else limit to curtail losses. exercise the option. 3)Sell deep OTM call option with underlying shares, earn premium + profit with increase prcie

Advantages •

Availability of Leverage

Figure 2.4

Small Investors Existing

SYSTEM

Approach &Prize 1) If Bullish buy stocks else sell it.

New

Peril &Prize Approach 1) Plain Buy/Sell implies unlimited profit/loss.

1) Buy Call/Put options based on market outlook 2) Hedge position if holding underlying stock

Peril 1) Downside remains protected & upside unlimited.

Advantages •

Losses Protected.

3.0 SWAPS A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated calculated based on the underlying underlying notional using applicable applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument


- 20 -

to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US$ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.

3.1 Why did swaps emerge? In the late 1970's, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations operations without without paying paying sizeable sizeable penalty. Moreover, this British British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting wanting to raise capital capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to state respective loan obligations with clarity. However this type of arrangement lead to development of more sophisticated swap market of today. Facilitators

The problem of locating potential counter parties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counterparty. Dealers work for investment, commercial or merchant banks. "By positioning the swap", dealers earn bidask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situ situat atio ion, n, the the deal dealer er woul wouldd offse offsett his his risks risks by matc matchi hing ng one step step with with anot anothe herr to streamline his payments. If the dealer is a counterparty paying fixed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by


- 21 -

matching multiple parties and by using other tools such as futures to cover an exposed position until the book is complete. Swap brokers, unlike a dealer do not take on a swap position themselves but simply locate counter parties with matching needs. Therefore, brokers are free of any risks involved with the transactions. After the counter parties are located, the brokers negotiate on behalf of the counter parties to keep the anonymity of the parties involved. By doing so, if the swap transaction falls through, counter parties are free of any risks associated with releasing their financial information. Brokers receive commissions for their services.

3.2 Swaps Pricing: There are four major components of a swap price. •

Benchmark price

•

Liquidity (availability of counter parties to offset the swap).

•

Transaction cost

•

Credit risk 7

Swap rates are based on a series of benchmark instruments. They may be quoted as a spread over the yield on these benchmark instruments or on an absolute interest rate basis. In the Indian markets the common benchmarks are MIBOR, 14, 91, 182 & 364 day T-bills, CP rates and PLR rates. Liquidity, which is function of supply and demand, plays an important role in swaps pricing. This is also affected by the swap duration. It may be difficult to have counter parties for long duration swaps, specially so in India Transaction costs include the cost of hedging a swap. Say in case of a bank, which has a floating floating obligation obligation of 91 day T. Bill. Now in order to hedge the bank would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The transaction cost would thus involve such a difference. Yield on 91 day T. Bill - 9.5% Cost of fund (e.g.- Repo rate) – 10% The transaction cost in this case would involve 0.5% 7

Source: www.appliederivatives.com


- 22 -

Credit risk must also be built into the swap pricing. Based upon the credit rating of the counterparty a spread would have to be incorporated. Say for e.g. it would be 0.5% for an AAA rating. Swap Market Participation’s

Since swaps swaps are privately privately negotiat negotiated ed products, there is no restriction restriction on who can use the market. However, parties with low credit quality have difficulty entering the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the U.S. many parties require their counter parties to have minimum assets of $10 million. million. This requirement requirement has become a standardized standardized representation representation of "eligible "eligible swap participants".

3.3 Introd Introduct uction ion of Forward Forward Rate Agreem Agreement entss and Interes Interestt Rate Swaps The Indian scene 8 Objective •

To further deepen the money markets

•

To enable banks, primary dealers and all India financial institutions to hedge interest rate risks.

These guidelines are intended to form the basis for development of Rupee derivative products such as FRAs/IRS in the country. They have been formulated in consultation with with mark market et part partic icip ipan ants ts.. Th Thee guide guideli line ness are are subj subject ect to revi review ew,, on the the basi basiss of development of FRAs/IRS market. Accordingly, it has been decided to allow scheduled commercial banks (excluding Regional Regional Rural Banks), primary dealers and all -India financial institutions institutions to undertake undertake FRAs/IRS as a product for their own balance sheet management and for market making purposes. Prerequisites

Participants are to ensure that appropriate infrastructure and risk management systems are put in place. Further, participants should also set up sound internal control system 8

Source: RBI Guidelines


- 23 -

whereby a clear functional functional separation of trading, trading, settlement, settlement, monitoring monitoring and control control and accounting activities is provided.

3.4 Description of the product A Forward Forward Rate Agreemen Agreementt (FRA) is a fina financ ncia iall contr contrac actt betwe between en two two part partie iess exchanging or swapping a stream of interest payments for a notional principal amount on settlement date, for a specified period from start date to maturity date. Accordingly, on the settlement date, cash payments based on contract (fixed) and the settlement rate, are made by the parties to one another. The settlement rate is the agreed benchmark/reference rate prevailing on the settlement date. An Interest Rate Swap (IRS) is a financial financial contract between two parties parties exchanging exchanging or swapping a stream of interest payments for a notional principal amount of multiple occasions on specified periods. Accordingly, on each payment date that occurs during the swap period-Cash payments based on fixed/floating and floating rates are made by the parties to one another. Currency swaps

can be defined as a legal agreement between two or more parties to

exchange interest obligation or interest receipts between two different currencies. It involves three steps: •

Initial exchange of principal between the counter parties at an agreed upon rate of exchange which is usually based on spot exchange rate. This exchange is optional and its sole objective is to establish the quantum of the respective principal amounts for the purpose for calculating the ongoing payments of interest and to establish the principal amount to be re-exchanged at the maturity of the swap.

•

Ongoing exchange of interest at the rates agreed upon at the outset of the transaction.

•

Re-exchange of principal amount on maturity at the initial rate of exchange.

This straight forward, three step process results in the effective transformation of the debt raised in one currency into a fully hedged liability in other currency. Participants

Schedule commercial banks.


- 24 -

Primary dealers All India financial institutions

3.5 Currency Swaps in India RBI in its slack season credit policy '97 allowed the authorized dealers to arrange currency swap without its prior approval. This was to enable those requiring long-term forward cover to hedge themselves without altering the external liability of the country. Prior to this policy RBI had been approving rupee foreign currency swaps between corporates on a case basis, but no such swaps were taking place. RBI in its process of making the Indian corporates globally competitive has simplified their access to this instrument by making changes in its credit policy. But despite an easing regulation, swaps have not hit the market in a big way. India has a strong dollar-rupee forward market with contracts being traded for one, two, six-month expiration. Daily trading volume on this forward market is around $500 million a day. Indian users of hedging services are also allowed to buy derivatives involving involving other currencies on foreign foreign markets. markets. Outside India, there is a small market for cash –settled forward contracts on the dollar –rupee exchange rate. While studying swaps in the Indian context, the counter parties involved are Indian corporates corporates and the swap dealers are the Authorized Authorized dealers of foreign exchange, exchange, i.e., the banks allowed by RBI to carry out the swaps. These banks form the counterparty to the corporates on both sides of the swap and keep a spread between the interest rates to be received and offered. One of the currencies involved is the Indian rupee and the other could be any foreign currency. The interest rate on the rupee is most likely to be fixed, and on foreign currency it could be either fixed or floating. 3.5.1 The Players

Swaps are instruments, which allow the user to hedge - that are to offset risk or to take risk deliberately in the expectation of making profit. The user in this case would be any corporate corporate having a foreign exchange exposure/ exposure/ a risk. A foreign exchange exchange exposure will


- 25 -

arise out of the mismatch between the currency of inflow and outflow. The outflow being considered here is the interest and the principal payment on the borrowings of the corporates. Corporates having such currency mismatches would be of the following types 3.5.2Corporates with rupee loan and forex revenue

Mainly the exporters would fall in this category. Corporates with foreign subsidiaries would also be having forex revenues but due to cheaper availability of funds abroad, it is unlikely that these subsidiaries would be funded by a rupee loan. Thus the main players meeting meeting this criterion criterion would be the exporters. exporters. The main players players in the Indian market are Tata Exports, Hindustan Levers Ltd., ITC Ltd., and Nestle Indian Ltd. among the others. 3.5.3 Corporates with forex loan and rupee revenue

The corporates having foreign currency loan could further be classified classified into two groups. One which have net imports and thus may have raised loans to meet their import requirements, for example Bharat Heavy Electricals Ltd., Apollo Tyres Ltd., Tata Power Co. Ltd. Two, which do not have net imports but have raised foreign currency loan for funding requirements, for example Arvind Mills Ltd., Ballarpur Industries etc. 3.5.4 Corporates with no foreign exposure

There may be corporates with no existing exposure but willing to take up an exposure in an expectation of making profit out of this transaction. Thus they would be willing to swap their rupee loan with forex loan and book in forward cover or make the payments on spot basis on the day of disbursements. These corporates may also consider the option of raising new loans in foreign currency and swap a rupee loan if it turns out to be cheaper option. Thus many corporates would fall under this category. 3.5.5 Banks

Banks act as the authorized dealers and are instrumental in arranging swaps. They have to take the swaps on their books. A bank would enter into swap with a party and then try to find another with opposite requirement to hedge itself against any fluctuation in exchange rates. They would normally keep a spread between the offer and bid rate thus make profit from transaction. They also take up the credit risk of counterparties.


- 26 -

3.6 The needs of the players and how currency swaps help meet these needs 3.6.1 To manage the exchange rate risk

Since the international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign exchange risk. The players mentioned above are facing this risk. A key question facing the players then is whether these exchange risks are so large as to affect their business. A related question is what, if any, special strategies should be followed to reduce the impact of foreign exchange risk. One-way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. The currency swap helps to achieve this without raising new funds; instead it changes existing cash flows. 3.6.2 To lower financing cost

Currency swaps can be used to reduce the cost of loan. The following example deals with such a case. Consider two Indian corporates A & B. Corporate A is an exporter with a rupee loan at 14% fixed rate. B has a dollar loan at LIBOR + 0.25% floating rate. Due to difference in the credit rating of the two companies, companies, the rates at which the loans are available available to them are different. A has access to 14% rupee loan and dollar loan at LIBOR + 0.25%. A would like to convert its rupee loan into a dollar loan, to reverse its revenue in dollars and B would like to convert the dollar loan into a fixed rupee loan thus crystallizing its cost of borrowing. They can enter into a swap and reduce the cost compared to what it would have been if they had taken a direct loan in the desired currencies. -

Comparative advantage

Company A Exporter Options:

Company B Options:

Borrow ruppe at 13%

Borrow ruppe at 14.5%

Borrow dollars at LIBOR +100 bps

Borrow dollars at LIBOR +200 bps


- 27 -

Company A has an absolute advantage advantage over B in both the markets/ rates. The advantage in terms of rupee funds is 150 bps while it is 100 bps in case of dollar rates. Thus B has a comparative advantage in terms of dollar rates. Now as A is an exporter he would be more interested in a dollar denominated loan to offset his future receivables. Therefore it would be advantageous if A would borrow at rupee rates and B borrows at LIBOR rates. Then they may go in for a currency swap. The net gain arising out of such a swap will be 50 bps, which may be shared between the parties. The swap will thus result in A paying B a floating rate of LIBOR + 75 bps in return for a 13% fixed rupee rate. The swap will take place on a notional principal basis. The effective cost for A is LIBOR + 75 bps and for B it is 14.25%. The effective cost for A is 12.75%. This results into a net saving of 25 bps for both the parties. Figure 3.1

LIBOR +75 bps Company A

12.75% in INR

Company B

13% in INR -

Libor +200 bps

To access restricted markets

Many countries have restrictions on the type of borrowers that can raise funds in their bond markets. Foe example an Indian firm exporting goods to Japan may wish to issue bonds in yen to form a natural natural hedge by reversing their cash flows. To issue a yen bond, the borrower must qualify for a single A credit rating. If the company does not qualify in this regard it would fail to issue yen denominated bond. By issuing bonds in the rupee market and then entering into a currency swap, the firm can meet its expectation of raising a yen denominated loan. 3.6.3 Swaps for reducing the cost of borrowing

With the introduction of rupee derivatives the Indian corporates can attempt to reduce their cost of borrowing and thereby add value. A typical Indian case would be a corporate with a high fixed rate obligation.


- 28 -

Eg. Mehta Ltd. an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of 18.5%. Today a 364-day T. bill is yielding 10.25%, as the interest rates have come down. The 3-month MIBOR is quoting at 10%. Fixed to floating 1 year swaps are trading at 50 bps over the 364-day T. bill vs 6-month MIBOR. The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next one year. The firm can thus benefit by entering into an interest rate fixed for floating swap, whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364 day treasury yield i.e. 10.25 + 0.50 = 10.75 %. Figure 3.2

Mehta Ltd

Fixed 10.75

Counter Party

3 Months MIBOR 18.75%s

MIBOR

The effective cost for Mehta Ltd. = 18.5 + MIBOR - 10.75 = 7.75 + MIBOR At the present 3m MIBOR at 10%, the effective cost is = 10 + 7.75 = 17.75% The gain for the firm is (18.5 - 17.75) = 0.75 % The risks involved for the firm are


- 29 -

- Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments. - The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond 10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firm hold a strong view that MIBOR shall remain below 10.75%. This will require continuous monitoring on the path of the firm. How does the bank benefit out of this transaction? The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also use this swap as an opportunity to hedge its own floating liability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%. Taking advantage of future views/ speculation If a bank holds a view that interest rate is likely to increase and in such a case the return on fixed rate assets will not increase, it will prefer to swap it with a floating rate interest. It may also swap floating rate liabilities with a fixed rate.

3.7 Factors to be looked at while doing a swap Though swaps can be used in the above conditions effectively, corporates need to look at a few factors before deciding to swap. The estimated net exposure

They need to estimate the net exposure that they are likely to have in the future. Projecting the growth in exports/ imports, taking into account the changes in management and government policies can do this. Expected range of exchange rates

This can be determined by a fundamental and technical analysis. For fundamental analysis one needs to keep track of the balance of payment condition, GDP growth rate, etc. of the country. The technical factors look at past trends and expected demand-supply position. Other factors like political stability also needs to be considered.


- 30 -

Expected interest rates

Since currency swaps include exchange of interest interest payments, the interest rates also need to be traced. By keeping an eye on the yield curve of long term bonds and the macro economic variables of different countries, the interest rates can be estimated. Amount of cover to be taken

Having estimated the amount of exposure, the expected exchange rates and the interest rates, the parties can determine the risks involved and can decide upon the amount of cover to be taken. This shall depend on the management policy whether they believe in minimizing the risk for a given level of return or maximizing the gain for a given level of risk. The risk taking capability of a corporate will depend upon the financial backup to absorb the losses, if any, the availability of time and resources to monitor the forex market.

3.8 Market Report- Issues of Concern Unfortunately, money markets as a whole are not developed. The biggest problem continues to be the structure of the money market. Two-way quotes are a fundamental necessity for a proper yield curve to develop and a reference rate to be established. The RBI does not encourage lend/borrow transaction on the same day. While foreign banks and some of the new banks are perennial borrowers in the inter-bank market, several nationalised banks and institutions are perennial lenders. This leaves the primary dealers to do the trading. But their limited funds do not enable them to become large players. This gives rise to uni-directional players who are averse to two-way quotes. This deters the development of a benchmark around which a term market can evolve. Right now, whatever trading is done is through the fixed rate. For IRS to happen there should be swaps in maturities. A benchmarking has to be done and for that we need a correct reference rate, which will have to evolve beyond the overnight rate (MIBOR). That can happen only if a term money market is in place. In India fixed rates are aplenty with banks and institutions borrowing and lending at fixed rates. They also adopt floating rates (Prime Lending Rate or PLR) while lending. But the PLR has two crucial deficiencies compared to rates like LIBOR: PLR is not a market related related rate, but determined, determined, somewhat somewhat arbitrarily, arbitrarily, on the basis of the bank rate. Besides


- 31 -

there are no two-way quotes in PLR, in the absence of which swap deals virtually become infructuous. Rates like LIBOR, Fed Funds Rate/ T.Bill Rate are those at which banks are prepared to lend and borrow in any currency. In India too, such a market does exist for the rupee- the call money market. Banks borrow/lend at market determined rates. But where the Indian money market differs from other major financial centers is that, in the latter money is available for periods ranging from 1 or 7 days to 3, 6 and 12 months, whereas in India, rupee is available for a day or two, up to a maximum period of 13 days, as a general rule. The reason being the fortnightly reserve requirements. Another deficiency is the lack of integration with the foreign exchange (FX) markets. In order to protect and control the exchange rate of the rupee, strong silos have been created. Forward premium between the rupee and another foreign currency does not reflect the interest rate differential. If anything, it reflects the estimated risk of depreciation of the local unit against the dollar. This gives rise to significant arbitrage opportunities between the two markets, which are protected through the RBI diktat. At present, the tenors available in the IRS market are short and the benchmark limited to only one, the Mumbai Inter-bank Offer Rate (MIBOR).

3.9 Some swaps in near future9 March 10 2001 ICICI inks 5-year rupee IRS with Citibank

ICICI has entered into a five-year rupee interest rate swap with Citibank. This is the fourth long-term swap deal in the IRS market during the fortnight. The ICICI-Citibank swap deal has a notional amount of Rs 50 crore. The fixed portion of the swap is based on the yield on the four-year government security, while the floating rate is based on the one-year G-sec yield. “The floating rate will be reset on an annual basi basis, s, for which which five five securi securiti ties es have have been been iden identi tifi fied ed to provi provide de a perfec perfectt resi residua duall maturity,” said an ICICI official.

9

Source: www.economictimes.com


- 32 -

11 MAY 2001 Vysya Bank, L&T in Rs 10-cr overnight index swap deal

VYSYA Bank and Larsen & Toubro have entered into an overnight index swap (OIS) transaction for Rs 10 crore. The one-year swap has Vysya Bank paying 8.75 per cent against the compounded NSE Mibor to L&T. The deal, brokered by eMecklai, was done over the internet. The verification of the swap differences will be carried out quarterly with settlement at maturity. 17 FEBRUARY Jet swaps $340-m floating loan with Credit Lyonnais

George Cherian

CREDIT Lyonnais and Jet Airways have concluded the largest interest rate swap in the country. country. A total of $340m of the air tax operator’s operator’s outstanding outstanding foreign currency floating rate loans has been swapped to fixed/ floating via a structured interest rate swap spread over four years. It will insulate Jet Airways against rising interest rates. It will also give Jet Airways the opportunity to take advantage of falling interest rates in later years. The swap, which has been executed in two tranches of $200m and $140m, is the largest ever derivatives transaction in the domestic market

4.0 Forward contracts & Futures & Options A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges. The salient features of forward contracts are: •

They are bilateral contracts and hence exposed to counter–party risk.

•

Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.


- 33 -

•

The contract price is generally not available in public domain.

•

On the expiration date, the contract has to be settled by delivery of the asset.

•

If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing transaction transaction costs and increasing increasing transactions transactions volume. This process of standardization reaches its limit in the organized futures market. Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. uncertainty. Similarly Similarly an importer importer who is required to make a payment payment in dollars dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets here supplies leverage to the speculator.

4.1 Limitations of forward markets •

Forward markets world-wide are afflicted by several problems:

•

Lack of centralization of trading

•

Illiquidity, and Counter party risk

In the first two of these, the basic problem is that of too much flexibility flexibility and generality. generality. The forward market is like a real estate market in that any two consenting adults can form contracts against each other. This often makes them design terms of the deal, which are very convenient in that specific situation, but makes the contracts non-tradable.


- 34 -

Count Counterp erpart artyy risk risk aris arises es from from the the possi possibi bili lity ty of defau default lt by any any one part partyy to the the transaction. When one of the two sides to the transaction declares bankruptcy, the other suffers. Even when for-ward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue.

4.2 Introduction to futures Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are: •

Quantity of the underlying

•

Quality of the underlying

•

The date and the month of delivery

•

The units of price quotation and minimum price change

•

Location of settlement

4.3 Distinction between futures and forwards contracts Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the presence of future price uncertainty. However futures are a significant improvement over the forward contracts as they eliminate counter party risk and offer more liquidity. Table 3.1 lists the distinction between the two.


- 35 -

Table 4.1 Distinction between futures and forwards 10

Futures Trad Tradee on on an orga organi nize zedd exc excha hang ngee Standardized co contract te terms Hence more liquid Requires margin payments

Forwards OTC OTC in natu nature re Customised co contract te terms Hence less liquid No margin payment

4.4

Futures Terminology The price at which an asset trades in the spot market.

•

Spot price:

•

Futures price:

•

Contract cycle:

The price at which the futures contract trades in the futures market. The period over which a contract trades. The index futures contracts

on the NSE have one-month, two-months and three-months expiry cycles, which expire on the last Thursday of the month. Thus a January expiration expiration contract contract expires on the last Thursday of January and a February expiration expiration contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is introduced for trading. •

Expiry date:

It is the date specified in the futures contract. This is the last day on

which the contract will be traded, at the end of which it will cease to exist. •

Contract size:

The amount of asset that has to be delivered under one contract. For

in-stance, the contract size on NSE’s futures market is 200 Nifties. •

Basis:

In the context of financial futures, basis can be defined as the futures price

minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. This reflects that futures prices normally exceed spot prices. •

Cost Cost of carry carry::

The relationship between futures prices and spot prices can be

summarized in terms of what is known as the cost of carry. This measures the storage cost plus the interest that is paid to finance the asset less the income earned on the asset. •

Initial margin:

The amount that must be deposited in the margin account at the time

a futures contract is first entered into is known as initial margin.

10

Source: Derivatives in India FAQ’s by Ajay Shah & Susan Thomas

Derivatives – Indian Scenario •

Marking-to-market:

- 36 -

In the futures market, at the end of each trading day, the margin

ac-count is adjusted to reflect the investor’s gain or loss depending upon the futures closing price. This is called marking–to–market. •

Maintenance margin:

This is somewhat lower than the initial initial margin. This is set to

ensure that the balance in the margin account never becomes negative. If the balance in the margin account falls below the maintenance margin, the investor receives a margin call and is expected to top up the margin account to the initial margin level before trading commences on the next day.

4.5 Introduction to options In this section, we look at the next derivative product to be traded on the NSE, namely options. Options are fundamentally different from forward and futures contracts. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up– front payment. 4.5.1 History of options

Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. Today exchange-traded options are actively traded on stocks, stock indexes, foreign currencies and futures contracts. The first trading in options began in Europe and the US as early as the eighteenth century. It was only in the early 1900s that a group of firms set up what was known as the put and call Brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other member firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered


- 37 -

from two deficiencies. First, there was no secondary market and second, there was no mechanism mechanism to guarantee guarantee that the writer writer of the option would honor the contract. It was in 1973, that Black, Merton and Scholes invented the famed Black Scholes formula. In April 1973, CBOE was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early ’80s, the number of shares underlying underlying the option contract sold each day exceeded the daily volume of shares traded on the NYSE. Since then, there has been no looking back.

4.6 Option Terminology •

Index options:

These options have the index as the underlying. Some options are

European while others are American. Like index futures contracts, index options contracts are also cash settled. •

Stock options:

Stock options are options on individual stocks. Options currently

trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. •

Buyer of an option:

The buyer of an option is the one who by paying the option

prem premiu ium m buys buys the the right right but not the the oblig obligat atio ionn to exerc exercis isee his his opti option on on the the seller/writer. •

Writer of an option:

The writer of a call/put option is the one who receives the

option option premium premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the holder the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. •

Option price:

Option price is the price which the option buyer pays to the option

seller. •

Expirati Expiration on date: date:

Thee date Th date speci specifi fied ed in the the opti option onss cont contrac ractt is known known as the the

expiration date, the exercise date, the strike date or the maturity.


Strike price:

- 38 -

The price specified in the options contract is known as the strike price

or the exercise price. •

American options:

American options are options that can be exercised at any time

upto the expiration date. Most exchange-traded options are American. •

European options:

European options are options that can be exercised only on the

expiration expiration date itself. itself. European European options options are easier to analyze than American American options, options, and properties of an American option are frequently deduced from those of its European counterpart. •

In-the-money option:

An in-the-money (ITM) option is an option that would lead to

a positive cashflow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price (i.e. spot price > strike price). If the index is much higher than the strike price, price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. •

At-the-money At-the-money option:

An at-the-money (ATM) option is an option that would lead

to zero cashflow if it were exercised immediately. An option on the index is at-themoney when the current index equals the strike price (i.e. spot price = strike price)._ •

Out-of-the-money option:

An out-of-the-money (OTM) option is an option that

would lead to a negative negative cashflow it it were exercised immediatel immediately. y. A call option on the index is out-of- the-money when the current index stands at a level which is less than the strike price (i.e. spot price < strike price). If the index is much lower than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM if the index is above the strike price. •

Intrinsic value of an option:

The option premium can be broken down into two

components - intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call isN½P which means the intrinsic value of a call is Max [0, (St – K)] which means the intrinsic value of a call is the (St – K). Similarly, the intrinsic value of a put is Max [0, (K -St )] ,i.e. the greater of 0 or (K - St ). K is the strike price and St is the spot price.


Time value of an option:

- 39 -

The time value of an option is the difference between its

premium and its intrinsic value. A call that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is a call’s time value, all else equal. At expiration, a call should have no time value. 11

Table 4.2 Distinction between futures and options

Futures Exchange traded, with novation Exchange defines the product Price is zero, strike price moves Price is zero Linear payoff Both long and short at risk

Options Same as futures. Same as futures. Strike price is fixed, price moves. Price is always positive. Nonlinear payoff. Only short at risk.

4.7 Futures and options An interesting question to ask at this stage is - when would one use options instead of futures? 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 genera generate te very very large large losse losses. s. Th This is chara charact cteri erist stic ic make makess opti option onss attr attrac acti tive ve to many many occasional market participants, who cannot put in the time to closely monitor their futures positions. 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 11

Source: www.derivativesindia.com


- 40 -

option. This is attractive to many people, and to mutual funds creating “guaranteed return products”. The Nifty index fund industry will find it very useful to make a bundle of a Nifty index fund and a Nifty put option to create a new kind of a Nifty index fund, which gives the investor protection against extreme drops in Nifty.

4.8 Index derivatives Index derivatives are derivative contracts, which derive their value from an underlying index. The two most popular index derivatives are index futures and index options. Index derivatives derivatives have become very popular popular worldwide. worldwide. In his report, Dr.L.C.Gupta Dr.L.C.Gupta attributes attributes the popularity of index derivatives to the advantages they offer. •

Insti Institu tuti tiona onall and and larg largee equi equity ty-ho -hold lders ers need need portf portfol olio io-he -hedgi dging ng faci facili lity ty.. Index Index– – derivatives are more suited to them and more cost–effective than derivatives based on individual stocks. Pension funds in the US are known to use stock index futures for risk hedging purposes.

•

Index derivatives offer ease of use for hedging any portfolio irrespective of its composition.

•

Stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered.

•

Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements.

•

Index derivatives are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificates.

The L.C.Gupta committee which was setup for developing a regulatory framework for derivatives trading in India had suggested a phased introduction of derivative products in the following order: 1. Index futures 2. Index options


- 41 -

3. Options on individual stocks With all the above infrastructure in place, trading of index futures and index options commenced at NSE in June 2000 and June 2001 respectively.

5.0 Payoff & Pricing of Futures and Options A payoff is the likely profit/loss that would accrue to a market participant with change in the price of the underlying asset. This is generally depicted in the form of payoff diag diagra rams ms whic whichh show show the the pric pricee of the the unde underl rlyi ying ng asse assett on the the X–ax X–axis is and and the the profits/losses on the Y–axis. In this section we shall take a look at the payoffs for buyers and sellers of futures and options.

5.1 Payoff for futures Futures contracts have linear payoffs. In simple words, it means that the losses as well as profits for the buyer and the seller of a futures contract are unlimited. These linear payoffs are fascinating as they can be combined with options and the underlying to generate various complex payoffs.

5.1.1 Payoff for buyer of futures: Long futures

The payoff for a person who buys a futures contract is similar to the payoff for a person who holds an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who buys a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves up, the long futures position starts making profits, and when the index moves down it starts making losses. Figure 5.1 shows the payoff diagram for the buyer of a futures contract. 5.1.2 Payoff for seller of futures: Short futures


- 42 -

The payoff for a person who sells a futures contract is similar to the payoff for a person who shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited downside. Take the case of a speculator who sells a two-month Nifty index futures contract when the Nifty stands at 1220. The underlying asset in this case is the Nifty portfolio. When the index moves down, the short futures position starts making profits, and when the index moves up, it starts making losses. Figure 5.2 shows the payoff diagram for the seller of a futures contract. Figure 5.1

Payoff for a buyer of Nifty futures

The figure shows the profits/losses for a long futures position. The investor bought futures when the index was at 1220. If the index goes up, his futures position starts making profit. If the index falls, his futures position starts showing losses. Profit

1220

0

Nifty

Loss Figure 5.2

Payoff for a seller of Nifty futures

The figure shows the profits/losses profits/losses for a short futures position. position. The investor investor sold futures when the index was at 1220. If the index goes down, his futures position starts making profit. If the index rises, his futures position starts showing losses. Profit

0

Loss

5.2 Options payoffs

1220

Nifty


- 43 -

The optionality characteristic of options results in a non-linear payoff for options. In simple words, 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. His profits are limited to the option premium, however his 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. We look here at the six basic payoffs. 5.2.1 Payoff profile of buyer of asset: Long asset

In this basic position, an investor buys the underlying asset, Nifty for instance, for 1220, and sells it at a future date at an unknown price,S4 it is purchased, the investor is said to be “long” the asset. Figure 5.3 shows the payoff for a long position on the Nifty.12 Figure 5.3

Payoff for investor who went Long Nifty at 1220

The figure shows the profits/losses from a long position on the index. The investor bought the index at 1220. If the index goes up, he profits. If the index falls he looses. Profit +60 0

1160

1220

1280

Nifty

-60 Loss 5.2.2 Payoff profile for seller of asset: Short asset

In this basic position, an investor shorts the underlying asset, Nifty for instance, for 1220, and buys it back at a future date at an unknown price S4 Once it is sold, the investor is said to be “short” the asset. Figure 5.4 shows the payoff for a short position on the Nifty.

12

Source: NSE Derivatives Core Module

Derivatives – Indian Scenario Figure 5.4

- 44 -

Payoff for investor who went Short Nifty at 1220

The figure shows the profits/losse profits/lossess from a short position on the index. The investor sold the index at 1220. If the index falls, he profits. If the index rises, he looses. Profit +60 0

1160 1220 1280

-60

Nifty

Loss 5.2.3 Payoff profile for buyer of call options: Long call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price exceeds the strike price, he makes a profit. Higher the spot price, more is the profit he makes. If the spot price of the underlying is less than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.5 gives the payoff for the buyer of a three month call option (often referred to as long call) with a strike of 1250 bought at a premium of 86.60. 5.2.4 Payoff profile for writer of call options: Short call

A call option gives the buyer the right to buy the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price exceeds the strike price, the buyer will exercise the option on the writer. Hence as the spot price increases the writer of the option starts making losses. Higher the spot price, more is the loss he makes. If upon expiration the spot price of the underlying is less than the strike price, the buyer lets his option expire un-exercised and the writer gets to


- 45 -

keep the premium. Figure 5.6 gives the payoff for the writer of a three month call option (often referred to as short call) with a strike of 1250 sold at a premium of 86.60. Figure 5.5

Payoff for buyer of call option

The figure shows the profits/losses for the buyer of a three-month Nifty 1250 call option. As can be seen, as the spot Nifty rises, the call option is in-the-money. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the Nifty-close and the strike price. The profits possible possible on this option option are potentially potentially unlimited. unlimited. However if Nifty falls below the strike of 1250, he lets the option expire. His losses are limited limited to the extent of the premium premium he paid for buying the option. Profit

0

1250

Nifty

86.60 Loss Figure 5.6

Payoff for writer of call option

The figure shows the profits/losses for the seller of a three-month Nifty 1250 call option. As the spot Nifty rises, the call option is in-the-money and the writer starts making losses. If upon expiration, Nifty closes above the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the Nifty-close and the strike price. The loss that can be incurred by the writer of the option is potentially unlimited, whereas the maximum profit is limited to the extent of the up-front option premium of Rs.86.60 charged by him. Profit 86.60 0

1250

Nifty

Loss 5.2.5 Payoff profile for buyer of put options: Long put


- 46 -

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. If upon expiration, the spot price is below the strike price, he makes a profit. Lower the spot price, more is the profit he makes. If the spot price of the underlying is higher than the strike price, he lets his option expire un-exercised. His loss in this case is the premium he paid for buying the option. Figure 5.7 gives the payoff for the buyer of a three month put option (often referred to as long put) with a strike of 1250 bought at a premium of 61.70. Figure 5.7

Payoff for buyer of put option

The figure shows the profits/losses for the buyer of a three-month Nifty 1250 put option. As can be seen, as the spot Nifty falls, the put option is in-the-money. If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option and profit to the extent of the difference between the strike price and Nifty-close. The profits possible on this option can be as high as the strike price. However if Nifty rises above the strike of 1250, he lets the option expire. His losses are limited to the extent of the premium he paid for buying the option. Profit

0 61.70

1250

Nifty

Loss

5.2.6 Payoff profile for writer of put options: Short put

A put option gives the buyer the right to sell the underlying asset at the strike price specified in the option. For selling the option, the writer of the option charges a premium. The profit/loss that the buyer makes on the option depends on the spot price of the underlying. Whatever is the buyer’s profit is the seller’s loss. If upon expiration, the spot price happens to be below the strike price, the buyer will exercise the option on the writer. If upon expiration the spot price of the underlying is more than the strike price, the


- 47 -

buyer lets his option expire un-exercised and the writer gets to keep the premium. Figure 5.8 gives the payoff for the writer of a three-month put option (often referred to as short put) with a strike of 1250 sold at a premium of 61.70. Payoff for writer of put option The figure shows the profits/losses for the seller of a three-month Nifty 1250 put option. As the spot Nifty falls, the put option is in-the-money and the writer starts making losses . If upon expiration, Nifty closes below the strike of 1250, the buyer would exercise his option on the writer who would suffer a loss to the extent of the difference between the strike price and Nifty-close. The loss that can be incurred by the writer of the option is a maximum extent of the strike price(Since the worst that can happen is that the asset price can fall to zero) whereas the maximum profit is limited to the extent of the up-front option premium of Rs.61.70 charged by him.

Figure 5.8

Profit 61.70 0

1250

Nifty

Loss

5.3 Pricing Index Futures Stock index futures began trading on NSE on the 12th June 2000. Ever since, the volumes and open interest has been steadily growing. Looking at the futures prices on NSE’s market, have you ever felt the need to know whether the quoted prices are a true reflection reflection of the underlying underlying index’s index’s price? Have you wondered wondered whether whether you could make risk-less profits by arbitraging between the underlying and futures markets? If so, you need to know the cost-of-carry to understand the dynamics of pricing that constitute the estimation of fair value of futures. 5.3.1 The cost of carry model

We use fair value calculation of futures to decide the no-arbitrage limits on the price of a futures contract. This is the basis for the cost-of-carry model where the price of the contract is defined as:


- 48 F=S+C

Where: F: Futures price S: Spot price C: Holding costs or carry costs

This can also be expressed as: F=s (1+r) T Where: r: Cost of financing T: Time till expiration

If F < s (1+r (1+r)) T or F > s (1+r) T, arbitrage opportunities would exist i.e. whenever the futures price moves away from the fair value, there would be chances for arbitrage. We know what the spot and future prices are, but what are the components of holding cost? The components of holding cost vary with contracts on different assets. At times the holding cost may even be negative. In the case of commodity futures, the holding cost is the cost of financing plus cost of storage and insurance purchased etc. In the case of equity futures, the holding cost is the cost of financing minus the dividends returns. Note: In the futures pricing examples worked out in this book, we are using the concept of discrete compounding, where interest rates are compounded at discrete intervals, for example, annually or semiannually. Pricing of options and other complex derivative securities requires the use of continuously compounded interest rates. Most books on derivatives use continuous compounding for pricing futures too. However, we have used discrete compounding as it is more intuitive and simpler to work with. Had we to use the concept of continuous compounding, the above equation would have been expressed as: F= Se rT Where: r: Cost of financing (using continuously compounded interest rate) T: Time till expiration e: 2.71828


- 49 -

5.3.2 Pricing futures contracts on commodities

Let us take an example of a futures contract on a commodity and work out the price of the contract. The spot price of silver is Rs.7000/kg. If the cost of financing is 15% annually, what should be the futures price of 100 gms of silver one month down the line ? Let us assume that we’re on 1st January 2001. How would we compute the price of a silver futures contract expiring on 30th January? From the discussion above we know that the futures price is nothing but the spot price plus the cost-of-carry. Let us first try to work out the components of the cost-of-carry model. 1. What is the spot price of silver? The spot price of silver, S= Rs.7000/kg. 2. What is the cost of financing for a month? (1+0.15) 30/365 3. What are the holding costs? Let us assume that the storage cost = 0. In this case the fair value of the futures price, works out to be = Rs.708. F=s (1+r) T + C = 700(1.15) 30/365 =Rs. 708 If the contract was for 3 month period i.e. expiring 30th March the cost of financing would increase increase the futures price. price. Therefore, Therefore, the futures price price would be C = 700(1.15) 90/365 = Rs.724.5. On the other hand, if the one-month contract was for 10,000 kg. Of silver instead of 100 gms, then it would involve a non-zero storage cost, and the price of the future contract would be Rs. 708 +the cost of storage. 5.3.3 Pricing futures contracts on equity index

A futures contract on the stock market index gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled; there is no delivery of the underlying stocks. In their short history of trading, index futures have had a great impact on the world’s securities securities markets. Indeed, index futures trading has been accused of making making the world’s stock markets more volatile than ever before. The critics claim that individual investors have been driven out to the equity markets because the actions of institutio institutional nal traders in both the spot and futures markets cause stock values to gyrate with no links to their fundamental values. Whether stock index futures trading is a blessing or a curse is


- 50 -

debatable. It is certainly true, however, that its existence has revolutionized the art and science of institutional equity portfolio management. The main differences between commodity and equity index futures are that:

_

•

There are no costs of storage involved in holding equity.

•

Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock.

Therefore, Cost of carry = Financing cost - Dividends Thus, a crucial crucial aspect of dealing dealing with equity futures as opposed to commodity commodity futures is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the futures price. 5.3.4 Pricing index futures given expected dividend amount

The pricing of index futures is also based on the cost-of-carry model, where the carrying cost is the cost of financing the purchase of the portfolio underlying the index, minus the present value of dividends obtained from the stocks in the index portfolio. Example

Nifty futures trade on NSE as one,two and three-month contracts. What will be the price of a new two-month futures contract on Nifty? 1. Let us assume that M & M will be declaring a dividend of Rs. 10 per share after 15 days of purchasing the contract. 2. Current value of Nifty is 1200 and Nifty trades with a multiplier of 200. 3. Since Nifty is traded in multiples of 200, value of the contract is 200*1200 = Rs.240,000. 4. If M & M has a weight of 7% in Nifty, its value in Nifty is Rs.16,800 i.e.(240,000 * 0.07). 5. If the market price of M & M is Rs.140, then a traded unit of Nifty involves 120 shares of M & M i.e.(16,800/140). 6. To calculate the futures price, we need to reduce the cost-of-carry to the extent of dividend received. The amount of dividend received is Rs.1200 i.e.(120 * 10). The dividend is received 15 days later and hence compounded only for the remainder of 45


- 51 -

days. To calculate the futures price we need to compute the amount of dividend received per unit of Nifty. Hence we divide the compounded dividend figure by 200. 7. Thus, futures price F = 1200(1.15) 60/365 {120*10(1.15) 45/365 /200} =Rs. 1221.80

5.3.5 Pricing index futures given expected dividend yield

If the dividend flow throughout the year is generally uniform, i.e. if there are few historical cases of clustering of dividends in any particular month, it is useful to calculate the annual dividend yield. F = s (1+r-q) T Where: F: futures price S: spot index value r: cost of financing q: expected dividend yield T: holding period

Example

A two-month futures contract trades on the NSE. The annual dividend yield on Nifty is 2% annualized. The spot value of Nifty 1200. What is the fair value of the futures contract? Fair value = 1200(1+.015-0.02) 60/365 =Rs. 1224.35 The cost of carry model explicitly explicitly defines defines the relationship relationship between the futures price and the related spot price. As we know, the difference between the futures price and the spot price is called the basis. Nuances •

As the date of expiration comes near, the basis reduces - there is a convergence of the futures price towards the spot price. On the date of expiration, the basis is zero. If it is not, then there is an arbitrage opportunity. Arbitrage opportunities can also arise when the basis (difference between spot and futures price) or the spreads (difference


- 52 -

between prices of two futures contracts) during the life of a contract are incorrect. At a later stage we shall look at how these arbitrage opportunities can be exploited. •

There is nothing but cost-of-carry related arbitrage that drives the behavior of the futures price.

•

Transactions costs are very important in the business of arbitrage.

e: Not e:

The pricing models discussed in this chapter give an approximate idea about the

true future price. However the price observed in the market is the outcome of the price– discovery discovery mechanism (demand–supply (demand–supply principle) principle) and may differ from the so-called so-called true price.

5.4 Pricing options An option buyer has the right but not the obligation to exercise on the seller. The worst that can happen to a buyer is the loss of the premium paid by him. His downside is limited to this premium, but his upside is potentially unlimited. This optionality is precious and has a value, which is expressed in terms of the option price. Just like in other free markets, it is the supply and demand in the secondary market that drives the rice of an option. On dates prior to 31 Dec 2000, the “call option on Nifty expiring on 31 Dec 2000 with a strike of 1500” will trade at a price that purely reflects supply and demand. There is a separate order book for each option which generates its own price. The values shown in Table 5.1 are derived from a theoretical model, namely the BlackScholes option pricing model. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market, which forces the prices in the table to come about. There are various models, which which help us get close to the true price of an option. option. Most of these are variants of the celebrated Black-Scholes model for pricing European options. Today most calculators and spreadsheets come with a built-in Black-Scholes options pricing pricing formula so to price options we don’t really need to memorize memorize the formula. formula. What we shall do here is discuss this model in a fairly non-technical way by focusing on the basic principles and the underlying intuition.


- 53 -

5.5 Introduction to the Black–Scholes formulae Intuition would tell us that the spot price of the underlying, exercise price, risk-free interes interestt rate, rate, volati volatilit lityy of the underl underlyin ying, g, time time to expira expiratio tionn and divide dividends nds on the underlying (stock or index) should affect the option price. Interestingly before Black and Scholes came up with their option pricing model, there was a widespread belief that the expected growth of the underlying ought to affect the option price. Black and Scholes demonstrate that this is not true. The beauty of the Black and Scholes model is that like any good model, it tells us what is important and what is not. It doesn’t promise to Table 5.1 Option prices: some illustrative values

Option strike price

Calls 1 mth

1 400

14 50

150 0

155 0

1600

117

79

48

27

13

3 mth 15 1 54 11 9 90 67 48 Puts 1 mth 8 19 38 66 102 3 mth 25 39 59 84 114 Assumptions: Nifty spot is 1500, Nifty volatility is 25% annualized, interest rate is 10%, and Nifty dividend yield is 1.5%. produce the exact prices that show up in the market, but definitely does a remarkable job of pricing options within the framework of assumptions of the model. Virtually all option pricing models, even the most complex ones, have much in common with the Black– Scholes model. Black and Scholes start by specifying a simple and well–known equation that models the way in which stock prices fluctuate. This equation called Geometric Brownian Motion, implies that stock returns will have a lognormal distribution, meaning that the logarithm of the stock’s re-turn will follow the normal (bell shaped) distribution. Black and Scholes then propose that the option’s price is determined by only two variables that are allowed to change: time and the underlying stock price. The other factors - the volatility, the


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exercise price, and the risk–free rate do affect the option’s price but they are not allowed to change. By forming a portfolio consisting of a long position in stock and a short position position in calls, calls, the risk of the stock is eliminate eliminated. d. This hedged portfolio portfolio is obtained obtained by setting the number of shares of stock equal to the approximate change in the call price for a change in the stock price. This mix of stock and calls must be revised continuously, a process known as delta hedging. Black and Scholes then turn to a little–known result in a specialized field of probability known as stochastic calculus. This result defines how the option price changes in terms of the change in the stock price and time to expiration. They then reason that this hedged combination of options and stock should grow in value at the risk–free rate. The result then is a partial differential equation. The solution is found by forcing a condition called a boundary condition on the model that requires the option price to converge to the exercise value at expiration. The end result is the Black and Scholes model.

5.6 The Black–Scholes option pricing formulae The Black–Scholes Black–Scholes formulas for the prices of European calls and puts on a non-dividend non-dividend paying stock are:

C = SN(d 1) – Xe-rT N(d2) P = Xe-rT N(-d2)- SN(-d1) Where d1 = [ ln s/x +(r+δ 2/2)T ]/ δ √T And d2 = d1 –δ√T •

The Black Scholes equation is done in continuous time. This requires continuous compounding. The “ r ” that in this is ln(1+r). E.g. if the interest rate per annum is 12%, 12%, you you need need to use ln1.1 ln1.122 or 0.113 0.1133, 3, whic whichh is cont contin inuou uousl slyy comp compou ounde ndedd equivalent of 12% per annum.

•

N () is the cumulative normal distribution. N(d1 ) is called the delta of the option which is a measure of change in option in option price with respect to change in the price of the underlying asset.


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δ a measu measure re of vola volati tili lity ty is the the annu annual aliz ized ed stan standa dard rd devi deviat atio ionn of cont contin inuo uousl uslyy compounded returns on the underlying. When daily sigma are given, they need to be converted into annualized sigma.

•

Σ annual = Σ daily * √number of trading days per year. On a average there are 250 trading days in a year.

•

X is the exercise price, S is the spot price and T the time to expiration.

5.7 Pricing index options Under the assumptions of the Black–Scholes options pricing model, index options should be valued in the same way as ordinary options on common stock. The assumption is that investors investors can costlessly purchase the underlying underlying stocks in the exact amount necessary to replicate the index; that is, stocks are infinitely divisible and that the index follows a diffusion process such that the continuously compounded returns distribution of the index is normally distributed. To use the Black–Scholes formula for index options, we must however make adjustments for the dividend payments received on the index stocks. If the dividend payment is sufficiently smooth, this merely involves replacing the current index value S in the model with Se-qT where q is the annual dividend yield and T is the time to expiration in years. The Black-Scholes formula is so commonly used that it comes programmed into most calculators and spreadsheets. Hence it is not necessary to memorize the formula. One only needs to know how to use it. e: Not e:

The pricing models discussed in this chapter give an approximate idea about the

true options price. However the price observed in the market is the outcome of the price– discovery discovery mechanism (demand–supply (demand–supply principle) principle) and may differ from the so-called so-called true price.


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Visit mbafin.blogspot.com for more

6.0Using index futures There are eight basic modes of trading on the index futures market:13 Hedging H1 Long stock, short Nifty futures H2 Short stock, long Nifty futures H3 Have portfolio, short Nifty futures H4 Have funds, long Nifty futures

Speculation

Source: NSE Derivatives Module & www.rediff/money/derivatives.htm & www.erivativesreview.com 13


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S1 Bullish index, long Nifty futures S2 Bearish index, short Nifty futures

Arbitrage A1 Have funds, lend them to the market A2 Have securities, lend them to the market

6.1 H1: Long stock, short Nifty futures Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks? Have you ever been a “stockpicker” and carefully purchased a stock based on a sense that it was worth more than the market price? A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks: 1. His understanding can be wrong, and the company is really not worth more than the market price; or, 2. The entire market moves against him and generates losses even though the underlying idea was correct.

The second outcome happens all the time. A person may buy Infosys at Rs.190 thinking that it would announce good results and the stock price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of Infosys was correct.

There is a peculiar problem here. Every buy position on a stock is simultaneously a buy y. position on Nift y.

This is because a LONG INFOSYS position INFOSYS position generally gains if Nifty

rises and generally loses if Nifty drops. The stock picker may be thinking he wants to be LONG INFOSYS, but a long position on Reliance effectively forces him to be LONG INFOSYS + LONG NIFTY. It is useful to ask: does the person feel bullish about INFOSYS or about the index? •

Those who are bullish about the index should just buy Nifty futures; they need not trade individual stocks.


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Those who are bullish about INFOSYS do wrong by carrying along a long position on Nifty as well.

There is a simple way out. Every time you adopt a long position on a stock, you should sell some amount of Nifty futures.

This offsets the hidden Nifty exposure that is inside

every long–stock position. Once this is done, you will have a position, which is purely about the performance of the stock. The

position position LONG INFOSYS + SHORT NIFTY is

a pure play on the value of INFOSYS, without any extra risk from fluctuations of the market index. When this is done, the stockpicker has “hedged away” his index exposure. Warning:

Hedging does not remove losses. The best that can be achieved using hedging

is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profits than the un-hedged un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. How do we actually do this?

1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose Suppose we take take WIPRO, WIPRO, whose beta is 1.2, 1.2, and suppose suppose we have have a LONG LONG WIPRO WIPRO position of Rs.200,000. 2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 *œ200,000, i.e. Rs.240,000. 3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To sell Rs.240,000 of Nifty we need to sell one market lot. 4. We sell one market lot of Nifty (200 nifties) to get the position: LONG WIPRO Rs.200,000, SHORT WIPRO Rs.240,000 This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.


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6.2 H2: Short stock, long Nifty futures Have you ever felt that a stock was intrinsically over-valued? That the profits and the quality of the company made it worth a lot less as compared to what the market thinks? Have you ever been a “stockpicker” and carefully sold a stock based on a sense that it was worth less than the market price? A person who feels like this takes a short position position on the cash market. While doing this, he faces two kinds of risks: 1. His understanding can be wrong, and the company is really worth more than the market price; or, 2. The entire market moves against him and generates losses even though the underlying idea was correct.

The second outcome happens all the time. A person may sell Reliance at Rs.190 thinking that Reliance would announce poor results and the stock price would fall. A few days later, Nifty rises, so he makes losses, even if his intrinsic understanding of Reliance was correct. There is a peculiar problem here. Every sell position on a stock is simultaneously a sell y. This is because a SHORT RELIANCE position generally gains if Nifty falls position on Nift y. and generally loses if Nifty rises. In this sense, a SHORT RELIANCE position is not a focused play on the valuation of Reliance. It carries a SHORT NIFTY position along with it, as incidental baggage. The stockpicker may be thinking he wants to be SHORT RELIANCE, but a short position on Reliance on the market effectively forces him to be SHORT RELIANCE + SHORT NIFTY. •

Those who are bearish about the index should just sell nifty futures; they need not trade individual stocks.

•

Those who are bearish about RELIANCE do wrong by carrying along a short position on Nifty as well.

There is a simple simple way out. Every time you adopt a short position position on a stock, you should buy some amount of Nifty futures.

This offsets the hidden Nifty exposure that is inside

every short–stock position. Once this is done, you will have a position which is purely about the performance of the stoc k. The position SHORT RELIANCE + LONG NIFTY is a pure


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play on the value of RELIANCE, RELIANCE, without any extra risk from fluctuations fluctuations of the market index. How do we actually do this?

1. We need to know the “beta” of the stock, i.e. the average impact of a 1% move in Nifty upon the stock. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take WIPRO, where the beta is 1.2, and suppose we have a SHORT WIPRO position of Rs.200,000. 2. The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 1.2 * 200,000, i.e. Rs.240,000. ¨

3. Suppose Nifty is at 1200, and the market lot on the futures market is 200. Hence each market lot of Nifty is Rs.240,000. To long Rs.240,000 of Nifty we need to buy one market lot. 4. We buy one market lot of Nifty (200 nifties) to get the position: SHORT WIPRO Rs.200, 000, LONG NIFTY Rs.240,000

This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to WIPRO, hence only successful forecasts about WIPRO will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty.

6.3 H3: Have portfolio, short Nifty futures Have you ever experienced experienced the feeling of owning owning an equity equity portfolio, and then, one day, becoming uncomfortable about the overall stock market? Sometimes, you may have a view that stock prices will fall in the near future. At other times, you may see that the market is in for a few days or weeks of massive volatility, and you do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you expect to need to sell shares in the near future, for example, example, in order to finance a purchase of a house. This planning planning can go wrong if by the time you sell shares, Nifty has dropped sharply.


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When you have such anxieties, there are two alternatives: 1 Sell shares immediately. This sentiment generates “panic selling” which is rarely optimal for the investor. 2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to “do something” when stock prices fall. In addition, with the index futures market, a third and remarkable alternative becomes available: 3 Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without “panic selling” of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index stocks or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual stocks, where only 30–60% of the stock risk is accounted for by index fluctuations) fluctuations).. Hence a position position LONG PORTFOLIO + SHORT NIFTY can often become one– tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures. Warning:

Hedging does not always make money. The best that can be achieved using

hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the unhedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. It does not make make sense sense to use this strategy strategy for long long periods periods of time time – if a two–ye two–year ar hedging hedging is


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desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. appropriate. The complete hedge may require require selling selling Rs.3 million million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, two–thirds of his portfolio is hedged and one–third ofthe portfolio is held unhedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.

6.4 H4: Have funds, buy Nifty futures Have you ever been in a situation where you had funds which needed to get invested in equity? Or of expecting to obtain funds in the future which will get invested in equity. Some common occurrences of this include: •

A closed-end fund which just finished its initial public offering has cash which is not yet invested.

•

Suppose a person plans to sell land and buy shares. The land deal is slow and takes weeks to complete. complete. It takes several weeks from the date that it becomes sure that the funds will come to the date that the funds actually are in hand.

•

An open-ended fund has just sold fresh units and has received funds.

Getting invested in equity ought to be easy but there are three problems: 1. A person may need time to research stocks, and carefully pick stocks that are expected to do well. This process takes time. For that time, the investor is partly invested in cash and partly invested in stocks. During this time, he is exposed to the risk of missing out if the overall market index goes up. 2. A person may have made up his mind on what portfolio he seeks to buy, but going to the market and placing market orders would generate large ‘impact costs’. The execution would be improved substantially if he could instead place limit orders and gradually accumulate accumulate the portfolio portfolio at favor-able favor-able prices. This takes time, and during this time, he is exposed to the risk of missing out if the Nifty goes up.


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3. In some cases, such as the land sale above, the person may simply not have cash to immediately buy shares, hence he is forced to wait even if he feels that Nifty is unusually cheap. He is exposed to the risk of missing out if Nifty rises. So far, in India, we have had exactly two alternative strategies which an investor can adopt: to buy liquid stocks in a hurry, or to suffer the risk of staying staying in cash. With Nifty futures, a third alternative becomes available:

•

The investor would obtain the desired equity exposure by buying index futures, immediately. A person who expects to obtain Rs.5 million by selling land would immedi immediate ately ly enter enter into into a positio positionn LONG LONG NIFTY NIFTY worth worth Rs.5 Rs.5 milli million. on. Simil Similarl arly, y, a closed end fund which has just finished its initial public offering and has cash which is not yet invested, can immediately enter into a LONG NIFTY to the extent it wants to be invested in equity. The index futures market is likely to be more liquid than individual stocks so it is possible to take extremely large positions at a low impact cost.

•

Later, the investor/closed-end fund can gradually acquire stocks (either based on detailed research and/or based on aggressive limit orders). As and when shares are obtain obtained, ed, one would would scale scale down the LONG LONG NIFTY NIFTY positio positionn corresp correspondi ondingl ngly. y. No matter how slowly stocks are purchased, this strategy would fully capture a rise in Nifty, so there is no risk of missing out on a broad rise in the stock market while this process is taking place. Hence, this strategy allows the investor to take more care and spend more time in choosing stocks and placing aggressive limit order s. s.

Hedging is often thought of as a technique that is used in the context of equity exposure. It is common for people to think that the owner of shares needs index futures to hedge against a drop in Nifty. Holding money in hand, when you want to be invested in shares, is a risk because Nifty may rise. Hence it is equally important for the owner of money to use index futures to hedge against a rise in Nift y! y! Table 6.1 Gradual acquisition of stocks, hedged


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On 17 Feb, Iqbal purchased 5000 nifties to obtain a position of Rs.5 million. From 18 Feb onwards, on each day, Iqbal purchased purchased one security security worth Rs.357,000 (at 17 Feb prices) and sold off a similar value of futures thus shrinking his futures position. For this example, we deliberately use non–index small stocks; hedging using index futures works for all portfolios regardless of what stocks go into them. Nifty rose sharply on 27 February and 28 February, so his outstanding futures position generated an infusion of cash for him on these days. This inflow paid for the higher stock prices that he suffered. Date

17 Feb 18 Feb 19 Feb 20 Feb 23 Feb 24 Feb 25 Feb 26 Feb 27 Feb 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 09 Mar Total

Futures position

+5,000,000 4,597,074 4,190,807 3,786,330 3,375,976 2,964,000 2,648,488 2,330,165 2,007,454 1,673,850 1,350,948 1,019,453 6 9 0, 8 5 3 3 6 2, 9 9 3 29,828

Stock purchase

2700 shares of ASIANHOTL 2800 shares of BATAINDIA 5400 shares of BOMDYEING 55500 shares of SAIL 6050 shares of ESCORTS 1600 shares of DABUR 500 shares of CIPLA 1150 shares of CADBURY 4700 shares of APOLLOTYRE 5100 shares of ICICIBK 2150 shares of ITCHOTEL 2100 shares of LAKME 700 shares of PFIZER 6300 shares of TITAN 4,982,538

Futur

MTM

es

profit/loss

sold

(In Rs.)

400 400 400 400 400 300 300 300 300 3 00 300 300 300 300

-17,042 38,430 18,801 55,828 1 3 ,7 9 5 65,300 2 5 ,2 9 0 3 5 ,1 1 2 7 6 ,2 4 8 -64,214 4 2 ,9 6 8 - 1 1, 5 8 2 -2,220 10,611 2 4 9 ,7 2 4

How do we actually do this?

1. Mr.Mehta obtained Rs.5 million on 17 Feb 1998. He made a list of 14 stocks to buy, at 17 Feb prices, totaling Rs.5 million. 2. At that that time time Nift Niftyy was was at 991. 991.70 70.. He ente entere redd into into a LONG LONG NIFT NIFTY Y MARC MARCH H FUTURES position for 5000 nifties, i.e. his long position was worth 5,053,600. 3. From 18 Feb 1998 to 09 March 1998 he gradually acquired the stocks (see Table 5.2). On each day, he purchased one stock and sold off a corresponding amount of futures.


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On each day, the stocks purchased were at a changed price (as compared to the price prevalent on 17 Feb). On each day, he obtained or paid the ‘mark–to–market margin’ on his outstanding futures position, thus capturing the gains on the index. 4. By 09 Mar 1998 he had fully invested in all the shares that he wanted (as of 17 Feb) and had no futures position left. 5. The same sequencing of purchases, without the umbrella of protection of the LONG NIFTY MARCH FUTURES position, would have cost Rs.249,724 more.

6.5 S1: Bullish index, long Nifty futures Do you sometimes think that the market index is going to rise? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from an upward movement in the index? Today, you have two choices: 1. Buy selected liquid securities, which move with the index, and sell them at a later date: or, 2. Buy the entire index portfolio and then sell it at a later date. The first alternative is widely used – a lot of the trading volume on liquid stocks is based on using these liquid stocks as an index proxy. However, these positions run the risk of making losses owing to company–specific news; they are not purely focused upon the index. The second alternative is cumbersome and expensive in terms of transactions costs. How do we actually do this? When you think the index will go up, buy the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000, the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor.


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Longer dated futures go well with long–term forecasts about the movement of the index. Shorter dated futures tend to be more liquid. 6.6 S2: Bearish index, short Nifty futures

Do you sometimes think that the market index is going to fall? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from a downward movement in the index? Today, you have two choices: 1. Sell selected liquid securities which move with the index, and buy them at a later date: or, 2. Sell the entire index portfolio and then buy it at a later date. The first alternative is widely used – a lot of the trading volume on liquid stocks is based on using these stocks as an index proxy. However, these positions run the risk of making losses owing to company–specific news; they are not purely focused upon the index. The second alternative is hard to implement. This strategy is also cumbersome and expensive in terms of transactions costs. How do we actually do this?

When you think the index will go down, sell the Nifty futures. The minimum market lot is 200 Nifties. Hence, if Nifty is at 1200, the investment is done in units of Rs.240,000. When the trade takes place, the investor is only required to pay up the initial margin, which is something like Rs.20,000. Hence, by paying an initial margin of Rs.20,000 the investor gets a claim on the index worth Rs.240,000. Similarly, by paying up Rs.200,000, the investor gets a claim on Nifty worth Rs.2.4 million. Futures are available at several different expirations. The investor can choose any of them to implement this position. The choice is basically about the horizon of the investor. Longer dated futures go well with long–term forecasts about the movement of the index. Shorter dated futures tend to be more liquid.

6.7 A1: Have funds, lend them to the market


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Would you like to lend funds into the stock market, without suffering the slightest risk? Traditional Traditional methods methods of loaning money into the stock market suffer from (a) price risk of shares and (b) credit risk of default of the counter-party. What is new about the index futures market is that it supplies a technology to lend money into the market without suffering any exposure to Nifty, and without bearing any credit risk. The basic idea is simple. The lender buys all 50 stocks of Nifty on the cash market, and simultaneously sells them at a future date on the futures market. It is like a repo. There is no price risk since the position is perfectly hedged. There is no credit risk since the counterparty on both legs is the NSCCL which supplies clearing services on NSE. It is an ideal lending vehicle for entities which are shy of price risk and credit risk, such as traditional banks and the most conservative corporate treasuries. How do we actually do this?

1. Calculate a portfolio which buys all the 50 stocks in Nifty in correct proportion, i.e. where the money invested in each stock is proportional to its market capitalization. 2. Round off the number of shares in each stock. 3. Using the NEAT software, a single keystroke can fire off these 50 orders in rapid succession into the NSE trading system. This gives you the buy position. 4. A moment later, sell Nifty futures of equal value. Now you are completely hedged, so fluctuations in Nifty do not affect you. 5. A few days later, you will have to take delivery of the 50 stocks and pay for them. This is the point at which you are “loaning money to the market”. 6. Some days later (anytime you want), you will unwind the entire transaction. 7. At this point, use NEAT to send 50 sell orders in rapid succession to sell off all the 50 stocks. 8. A moment later, reverse the futures position. Now your position is down to 0. 9. A few days later, you will have to make delivery of the 50 stocks and receive money for them. This is the point at which “your money is repaid to you”.


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What is the interest interest rate that you will receive? receive? We will use one specific case, where you will unwind the transaction on the expiration date of the futures. In this case, the difference difference between the futures price and the cash Nifty is the return to the moneylender moneylender,, with two complications: the moneylender additionally earns any dividends that the 50 shares pay while he has held them, and the moneylender suffers transactions costs (impact cost, brokerage) in doing these trades. On 1 July 1998, if the Nifty spot is 942.25, and the Nifty July 1998 futures are at 956.5 then the difference (1.5% for 30 days) is the return that the moneylender obtains. Example

On 1 August, Nifty is at 1200. A futures contract is trading with 27 August expiration for 1230. Ashish wants to earn this return (30/1200 for 27 days). 1. He buys Rs.3 million of Nifty on the spot market. In doing this, he places 50 market orders and ends up paying slightly more. His average cost of purchase is 0.3% higher, i.e. he has obtained the Nifty spot for 1204. 2. He sells Rs.3 million million of the futures at 1230. The futures market is extremely liquid liquid so the market order for Rs.3 million goes through at near–zero impact cost. 3. He takes delivery of the shares and waits. 4. While waiting, a few dividends come into his hands. The dividends work out to Rs.7,000. 5. On 27 August, at 3:15, Ashish puts in market orders to sell off his Nifty portfolio, putting 50 market orders to sell off all the shares. Nifty happens to have closed at 1210 and his sell orders (which suffer impact cost) goes through at 1207. 6. The futures position spontaneously expires on 27 August at 1210 (the value of the futures on the last day is always equal to the Nifty spot). 7. Ashish has gained Rs.3 (0.25%) on the spot Nifty and Rs.20 (1.63%) on the futures for a return of near 1.88%. In addition, he has gained Rs.70,000 or 0.23% owing to the dividends for a total return of 2.11% for 27 days, risk free. It is easier to make a rough calculation of the return. To do this, we ignore the gain from dividends and we assume that transactions costs account for 0.4%. In the above case, the


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return is roughly 1230/1200 or 2.5% for 27 days, and we subtract 0.4% for transactions costs giving 2.1% for 27 days. This is very close to the actual number.

6.8 A2: Have securities, lend them to the market Do you have a portfolio of shares which is earning you nothing? Would you like to juice up your returns by earning revenues from stocklending? Most owners of shares answer in the affirmative to these questions. Yet, stocklending schemes that are widely accessible do not exist in India. The index futures market offers a riskless mechanism for (effectively) loaning out shares and earning a positive return for them. It is like a repo; you would sell off your certificates and con-tract to buy them back in the future at a fixed price. There is no price risk (since you are perfectly hedged) and there is no credit risk (since your counterparty on both legs of the transaction is the NSCCL). The basic idea is quite simple. You would sell off all 50 stocks in Nifty and buy them back at a future date using the index futures. You would soon receive money for the shares you have sold. You can deploy this money as you like until the futures expiration. On this date, you would buy back your shares, and pay for them. How do we actually do this?

Suppose you have Rs.5 million of the NSE-50 portfolio (in their correct proportion, with each share being present in the portfolio with a weight that is proportional to its market capitalization). 1. Sell off all 50 shares on the cash market. This can be done using a single keystroke using the NEAT software. 2. Buy index futures of an equal value at a future date. 3. A few days later, you will receive money and have to make delivery of the 50 shares. 4. Invest this money at the riskless interest rate. 5. On the date that the futures expire, at 3:15 PM, put in 50 orders (using NEAT again) to buy the entire NSE-50 portfolio.


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6. A few days later, you will need to pay in the money and get back your shares. When is this worthwhile? When the spot-futures basis (the difference between spot Nifty and the futures Nifty) is smaller than the riskless interest rate that you can find in the economy. If the spot–futures basis is 2.5% per month and you are loaning out the money at 1.5% per month, it is not profitable. Conversely, if the spot-futures basis is 1% per month and you are loaning out money at 1.2% per month, this stocklending could be profitable. It is easy to approximate the return obtained in stock lending. To do this, we assume that transactions costs account for 0.4%. Suppose the spot–futures basis is x% and suppose the rate at which funds can be invested invested is y% Then the total return is y-x-0.4%, over the time that the position is held. This can also be interpreted as a mechanism to obtain a cash loan using your portfolio of Nifty shares as collateral. In this case, it may be worth doing even if the spot–futures basis is somewhat wider. Example

Suppose the Nifty spot is 1100 and the two–month futures are trading at 1110. Hence the spot– futures basis (1110/1100) is 0.9%. Suppose cash can be risklessly invested at 1% per month. Over two months, funds invested at 1% per month yield 2.01%. Hence the total return that can be obtained in stocklending is 2.01-0.9-0.4 or 0.71% over the two– month period. Let us make this concrete using a specific sequence of trades. Suppose Akash has Rs.4 million of the Nifty portfolio which he would like to lend to the market. 1. Akash puts in sell orders for Rs.4 million of Nifty using the feature in NEAT to rapidly place 50 market orders in quick succession. The seller always suffers impact cost; suppose he obtains an actual execution at 1098. 2. A moment later, Akash puts in a market order to buy Rs.4 million of the Nifty futures. The order executes at 1110. At this point, he is completely hedged.


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3. A few days later, Akash makes delivery of shares and receives Rs.3.99 million (assuming an impact cost of 2/1100). 4. Suppose Akash lends this out at 1% per month for two months. 5. At the end of two months, he get back Rs.4,072,981. Translated in terms of Nifty, this is 1098*1.012 or 1120. 6. On the expiration date of the futures, he puts in 50 orders, using NEAT, placing market orders to buy back his Nifty portfolio. Suppose Nifty has moved up to 1150 by this time. This makes shares are costlier in buying back, but the difference is exactly offset by profits on the futures contract. When the market order is placed, suppose he ends up paying 1153 and not 1150, owing to impact cost. He has funds in hand of 1120, and the futures contract pays 40 (1150-1110) (1150-1110) so he ends up with a clean profit, on the entire transaction, of 1120 + 40 - 1153 or 7. On a base of Rs.4 million, this is Rs.25, 400. Table 6.2 Market watch showing bid and ask for various futures contracts

Month November December

Quantity 1 000 2 00

Bid 1 009 1 022

Ask 1 0 1 0. 5 10 25

Quantity 1 000 4 00

7.0 Using index options There are potentially innumerable ways of trading on the index options market. However we shall look at eight basic modes of trading on the index futures market: Hedging H5 Have portfolio, buy puts


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Speculation S3 Bullish index, buy Nifty calls or

sell Nifty puts

S4 Bearish index, sell Nifty calls or buy Nifty puts S5 Anticipate volatility, buy a call and a put at same strike S6 Bull spreads, Buy a call and sell another S7 Bear spreads, Sell a call and buy another

Arbitrage A3 Put-call parity with spot-options arbitrage A4 Arbitrage beyond option price bounds14

7.1 H5: Have portfolio, buy puts Have you ever experienced experienced the feeling of owning owning an equity equity portfolio, and then, one day, becoming uncomfortable about the overall stock market? Sometimes you may have a view that stock prices will fall in the near future. Many investors simply do not want the fluctuations of these three weeks. One way to protect your portfolio from potential downside due to a market drop is to buy portfolio insurance. Index options is a cheap and easily implementable way of seeking this insurance. The idea is simple. To protect the value of your portfolio from falling below a particular level, buy the right number of put options with the right strike price. When the index falls your portfolio will lose value and the put options bought by you will gain, effectively ensuring that the value of your portfolio portfolio does not fall below a particular level. This level depends on the strike price of the options chosen by you. Portfolio insurance using put options is of particular interest to Mutual funds who already own well-diversified portfolios. By buying puts, the fund can limit its downside in case of a market fall. How do we actually do this?

Source: NSE Derivatives Module, www.derivativesindia.com, www.erivativesreview.com, www.rediff/money/derivatives.htm

14


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We need to know the “beta” of the portfolio. We look at two cases, case one where the portfolio has a beta of 1 and case two where the portfolio beta is not equal to 1. Portfolio insurance when portfolio beta is 1.0

1. Assume we have a well-diversified portfolio with a beta of 1.0, which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1250 and you decide to buy puts with a strike of 1125. This will insure your portfolio against an index fall lower than 1125. 3. When the portfolio beta is one, the number of puts to buy is simply equal to the portfolio value divided by the spot index. Now let us look at the outcome. We have just bought two–month Nifty puts at a strike of 1125. This is designed to ensure that the value of our portfolio does not decline below Rs.0.90 million. (For a portfolio with a beta of 1, a 10% fall in the index directly translates into a 10% fall in the portfolio value). During the two–month period, suppose the Nifty drops to 1080. This is a 13.6% fall in the index. The portfolio value too falls at the same rate and declines declines to Rs.0.864 million. million. However the options provide a payoff of (1125-1080)*4*200 (1125-1080)*4*200 which is equal to Rs.36,000. Rs.36,000. This is the amount needed to bring the value of the portfolio back to Rs.0.90 million. Portfolio insurance when portfolio beta is not 1.0

1. Assume we have a portfolio with beta equal to 1.2 which we would like to insure against a fall in the market. 2. Now we need to choose the strike at which we should buy puts. This is largely a function of how safe we want to play. Assume that the spot Nifty is 1200 and we decide to buy puts with a strike of 1140. This will insure our portfolio against an index fall lower than 1140. 3. For a portfolio with a non-unit beta, the number of puts to buy equals (portfolio value * portfolio beta)/Index. Assume our portfolio is worth Rs.1 million with a beta of 1.2. Hence the number of puts we need to buy to protect our portfolio from a downside is


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(10,00,000 *1.2)/1200 which works out to 1000. At a market lot of 200, it means that we will have to buy 5 market lots of two month puts with a strike of 1140. Now let us look at the outcome. We have just bought two month Nifty puts at a strike of 1140. This is designed to ensure the value of our portfolio does not decline below Rs.0.94 million. (For a portfolio with a beta of 1.2, an index fall of 5% translates into a 6% fall in the portfolio value). During the two-month two-month period, suppose the Nifty drops to 1080. The portfolio value has declined to Rs.0.88 million. (Again, for a portfolio with a beta of 1.2, a 10% fall in the index translates into a 12% fall in the portfolio value). However the options provide a payoff of (1140-1080)*5*200 which is equal to Rs.60,0000. This is the amount needed to bring the value of the portfolio back to Rs.0.94 million.

7.2 S3: Bullish index, buy Nifty calls or sell Nifty puts Do you sometimes think that the market index is going to rise? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from an upward movement in the index? Today, using options you have two choices: 1. Buy call options on the index; or, 2. Sell put options on the index We have already seen the payoff of a call option. The downside to the buyer of the call option is limited to the option premium he pays for buying the option. His upside however is potentially unlimited. Having decided decided to buy a call, which one should you buy? Table 7.1 gives the premia for one-month calls and puts with different strikes. Given that there are a number of one– month calls trading, each with a different strike price, the obvious question is: which strike should you choose? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. The following options are available: 1. A one month call on the Nifty with a strike of 1200.


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2. A one month call on the Nifty with a strike of 1225. 3. A one month call on the Nifty with a strike of 1250. 4. A one month call on the Nifty with a strike of 1275. 5. A one month call on the Nifty with a strike of 1300. Which of these options you choose largely depends on how strongly you feel about the likelihood of the upward movement in the market index, and how much you are willing to lose should this upward movement not come about. There are five one–month calls and five one–month puts trading in the market. Table 7.1 One-month calls and puts trading at different strikes

The spot Nifty level is 1250. There are five one-month calls and five one-month puts trading in the market. Figure 7.1 shows the payoffs from buying calls at different strikes. Figure 7.2 shows the payoffs from writing puts at different strikes. Nifty 1250 1250 1250 1250 1250

Strike price of option 1200 1225 1250 1275 1300

Call Premium (Rs.) 80.10 63.65 49.45 37.50 27.50

Put Premium (Rs.) 18.15 26.50 37.00 49.80 64.80

As a person who wants to speculate on the hunch that the market index may rise, you can also do so by selling or writing puts. As the writer of puts, you face a limited upside and an unlimited downside. Having decided to write a put, which one should you write? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose ? This largely depends on how strongly you feel about the likelihood of the upward movement in the market index. In the example in Figure 7.2, at a Nifty level of 1250, one option is in–the–money and one is out–of–the–money. As expected, the in–the–money option fetches the highest premium of Rs.64.80 whereas the out–of–the–money option has the lowest premium of Rs.18.15. Payoff for buyer of call options at various strikes The figure shows the profits/losses for a buyer of Nifty calls at various strikes. The in– the–money option with a strike of 1200 has the highest premium of Rs.80.10 whereas the out–of–the–money option with a strike of 1300 has the lowest premium of Rs.27.50.

Figure 7.1


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Profit

1200

1250

1280.10

27.50

1300 1299.45

1327.50 Nifty

49.45 80.10 Loss Payoff for writer of put options at various strikes The figure shows the profits/losses for a writer of Nifty puts at various strikes. The in– the–money option with a strike of 1300 fetches the highest premium of Rs.64.80 whereas the out–of–the–money option with a strike of 1200 has the lowest premium of Rs.18.15.

Figure 7.2

Profit 64.80 37.00 18.15 1200 1250 1981.85 1213 1235.20

1300

Nifty

Loss

7.3 S4: Bearish index: sell Nifty calls or buy Nifty puts


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Do you sometimes think that the market index is going to drop? That you could make a profit by adopting a position on the index? How does one implement a trading strategy to benefit from a downward movement in the index? Today, using options, you have two choices: 1. Sell call options on the index; or, 2. Buy put options on the index We have already seen the payoff of a call option. The upside to the writer of the call option is limited to the option premium he receives upright for writing the option. His downside however is potentially unlimited. Having decided to write a call, which one should you write? Table 7.2 gives the premiums for one month calls and puts with different strikes. Given that there are a number of one-month calls trading, each with a different strike price, the obvious question is: which strike should you choose ? Let us take a look at call options with different strike prices. Assume that the current index level is 1250, risk-free rate is 12% per year and index volatility is 30%. You could write the following options : 1. A one month call on the Nifty with a strike of 1200. 2. A one month call on the Nifty with a strike of 1225. 3. A one month call on the Nifty with a strike of 1250. 4. A one month call on the Nifty with a strike of 1275. 5. A one month call on the Nifty with a strike of 1300. Which of this options you write largely depends on how strongly you feel about the likelihood of the downward movement in the market index and how much you are willing to lose should this downward movement not come about. Table 7.2 One month calls and puts trading at different strikes

The spot Nifty level is 1250. There are five one-month calls and five one-month puts trading in the market. Figure 7.3 shows payoff for seller of various calls at different strikes. Figure 7.4 shows the payoffs from buying puts at different strikes. Nifty 1250 1250 1250 1250

Strike price of option 1200 1225 1250 1275

Call Premium (Rs.) 80.10 63.65 49.45 37.50

Put Premium (Rs.) 18.15 26.50 37.00 49.80

Derivatives – Indian Scenario 1250

1300

- 78 27.50

64.80

As a person who wants to speculate on the hunch that the market index may fall, you can also buy puts. As the buyer of puts you face an unlimited upside but a limited downside. If the index does fall, you profit to the extent the index falls below the strike of the put purchased by you. Having decided to buy a put, which one should you buy? Given that there are a number of one-month puts trading, each with a different strike price, the obvious question is: which strike should you choose? This largely depends on how strongly you feel about the likelihood of the downward movement in the market index. Figure 7.3

Payoff for seller of call option at various strikes

The figure shows the profits/losses for a seller of Nifty calls at various strike prices. The in–the–money option has the highest premium of Rs.80.10 whereas the at–the–money option has the lowest premium of Rs.27.50. Profit 80.10 1327.5

49.45 27.50 1 200

Loss

Figure 7.4

12 50

1280.10

13 00 Nifty

1299.45

Payoff for buyer of put options at various strikes

The figure shows the profits/losse profits/lossess for a buyer of Nifty puts at various various strike prices. The in–the–money option has the highest premium of Rs.64.80 whereas the at–the–money option has the lowest premium of Rs.18.50. Profit

Derivatives – Indian Scenario 1182.85 18.15

| 1213 1 200

235.20

- 79 | 12 50

| 1300

Nifty

37.00 64.80 Loss

7.4 S5: Anticipate volatility; buy a call and a put Do you sometimes think that the market index is going to go through large swings in a given period, but have no opinion on the direction of the swing? This strategy is useful in times of uncertainty uncertainty (e.g. recently during the WTC attacks). attacks). How does one implement implement a trading strategy to benefit from market volatility? Combinations of call and put options provide an excellent way to trade on volatility. Here is what you would have to do: 1. Buy call options on the index at a strike K and maturity T, and 2. Buy put options on the index at the same strike K and of maturity T. This combination of options is often referred to as a Straddle and is an appropriate strategy for an investor who expects a large move in the index but does not know in which direction the move will be. Consider an investor who feels that the index which currently stands at 1252 could move significantly in three months. The investor could create a straddle by buying both a put and a call with a strike close to 1252 and an expiration date in three months. Suppose a three month call at a strike of 1250 costs Rs.95.00 and a three month put at the same strike cost Rs.57.00. To enter into this positions, the investor faces a cost of Rs.152.00. If at the end of three months, the index remains at 1252, the strategy costs the investor Rs.150. (An up-front payment of Rs.152, the put expires worthless and the call expires worth Rs.2). If at expiration the index settles around 1252, the investor incurs losses. However, if as expected by the investors, the index jumps or falls significantly, he profits. For a straddle to be an effective strategy, the investor’s beliefs about the market movement movement must be different different from those of most other market participants. participants. If the general


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view is that there will be a large jump in the index, this will reflect in the prices of the options. Figure 7.5

Payoff for buyer of three-month call and put options at strikes of 1250

The figure shows the profits/losses profits/losses for a combinatio combinationn of a long call and a long put at the same strike and expiration. The investor has bought both a call and a put on the Nifty index. If on the expiration date, the index closes between 1098 and 1402, he losses a maximum of Rs.152. If however, his expectation of high volatility does come true, his profits are potentially unlimited. If for instance the index jumps to 1420, he makes a neat profit of Rs.18 i.e. (1420-1250)-152. The effectiveness of this combination depends how diffe differen rentt is the the inves investo tors rs beli belief ef about about marke markett move moveme ment nt from from that that of most most other other participants. The higher the cost of setting up this combination, the more the index would have to move for it to be profitable.

Profit

1098 |

1193 |

1250 |

1345 |

1402 |

57.00 95.00 152.00

Loss

Table 7.3 Three-month calls and puts trading at different strikes

Given below are the three-month call and put option premia on the S&P CNX Nifty. An investor who decides to play on the volatility of the market must decide at what strike to


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generate the straddle. In this case he has three three-month option contracts to choose from. Nifty

Strike price of option

Call Premium (Rs.)

Put Premium (Rs.)

1248 1248 1248

1250 1245 1230

48 50.65 59.05

38.30 35.95 29.50

7.5 S6: Bull spreads - Buy a call and sell another There are times when you think the market is going to rise over the next two months, however in the event that the market does not rise, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes up is called a bull spread. The cost of the bull spread is the cost of the option that is purchased, less the cost of the option that is sold. Table 7.4 gives the profit/loss incurred on a spread position as the index changes. Figure 7.6 shows the payoff from the bull spread. Broadly, we can have three types of bull spreads: 1. Both calls initially out-of-the-money, 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing to take. The most aggressive aggressive bull spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. Table 7.4 Expiration day cash flows for a Bull spread using two-month calls

The table shows possible expiration day profit for a bull spread created by buying one market lot of calls at a strike of 1260 and selling a market lot of calls at a strike of 1350. The cost of setting up the spread is the call premium paid (Rs.76.50) minus the call premium received (Rs.37.85), which is Rs.38.65. This is the maximum loss that the position will make. On the other hand, the maximum profit on the spread is limited to


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Rs.51.35. Beyond an index level of 1350, any profits made on the long call position will be cancelled by losses made on the short call position, effectively limiting the profit on the combination.

Nif Nifty ty

124 5 125 5 126 5 127 5 128 5 129 5 130 5 131 5 132 5 133 5 134 5 135 5 136 5

Figure 7.6

Buy Buy Jan Jan 1260 12S60 ell Jan 1350 Cash Flow Call Call

Profit & Loss (Rs.)

0 0 +5 +15 +25 +35 +45 +55 +65 +75 +85 +95 +105

-38.95 -38.65 -33.65 -23.656 -13.65 -3.65 +6.35 +16.35 +26.35 +36.35 +46.35 +51.35 +51.35

0 0 0 0 0 0 0 0 0 0 0 -5 - 15

0 0 5 15 25 35 45 55 65 75 85 90 90

Payoff for a bull spread created using call options

The figure shows the profits/losses for a bull spread.As the index moves above 1260, the position starts making profits (cutting losses) until the spot reaches 1350. Beyond 1350, the profits made on the long call position get offset by the losses made on the short call position and hence the maximum profit on this spread is made if the index on the expiration day closes at 1350. Hence the payoff on this spread lies between 38.85 to 51.35. Profit 51.35

37.85 1260

1298.65

1336.50

1350

1387.85

Derivatives – Indian Scenario Loss

|

- 83 |

|

|

|

38.65 76.50

7.6 S7: Bear spreads - sell a call and buy another There are times when you think the market is going to fall over the next two months, however in the event that the market does not fall, you would like to limit your downside. One way you could do this is by entering into a spread. A spread trading strategy involves taking a position in two or more options of the same type, that is, two or more calls or two or more puts. A spread that is designed to profit if the price goes down is called a bear spread. A bear spread created using calls involves initial cash inflow since the price of the call sold is greater than the price of the call purchased. Table 7.5 gives the profit/loss incurred on a spread position as the index changes. Figure 7.7 shows the payoff from the bull spread. Broadly we can have three types of bear spreads: 1. Both calls initially out-of-the-money, 2. One call initially in-the-money and one call initially out-of-the-money, and 3. Both calls initially in-the-money. The decision about which of the three spreads to undertake depends upon how much risk the investor is willing willing to take. The most aggressive aggressive bear spreads are of type 1. They cost very little to set up, but have a very small probability of giving a high payoff. As we move from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative and cost higher to set up. Bear spreads can also be created by buying a put with a high strike price and selling a put with a low strike price. Payoff for a bear spread created using call options The figure shows the profits/losses for a bear spread. As can be seen, the payoff obtained is the sum of the payoffs of the two calls, one sold at Rs.76.50 and the other bought at Rs.37.85. The maximum gain from setting up the spread is Rs.38.65 which is the

Figure 7.7


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difference difference between the call premium received received and the call premium paid. The upside on the position is limited to this amount. Hence the payoff on this spread lies between +38.85 to -51.35.

Profit 76.50

38.65 1260 1298.65 1336.50 1350 | | | |

1387.85 |

37.85 51.35

Loss Table 7.5 Expiration day cash flows for a Bear spread using two-month calls

The table shows possible expiration day profit for a bear spread created by selling one market lot of calls at a strike of 1260 and buying a market lot of calls at a strike of 1350.

Nif Nifty ty

124 5 125 5 126 5 127 5 128 5 129 5 130 5 131 5 132 5 133 5 134 5

Buy Buy Jan Jan 1350 13S50 ell Jan 1260 Cash Flow Call Call

Profit & Loss (Rs.)

0 0 0 0 0 0 0 0 0 0 0

+38.95 +38.65 +33.65 +23.656 +13.65 +3.65 - 6. 3 5 -16.35 -26.35 -36.35 -46.35

0 0 -5 - 15 - 25 - 35 - 45 - 55 - 65 - 75 - 85

0 0 -5 - 15 - 25 - 35 - 45 - 55 - 65 - 75 - 85

Derivatives – Indian Scenario 135 5 136 5

+5 +15

- 85 - 95 - 105

- 90 - 90

-51.35 - 5 1. 3 5

7.7 A3: Put-call parity with spot-options arbitrage Have you ever wondered how the put prices relate to the call prices? If you happen to know the call price on an asset, would that help you to get some idea of the price of a put on the same asset? Do put prices have anything at all to do with call prices? Of course, they do. The put and the call prices are related by a condition called the put-call parity. We shall see how. Put-call parity

To get an intuitive understanding about the put-call parity, we could think of it in the following way. I buy the asset on spot, paying S. I buy a put at X, paying P, so my downside below X is taken care of (if S < X, I will exercise the put). I sell a call at X, earning C, so if S > X, the call holder will exercise on me, so my upside beyond X is gone. This gives me X on T with certainty. This means that the portfolio of S+P-C is nothing but a zero-coupon bond which pays X on date T. What happens if the above equation does not hold good ? It gives rise to arbitrage opportunities. The put-call parity basically explains the relationship between put, call, stock and bond prices. It is expressed as: S + P – C = X / (1+r) T Where: S: Current index level X: Exercise price of option T: Time to expiration C: Price of call option P: Price of put option R: risk-free rate of interest


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The above expression expression shows that the value value of a Europea Europeann call call with with a certai certainn exercis exercisee price and exercise date can be deduced from the value of a European put with the same exercise exercise price and date and vice versa. It basically basically means that the payoff from holding a call plus an amount of cash equal to X / (1+r) T is the same as that of holding a put option plus the index. Case 1

Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96.50 and the price of a three month Nifty 1260 put is Rs.60. In this case we can see that S + P – C (not equal to) X / (1+r) T 1325 > 1321.30 What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio A is overpriced relative to portfolio B. What would be the arbitrage strategy in this case? Sell the securities in portfolio A and buy those in portfolio B. This involves shorting the index and a put on the index and buying a call. How would one short the index? One way to do it would be to actually sell off all 50 Nifty stocks in the proportions proportions in which they exist in the index. Another easier way to do this would be to sell units of Index funds instead of the actual index stocks. This would achieve a similar similar outcome. This entire set of transactions transactions generates generates an up-front cash-flow of (1265 + 60 - 96.50) = Rs.1228.50. When invested at the riskfree rate of 12%, this amount grows to Rs.1265.35. At expiration, if the index is higher than 1260, you will exercise the call. If the index is lower than 1260, the buyer of the put will exercise on you. In either case, the investor ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.5.35 (i.e. 1265.35-1260). How do we actually do this?

1. Sell off all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done using a single keystroke using the NEAT software.


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2. Sell a three month Nifty 1260 put. 3. Buy a three month Nifty 1260 call. 4. You will receive the money for the stocks and the put sold and have to make delivery delivery of the 50 shares. 5. Invest this money at the riskless interest rate. In three months Rs.1228.50 will grow to Rs.1265.35. 6. On the exercise date at 3:15 PM, if the Nifty is above 1260, exercise the call. If the Nifty is below 1260, the put will be exercised on you. 7. Either way, you end up buying the index at Rs.1260. 8. The riskless profit on the transaction works out to be Rs.5.35. Case 2:

Suppose Nifty stands at 1265, the risk-free rate of interest is 12% per annum, the price of a three month Nifty 1260 call is Rs.96 and the price of a three month Nifty 1260 put is 51.50. In this case, we can see that S + P – C (not equal to) X / (1+r) T 1316.50 < 1320.80 What does this mean? If we think of index plus put as portfolio A and the call plus cash as portfolio B, clearly portfolio B is overpriced relative to portfolio A. What would be the arbitrage strategy in this case? Buy the securities in portfolio A and sell those in portfolio B. This involves buying the index and a put on the index and selling a call. How would one buy the index? One way to do it would be to actually buy all 50 Nifty stocks in the proportions in which they exist in the index. An easier way to do this would be to buy units of Index funds instead of the actual index stocks. This would achieve a similar outcome. outcome. This entire set of transactions transactions involves an initial initial investment of Rs.1220.50(i.e Rs.1220.50(i.e.. 1265 - 51.50 + 96) When financed at the riskfree riskfree rate of 12%, the repayment repayment required at the end of three months is Rs.1257. At expiration if the index is lower than 1260, you will exercise the put. If the index is higher than 1260, the buyer of the call will exercise on you. In either case, the investor


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ends up buying the index at Rs.1260. Hence the net profit on the entire transaction is Rs.3 (1260 - 1257). How do we actually do this?

1. Buy all 50 index shares on the cash market in the proportion in which they exist in the index. This can be done using a single keystroke using the NEAT software. 2. Buy a three month Nifty 1260 put. 3. Sell a three month Nifty 1260 call. 4. You will have to pay for the shares and the put, and will receive the call premium. The entire set of transactions will require an initial outflow of Rs.1221.20. 5. Finance this money at the riskless interest rate. The repayment at the end of three months works out to Rs.1257. 6. On the exercise date at 3:15 PM, if the Nifty is below 1260, exercise the put. If the Nifty is above 1260, the call will be exercised on you. 7. Either way, you end up selling the index at Rs.1260. 8. The riskless profit on the transaction works out to be Rs.3.

7.8 A4: Arbitrage beyond option price bounds The value of an option before expiration depends on six factors: ¦

The level of the underlying index ¦

The exercise price of the option ¦

The time to expiration ¦

The volatility of the index The risk-free rate of interest ¦

Dividends expected during the life of the option These factors set general boundaries for possible option prices. If the option price is above above the the uppe upperr bound bound or belo below w the the lowe lowerr bound bound,, ther theree are are profi profita tabl blee arbi arbitr trage age opportunities. We shall try to get an intuitive understanding about these bounds. Upper bounds for calls and puts


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A call option gives the holder the right to buy the index for a certain price. No matter what happens, the option can never be worth more than the index. Hence the index level is an upper bound to the option price. C (less than equal to) I If this relationship is not true, an arbitrageur can easily make a riskless profit by buying the index and selling the call option. As we know a put option gives the holder the right to sell the index for X. No matter how low the index becomes, the option can never be worth more than X. Hence, P (less than equal to) X If this is not true, an arbitrageur would make profit by writing puts. Lower bounds for calls and puts

The lower bound for the price of a call option is given by S-X (1+r) –T The price of a call must be worth at least this much else, it will be possible to make risk less profit S-X (1+r) –T < C Consider an example. Suppose the exercise price for a three-month Nifty call option is 1260. The spot index stands at 1386 and the risk-free rate of interest is 12% per annum. In this case, he lower lower bound for the option option price is 1386-1260 1386-1260 (1+1.2) –0.25 i.e. 161.20 Suppose the call is available at a premium of Rs.150 which is less than the theoretical minimum of Rs. 163.20. An arbitrageur can buy a call and short the index. This provides a cashflow of 1386-150 = 1236. If invested for three months at 12% per annum, the Rs.1236 grows to Rs.1273. At the end of three months, the option expires. At this point, the following could happen: 1. The index is above 1260, in which case the arbitrageur exercises his option and buys back the index at 1260 making a profit of Rs.1273 - 1260 = Rs.13. 2. The index is below 1260 at say 1235, in which case the arbitrageur buys back the index at the market price. He makes an even greater profit of 1273 - 1235 = Rs.38.


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The lower bound for the price of a put option is given by X (1+r) -T –S. The price of a put must be worth at least this much else, it will be possible to make riskless profits. X (1+r) -T –S. < P Consider Consider an Example. Suppose exercise price for three- month Nifty put option is 1260. The spot index stands at 1165 and the risk-free rate of interest is 12% per annum. In this case the lower bound for the option price is Rs.59.80. Suppose the put is available at a premium of Rs.45 which is less than the theoretical minimum of Rs.59.80. An arbitrageur can borrow Rs.1210 for three months to buy both the put and the index. At the end of the three months, the arbitrageur will be required to pay Rs.1246.3. Three months later the option expires. At this point, the following could happen: 1. The index is below 1260, in which case the arbitrageur exercises his option, sells the index at Rs.1260, repays the loan amount of Rs.1246.3 and makes a profit of Rs.13.7. 2. The index is above 1260 at say 1275, in which case the arbitrageur discards the option, sells the index at 1275, repays the loan amount of Rs.1246.3 and makes an even greater profit of 1275 - 1246.3 = Rs.28.7.


Bibliography


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Books 1. Option Optionss Futures, Futures, and and other other Derivat Derivative ivess by John C Hull Hull 2. Deri Deriva vati tive vess FAQ by by Ajay Ajay Sha Shahh 3. NSE’s Certifi Certification cation in Financia Financiall Markets: Markets: - Derivat Derivatives ives Core module module 4. Investm Investment ent Moni Monitor tor Maga Magazin zinee July July 2001 2001

Reports 1. Regulatory Regulatory framework framework for for financial financial derivati derivatives ves in India India by Dr. L.C.Gupt L.C.Guptaa 2. Risk containment containment in the the derivati derivatives ves markets markets by Prof.J.R.Verma Prof.J.R.Verma

Websites •

www.derivativesindia.com

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www.nse-india.com

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www.sebi.gov.in

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www.rediff/money/derivatives.htm

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www.igidr.ac.in/~ajayshah

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www.iinvestor.com

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www.appliederivatives.com

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www.erivativesreview.com

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www.economictimes.com

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www.cboe.com (Chicago Board of Exchange)

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www.adtading.com

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www.numa.org



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Derivatives Project Report

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