Q1.1: What is a "spot" transaction?
A: In a spot market, transactions are settled "on the spot". Once a trade is agreed upon, the settlement – i.e. the actual exchange of money for goods – takes place with the minimum possible delay. When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market.
Q1.2: That's okay for shirts - but does it ever happen in finance?
A: There are two real–world implementations of a spot market: rolling settlement and real-time gross settlement (RTGS). With rolling settlement, trades are netted through one day, and settled x working days later; this is called T + x rolling settlement. For example, with T+5 rolling settlement, trades are netted through Monday, and the net open position as of Monday evening is settled on the coming Monday. Similarly, trades are netted through Tuesday, and settled on the coming Tuesday. With RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close approximation, and RTGS is a true spot market. The equity market in India today, for the major part, is not a spot market. For example, the bulk of trading on NSE takes place with netting from Wednesday to Tuesday, and
then settlement takes place five days later. This is not a spot market. The "international standard" in equity markets is T+3 rolling settlement.
Q1.3: What is a "forward" transaction?
A: In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon. Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2001 at Rs.5,000/tola. Here, Rs. 5,000/tola is the "forward price of 31 Dec 2001 Gold". The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31
Dec 2001, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2001, and give 100 tolas of gold in exchange.
Q1.4: What are "derivatives"?
A: A derivative is a financial instrument which derives its value from some other financial price. This "other financial price" is called the underlying. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the "derivative" and wheat on the
spot market is "the underlying". The terms "derivative contract", "derivative product", or "derivative" are used interchangeably. The most important derivatives are futures and options.
Q1.5: What are "exchange–traded derivatives"?
A: Derivatives which trade on an exchange are called "exchange–traded derivatives". Trades on an exchange generally take place with anonymity. Trades at an exchange generally go through the clearing corporation.
Q1.6: What are "OTC derivatives"?
A: A derivative contract which is privately negotiated is called an OTC derivative. OTC trades have no anonymity, and they generally do not go through a clearing corporation. Every derivative product can either trade OTC (i.e., through private negotiation), or on an exchange. In one specific case, the jargon demarcates this clearly: OTC futures contracts are called "forwards" (or, exchange–traded forwards are called "futures"). In other cases, there is no such distinguishing notation. There are "exchange–traded options" as opposed to "OTC options"; but they are both called options.
Q1.7: Is "badla" trading like derivatives trading?
A: No. Badla is a mechanism to avoid the discipline of a spot market; to do trades on the spot market but not actually do settlement. The "carryforward" activities are mixed together with the spot market. A well functioning spot market has no possibility of carryforward. Derivatives trades take place distinctly from the spot market. The spot price is separately observed from the derivative price. A modern financial system consists of a spot market which is a genuine spot market, and a derivatives market which is separate from the spot market.
Q1.8: What are the instruments traded in the derivatives industry, and what are their relative sizes?
A: This information is summarised in Tables 1.1 and 1.2 which are taken from Jorion (2000).
Q1.9: Why is hedging using derivatives termed "risk transfer"?
A: One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy. This can be viewed as being like insurance, with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance. A risk averse person buys insurance; a risk–seeking person sells insurance. On an options market, an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options. One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way. In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates. By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk.
In these ways, derivatives supply a method for people to do hedging and reduce their risks. As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).
Q1.10: What happens to market quality and price formation on the cash market once derivatives trading commences?
A: The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once derivatives trading comes about. Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market. Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities,
and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency.
From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market. Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market.
A liquid derivatives market tends to become the focus of speculation and price discovery. When news breaks, the derivative market reacts first. The information propagates down to the cash market a short while later, through the activities of arbitrageurs.
Forward contracts
Q2.1: Why is forward contracting useful?
A: Forward contracting is valuable in hedging and speculation. The classic hedging application is that of a wheat farmer forward-selling his harvest, at the time of sowing, in order to eliminate price risk. Conversely, a bread factory could buy wheat forward in order to assist production planning without the risk of price fluctuations. If a speculator has information or analysis which forecasts an upturn in a price, then she can adopt a buy position (go long) on the forward market instead of the cash market. The speculator would wait for the price to rise, and then close out the position on the forward market (by selling off the forward contracts). This is a good alternative to speculation using the spot market, which involves buying wheat, storing it for a while, and then selling it off. A speculator prefers transactions involving a forward market because (a) the costs of taking or making delivery of wheat is avoided, and (b) funds are not blocked for the purpose of speculation.
Q2.2: What is "leverage"?
A: Suppose a user of a forward market adopts a position worth Rs.100. As mentioned above, no money changes hands at the time the deal is signed. In practice, a good–faith deposit would be needed. Suppose the user puts up Rs.5 of collateral. Using Rs.5 of capital, a position of Rs.100 is taken. In this case, we say there is "leverage of 20 times". This example involves a forward market. More generally, all derivatives involve leverage. Leverage makes derivatives useful; leverage is also the source of a host of disasters, payments crises, and systemic risk on financial markets. Understanding and controlling
leverage is equivalent to understanding and controlling derivatives.
Q2.3: What are the problems of forward markets?
A: Forward markets tend to be afflicted by poor liquidity and from unreliability deriving from "counterparty risk" (also called "credit risk").
Q2.4: Why do forward markets have poor liquidity?
A: One basic problem of forward markets is that of too much flexibility and generality. The forward market is like the real estate market in that any two consenting adults can form custom–designed contracts against each other. This often makes them design terms of the deal which are very convenient in that specific situation; this can make the contracts non-tradeable since others might not find those specific terms useful. In addition, forward markets are like the real estate market in that buyers and sellers find each other using telephones. This is inefficient and time–consuming. Every user
faces the risk of not trading at the best price available in the country. Forward markets often turn into small clubs of dealers who earn elevated intermediation fees. This elevates the fees paid by users, i.e. it makes the forward market illiquid from the user perspective.
Q2.5: Why are forward markets afflicted by counterparty risk?
A: A forward contract is a bilateral relationship between two people. Each requires good behaviour on the part of the other for the contract to perform as promised. Suppose L agrees to buy gold from S at a future date T at a (forward) price of Rs.5,000/tola. If, on date T, the gold spot price is at Rs.4,000/tola, then L loses Rs.1,000/tola and S gains Rs.1,000/tola by living up to the terms of the contract. When L buys at Rs.5,000/tola by the terms of the contract, he is paying Rs.1,000 more than what could be obtained on the spot market at the same time. Hence, L is tempted to declare bankruptcy and avoid performing as per the contract. Conversely, if on date T the gold spot price is at Rs.6,000/tola, then L gains and S loses by living up to the terms of the contract. S stands to sell gold at Rs.5,000/tola by the terms of the contract, which is Rs.1,000/tola worse than what could be obtained by selling into the spot market at date T. In this case, S is tempted to declare bankruptcy and avoid performing as per the contract. In either case, this leads to counterparty risk. When one of the two sides of the transaction chooses to declare bankruptcy, the other suffers. Forward markets have one basic property: the larger the time period over which the forward contract is open, the larger are the potential price movements, and hence the larger is the counterparty risk.
Q2.6: How does counterparty risk affect liquidity?
A: A market where counterparty risk is present generally collapses into a small club of participants, who have homogeneous credit risk, and who have formed social and cultural methods for handling bankruptcies. Club markets do not allow for free entry into intermediation. They support elevated
intermediation fees for club members, have fewer market participants, and result in reduced liquidity.
Sometimes, regulators who are afraid of payments crises forcibly shut out large numbers of participants from an OTC derivatives market. This automatically generates a club market, and yields a fraction of the liquidity which could come about if participation could be enlarged.
Futures
Q3.1: What is "price–time priority"?
A: A market has price–time priority if it gives a guarantee that every order will be matched against the best available price in the country, and that if two orders are equal in price, the one which came first will be matched first. Forward markets, which involve dealers talking to each other on phone, do not have price–time priority. Floor–based trading with open–outcry does not have price–time priority. Electronic exchanges with order matching, or markets with a monopoly market maker, have price–time priority. On markets without price–time priority, users suffer greater search costs, and there is a greater risk of fraud.
Q3.2: What is a futures contract?
A: A futures contract is a forward contract which trades on an exchange.
Q3.3: How does the futures market solve the problems of forward markets?
A: Futures markets feature a series of innovations in how trading is organised:
• Futures contracts trade at an exchange with price–time priority. All buyers and sellers come to one exchange. This reduces search costs and improves liquidity. This harnesses the gains that are commonly obtained in going from a non–transparent club market (based on telephones) to an anonymous, electronic exchange which is open to participation. The anonymity of the exchange environment largely eliminates cartel formation.
• Futures contracts are standardised – all buyers or sellers are constrained to only choose from a small list of tradeable contracts defined by the exchange. This avoids the illiquidity that goes along with the unlimited customisation of forward contracts.
• A new credit enhancement institution, the clearing corporation, eliminates counterparty risk on futures markets. The clearing corporation interposes itself into every transaction, buying from the seller and selling to the buyer. This is called novation. This insulates each from the credit risk of the other. In futures markets, unlike in forward markets, increasing the time to expiration does not increase the counterparty risk. Novation at the clearing corporation makes it possible to have safe trading between
strangers. This is what enables large–scale participation into the futures market – in contrast with small clubs which trade by telephone – and makes futures markets liquid.
Q3.4: What is cash settlement?
A: The forward or futures contracts discussed so far involved physical settlement. On 31 Dec 2001, the seller was supposed to come up with 100 tolas of gold and the buyer was supposed to pay for it. In practice, settlement involves high transactions costs. This is particularly the case for products such as the equity index, or an inter–bank deposit, where effecting settlement is extremely difficult or impossible. In these cases, futures markets use "cash settlement". Here, the terminal value of the product is deemed to be equal to the price seen on the spot market. This is used to determine cash transfers from the counterparties of the futures contract. The cash transfer is treated as settlement.
Example. Suppose L has purchased 30 units of Nifty from S at a price of 1500 on 31 Dec 2000. Suppose we come to the expiration date, i.e. 31 Dec 2000, and the Nifty spot is actually at 1600. In this case, L has made a profit of Rs.100 per Nifty and S has made a loss of Rs.100 per Nifty. A profit/loss of Rs.100 per nifty applied to a transaction of 30 nifties translates into a profit/loss of Rs.3,000. Hence, the clearing corporation organises a payment of Rs.3,000 from S and a payment of Rs.3,000 to L. This is called cash settlement. Cash settlement was an important advance, which extended the reach of derivatives into many products where physical settlement was unviable.
Q3.5: What determines the price of a futures product?
A: Supply and demand on the secondary market determines the futures price. On dates prior to 31 Dec 2000, the "Nifty futures expiring on 31 Dec 2000" trade at a price that purely reflect supply and demand. There is a separate order book for each futures product which generates its own price. Economic arguments give us a clear idea about what the price of a futures should be. If the secondary market prices deviate from these values, it would imply the presence of arbitrage opportunities, which (we might expect) would be swiftly exploited. But there is nothing innate in the market which forces the theoretical prices to come about.
Q3.6: Doesn't the clearing corporation adopt an enormous risk by giving out credit guarantees to all brokerage firms?
A: Yes, it does.
If a brokerage firm goes bankrupt with net obligations of Rs.1 billion, the clearing corporation has a legal obligation of Rs.1 billion. The clearing corporation is legally obliged to either meet these obligations, or go bankrupt itself. There is no third alternative. There is no committee that meets to decide whether the settlement fund can be utilised; there are no escape clauses. It is important to emphasise that when L buys from S, at a legal level, L has bought from the clearing corporation and the clearing corporation has bought from S. Whether S lives up to his obligations or not, the clearing corporation is the counterparty to L. There is no escape clause which can be invoked by the clearing corporation if S defaults.
Q3.7: How does the clearing corporation assure it does not go bankrupt itself?
A: The futures clearing corporation has to build a sophisticated risk containment system in order to survive. Two key elements of the risk containment system are the "mark to market margin" and "initial margin". These involve taking collateral from traders in such a way as to greatly diminish the incentives for traders to default. Electronic trading has generated a need for online, realtime risk monitoring. In India, trading takes place swiftly and funds move through the banking system slowly. Hence the only meaningful notion of initial margin is one that is paid upfront. This leads to the notion of brokerage firms placing collateral, and obtaining limits upon the risk of their position as a function of the amount of collateral with the clearing corporation.
Q3.8: Can we concretely sketch the operations of one futures market?
A: On 1 January, an exchange decides to trade three gold futures contracts with expiration 31 Jan, 28 Feb and 31 Mar respectively. The three futures contracts all trade at the same time, with three distinct prices. Traders can buy/sell all three contracts as they please. All through January, no settlement takes place. Positions are netted; i.e. if a person buys 100g of 31 Jan gold and then (a few days later) sells off 100g of 31 Jan gold, his net position drops to 0. Trading for the January contract stops on 31 Jan. All net open positions on this contract, as of the close of trading of 31 Jan, have to do settlement on 2 February (T+2 settlement). A buy position (as of close of trading on 31 Jan) has to bring money on 2
Feb, and a sell position (as of close of trading on 31 Jan) has to bring gold on 2 Feb. On 1 Feb, when trading commences, the exchange announces the start of trading on a new contract, one which expires on 30 Apr, thus ensuring that three contracts always trade at any one time. Similarly, on 28 Feb, trading for the Feb contract stops. On 1 March, a new 31 May contract is born. On 2 March, open positions of the Feb contract are settled.
Q3.9: Why is the equity cash market in India said to have "futures-style settlement"?
A: India's "cash market" for equity is ostensibly a cash market, but it functions like a futures markets in every respect. NSE's "EQ" market is a weekly futures market with tuesday expiration. The trading
modalities on NSE from wednesday to tuesday, in trading ITC, are exactly those that would be seen if a futures market was running on ITC with tuesday expiration. On NSE, when a person buys on thursday, he is not obligated to do delivery and payment right away, and this buy position can be reversed on friday thus leaving no net obligations. Equity trading on NSE involves leverage of seven times. Like all futures markets, trading at the NSE is centralised and there is no counterparty risk owing to novation at the clearing corporation (NSCC). The only difference between ITC trading on NSE, and ITC trading on a true futures market, is that futures contracts with several different expiration dates would all trade at the same time on a true futures market; this is absent on India's "cash market".
Options
Q4.1: What is an "option"?
A: An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price. A "call option" gives one the right to buy, a "put option" gives one the right to sell. Consider a typical transaction. On 1 July 2000, S sells a call option to L for a price of Rs.3.25. Now L has the right to come to S on 31 Dec 2000 and buy 1 share of Reliance at Rs.500. Here, Rs.3.25 is the "option price", Rs.500 is the "exercise price" and 31 Dec 2000 is the "expiration date". L does not have to buy 1 share of Reliance on 31 Dec 2000 at Rs.500 from S (unlike a forward/futures contract which is binding on both sides). It is only if Reliance is above Rs.500, on 31 Dec 2000, that L will find it useful to exercise his right. If L chooses to exercise the option, S is obliged to live up to his end of the deal: i.e. S stands ready to sell a share of Reliance to L at Rs.500 on 31 Dec 2000. Hence, at option expiration, there are two outcomes that are possible: an option could be profitably exercised, or it could be allowed to die unused. If the option lapses unused, then L has lost the original option price (Rs.3.25) and S has gained it. When L and S enter into a futures contract, there is no payment (other than initial margin). In contrast, the option has a positive price which is paid in full on the date that the option is purchased.
Options come in two varieties – european and american. In a european option, the holder of the option can only exercise his right (if he should so desire) on the expiration date. In an american option, he can exercise this right anytime between purchase date and the expiration date. The price of an option is determined on the secondary market. An option always has a non-negative value: i.e., the value of an option is never negative.
Q4.2: How would index options work?
A: As with index futures, index options are cash settled. Suppose Nifty is at 1500 on 1 July 2000. Suppose L buys an option which gives him the right to buy Nifty at 1600 from S on 31 Dec 2000. It turns out that this option is worth roughly Rs.90. So a payment of Rs.90 passes from L to S for having this option. When 31 Dec 2000 arrives, if Nifty is below 1600, the option is worthless and lapses without exercise. Suppose Nifty is at 1650. Then (in principle) L can exercise the option, buy Nifty using the option at 1600, and sell off this Nifty on the open market at 1650. So L has a profit of Rs.50 and S has a loss of Rs.50. In this case, "cash settlement" consists of NSCC imposing a charge of Rs.50 upon S and paying it to L.
Q4.3: What kinds of Nifty options would trade?
A: The strike prices and expiration dates for traded options are selected by the exchange. For example, NSE may choose to have three expiration months, and five strike prices (1200,1300,1400,1500,1600). There would be two types of options: put and call. This gives a total of 30 distinct traded options (3 × 5 × 2), with 30 distinct order books and prices. A typical set of option prices is shown in Table 4.1. It illustrates the intruiging nature of option prices. When Nifty is at 1500, the right to buy Nifty at 1600 one month away is worth little (Rs.13). The buyer of this option puts down Rs.13 when the option is purchased, and this fee is non–refundable. If Nifty turns out to be above 1600 after a month, this option will prove to be valuable. If Nifty proves to be at 1602 after a month, the option will pay Rs.2.
Conversely when Nifty is at 1500, the right to sell Nifty at 1400 one month away isn't worth much (Rs.
: this is the "insurance premium" for protecting yourself against a fall in Nifty of worse than a hundred points. However, when we increase the time to expiration of the option, there is a greater chance that prices can move around, and these same options become worth more: e.g. the right to sell Nifty at 1600 is worth Rs.25 when we consider a three–month horizon (i.e. insurance against a hundred–point drop on a three–month horizon). Q4.4: When would one use options instead of futures?
A: 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 a futures: which is free to enter
into, but can generate very large losses. This characteristic makes options attractive to many occasional market participants, who cannot put in the time to closely monitor their futures positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy insurance which reimburses the full extent to which Nifty drops below the strike price of the put option. This is attractive to many people, and to mutual funds creating "guaranteed return products". 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. Selling put options is selling insurance, so anyone who feels like earning revenues by selling insurance can set himself up to do so on the index options market. More generally, options offer "nonlinear payoffs" whereas futures only have "linear payoffs". By combining futures and options, a wide variety of innovative and useful payoff structures can be created.
Q4.5: What are the patterns found, internationally, in options versus futures products on a given underlying?
A: In general, both futures and options trade on all underlyings abroad. Indeed, the international
practice is to launch futures and options on a new underlying on the same day.
Q4.6: What determines the price of an option?
A: Supply and demand on the secondary market drives the option price. 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. If the secondary market prices deviate from these values, it would imply the presence of arbitrage 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.
Indian Derivatives Scenario
Q5.1: What is the status of derivatives in the equity market in India?
A: As mentioned in Question 3.9, trading on the "spot market" for equity has actually always been a futures market with weekly or fortnightly settlement. These futures markets feature the risks and difficulties of futures markets, without the gains in price discovery and hedging services that come with a separation of the spot market from the futures market. India's primary market has experience with derivatives of two kinds: convertible bonds and warrants (a slight variant of call options). Since these warrants are listed and traded, options markets of a limited sort already exist. However, the trading on these instruments is very limited.
A variety of interesting derivatives markets exist in the informal sector. These markets trade contracts like bhav-bhav, teji-mandi, etc. For example, the bhav-bhav is a bundle of one in-the-money call option and one in-the-money put option. These informal markets stand outside the mainstream institutions of India's financial system and enjoy limited participation.
In 1995, NSE asked SEBI whether it could trade index futures. In 2000, SEBI gave permissions to NSE and BSE to trade index futures. In addition, futures and options on Nifty will also trade at the Singapore Monetary Exchange (SIMEX) from end–August 2000.
Q5.2: What derivatives exist in India in the interest-rates area?
A: The RBI has permitted OTC trades in interest rate forwards and swaps. These markets have so far had very little liquidity.
Q5.3: What derivatives exist in India in the foreign exchange area?
A: 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 other currencies on foreign markets. Outside India, there is a small market for cash–settled forward contracts on the dollar–rupee exchange rate.
Q5.4: What is the status in India in the area of commodity derivatives?
A: India produces a range of commodities that enjoy a high global rank in production. The weighted rank of India in the global supply function pertinent to these commodities is between two and three. The impact of the commodity sector on the total economy is considerable. A reforms program towards building commodity futures exchanges is being effected under the aegis of the Forward Markets Commission (FMC), which is constituted under the Ministry of Consumer Affairs and Public Distribution.
Futures contracts in pepper, turmeric, gur (jaggery), hessian (jute fabric), jute sacking, castor seed, potato, coffee, cotton, and soybean and its derivatives are traded in 18 commodity exchanges located in various parts of the country. Futures trading in other edible oils, oilseeds and oil cakes have been permitted. Trading in futures in the new commodities, especially in edible oils, is expected to commence in the near future. The sugar industry is exploring the merits of trading sugar futures contracts. The policy initiatives and the modernisation programme include extensive training, structuring a reliable clearinghouse, establishment of a system of warehouse receipts, and the thrust towards the establishment of a national commodity exchange. The Government of India has constituted a committee to explore and evaluate issues pertinent to the establishment and funding of the proposed national commodity exchange for the nationwide trading of commodity futures contracts, and the other institutions and institutional processes such as warehousing and clearinghouses.
With commodity futures, delivery is best effected using warehouse receipts (which are like dematerialised securities). Warehousing functions have enabled viable exchanges to augment their strengths in contract design and trading. The viability of the national commodity exchange is predicated on the reliability of the warehousing functions. The programme for establishing a system of warehouse receipts is in progress. The Coffee Futures Exchange India (COFEI) has operated a system of warehouse receipts since 1998.
Q5.5: Do Indian derivatives users have access to foreign derivatives markets?
A: The RBI setup a committee, headed by R. V. Gupta, which has established guidelines through which Indian users can obtain hedging services using derivatives exchanges outside India.
Q5.6: Why do people talk about "starting derivatives in India" if some derivatives already exist?
A: It is useful to note here that there are no exchange-traded financial derivatives in India today. Neither the dollar-rupee forward contract (Question 5.3) nor the option-like contracts (Question 5.1) are exchange-traded. These markets hence lack centralisation of price discovery and can suffer from counterparty risk. We do have exchanges trading derivatives, in the form of commodity futures exchanges. However, they do not use financials as underlyings. In this sense, the index futures market will be the first exchange–traded derivatives market, which uses a financial underlying.
Equity derivatives
Q6.1: Worldwide, what kinds of derivatives are seen on the equity market?
A:Worldwide, the most successful equity derivatives contracts are index futures, followed by index options, followed by security options.
Q6.2: At the individual stock level, are futures or options better?
A: Internationally, options on individual stocks are commonplace; futures on individual stocks are rare. This is partly because regulators (e.g. in the US) frown upon the idea of doing futures trading on individual stocks.
Q6.3: Why have index derivatives proved to be more important than individual stock derivatives?
A: Security options are of limited interest because the pool of people who would be interested (say) in options on ACC is limited. In contrast, every single person with any involvement in the equity market is affected by index fluctuations. Hence risk-management using index derivatives is of far more importance than risk-management using individual security options.
This goes back to a basic principle of financial economics. Portfolio risk is dominated by the market index, regardless of the composition of the portfolio. All portfolios of around ten stocks or more have a pattern of risk where 70% or more of their risk is indexrelated. Hence investors are more interested in using index–based derivative products. Index derivatives also present fewer regulatory headaches when compared to leveraged trading on individual stocks. Internationally, this has led to regulatory encouragement for index futures and discouragement against futures on individual stocks.
Index futures
Q7.1: How do futures trade?
A: In the cash market, the basic dynamic is that the issuer puts out paper, and people trade this paper. In contrast, with futures (as with all derivatives), there is no issuer, and hence, there is no fixed issue size. The net supply of all derivatives contracts is 0. For each buyer, there is an equal and opposite seller. A contract is born when a buyer and a seller meet on the market. The total number of contracts that exist at a point is called open interest.
Q7.2: How would a seller "deliver" a market index?
A: On futures markets, open positions as of the expiration date are normally supposed to turn into delivery by the seller and payment by the buyer. It is not feasible to deliver the market index. Hence open positions are squared off in cash on the expiration date, with respect to the spot Nifty. Specifically, on the expiration date, the last mark to market margin is calculated with respect to the spot Nifty instead of the futures price.
Q7.3: What products will be traded on NSE's market?
A: Three Nifty futures contracts will trade at any point in time, expiring in three near months. The expiration date of each contract will be the last thursday of the month. For example, in January 1996 we will see three tradeable objects at the same time: a Nifty futures expiring on 25 January, a Nifty futures expiring on 29 February, and a Nifty futures expiring on 28 March.
The three futures trade completely independently of each other. Each has a distinct price and a distinct limit order book. Hence, once this market trades, there would be four distinct prices that can be observed: the Nifty spot, and three Nifty futures prices.
Q7.4: What is the market lot?
A: The market lot is 200 nifties. A user will be able to buy 200 or 400 nifties, but not 300 nifties. If Nifty is at 1500, the smallest transaction will have a notional value of Rs.300,000.
Q7.5: What kind of margins do we expect to see?
A: The initial (upfront) margin on trading Nifty is likely to be around 7% to 8%. Thus, a position of Rs.300,000 (around 200 nifties) will require up–front collateral of Rs.21,000 to Rs.24,000. Nifty futures at SIMEX will probably involve a somewhat lower initial margin as compared with Nifty futures at NSE. Since the BSE Sensex is more volatile than Nifty, a higher initial margin will be required for trading it. The daily mark–to–market margin will be similar to that presently seen on the cash market, with two key differences:
• As is presently the case, mark-to-market losses will have to be paid in by the trader to NSCC. However, mark-to-market profits will be paid out to traders by NSCC – this is not presently done on the cash market.
• Hedged futures positions will attract lower margin – if a person has purchased 200 October nifties and sold 200 November nifties, he will attract much less than 7–8% margin. In the present cash market, all positions attract 15% initial (upfront) margin from NSCC, regardless of the extent to which they are hedged.
Q7.6: Isn't this level of leverage much more dangerous than what we presently see on NSE?
A: Individual stocks are more volatile, and more vulnerable to manipulative episodes such as short squeezes. Hence, highly leveraged trading on individual stocks is fraught with problems. In contrast, the index futures/options are cash settled, and are based on an underlying (the index) which is hard to manipulate.
Q7.7: Who are the users of index futures?
A: As with all derivatives, there are (a) speculators, (b) hedgers and (c) arbitrageurs. Speculators would make forecasts about movements in Nifty or movements in futures prices. Hedgers would take buy or sell positions on Nifty futures in offsetting equity exposure that they have, which they consider undesirable.
Arbitrageurs lend or borrow money from the market, depending on whether rates of return are attractive.
Q7.8: What kind of liquidity is expected on index derivatives markets?
A: Impact cost on index derivatives markets is likely to be much smaller than that seen on the spot index. One thumb rule which is commonly used internationally is that transactions costs on trading index futures are around one–tenth the cost of trading the spot index. When this level of liquidity is attained, we will be able to trade Rs.1 million of Nifty futures in a market impact cost of 0.01%. High liquidity is the essential appeal of index derivatives. If trading on the spot market were cheap, then many portfolio modifications would get done there itself. However, because transactions costs on the cash market are high, using derivatives is an appealing alternative.
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Thanks
Tips4Trade Team
www.tips4trade.com
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