Security Analysis & Portfolio Management “DERIVATIVES " By B.Pani (M.Com,LLB,FCA,FICWA,ACS,DISA,MBA)

Derivative securities, more appropriately termed as derivative contracts, are assets which confer the investors who take positions in them with certain rights or obligations.

Why Do We Call Them Derivatives? They owe their existence to the presence of a market for an underlying asset or portfolio of assets, which may be considered as primary securities. Consequently such contracts are derived from these underlying assets, and hence the name. Thus if there were to be no market for the underlying assets, there would be no derivatives

Broad Categories of Derivatives Forward Contracts Futures Contracts Options Contracts Swaps

Definition of a Forward Contract A forward contract is an agreement between two parties that calls for the delivery of an asset on a specified future date at a price that is negotiated at the time of entering into the contract.

Forward Contracts (Cont…) Every forward contract has a buyer and a seller. The buyer has an obligation to pay cash and take delivery on the future date. The seller has an obligation to take the cash and make delivery on the future date

Definition of a Futures Contract A futures contract too is a contract that calls for the delivery of an asset on a specified future date at a price that is fixed at the outset. It too imposes an obligation on the buyer to take delivery and on the seller to make delivery. Thus it is essentially similar to a forward contract.

Forward versus Futures Yet there are key differences between the two types of contracts. A forward contract is an Over-the-Counter or OTC contract. This means that the terms of the agreement are negotiated individually between the buyer and the seller.

Forward vs. Futures (Cont…) Futures contracts are however traded on organized futures exchanges, just the way common stocks are traded on stock exchanges. The features of such contracts, like the date and place of delivery, and the quantity to be delivered per contract, are fixed by the exchange.

Forward vs. Futures (Cont…) The only job of the potential buyer and seller while negotiating a contract, is to ensure that they agree on the price at which they wish to transact.

Forward Contracts vs Futures Contracts ForwardFutures Private contract between two partiesTraded on an exchange Not standardizedStandardized Usually one specified delivery dateRange of delivery dates Settled at end of contractSettled daily Delivery or final settlement usualUsually closed out prior to maturity Some credit riskVirtually no credit risk 2.11

Options An options contract gives the buyer the right to transact on or before a future date at a price that is fixed at the outset. It imposes an obligation on the seller of the contract to transact as per the agreed upon terms, if the buyer of the contract were to exercise his right.

Rights What is the difference between a Right and an Obligation. An Obligation is a binding commitment to perform. A Right however, gives the freedom to perform if desired. It need be exercised only if the holder wishes to do so.

Rights (Cont…) In a transaction to trade an asset at a future date, both parties cannot be given rights. For, if it is in the interest of one party to go through with the transaction when the time comes, it obviously will not be in the interest of the other.

Rights (Cont…) Consequently while obligations can be imposed on both the parties to the contract, like in the case of a forward or a futures contract, a right can be given to only one of the two parties. Hence, while a buyer of an option acquires a right, the seller has an obligation to perform imposed on him.

Options (Cont…) We have said that an option holder acquires a right to transact. There are two possible transactions from an investor’s standpoint – purchases and sales. Consequently there are two types of options – Calls and Puts.

Options (Cont…) A Call Option gives the holder the right to acquire the asset. A Put Option gives the holder the right to sell the asset. If a call holder were to exercise his right, the seller of the call would have to make delivery of the asset.

Options (Cont…) If the holder of a put were to exercise his right, the seller of the put would have to accept delivery. We have said that an option holder has the right to transact on or before a certain specified date. Certain options permit the holder to exercise his right only on a future date.

Options (Cont…) These are known as European Options. Other types of options permit the holder to exercise his right at any point in time on or before a specified future date. These are known as American Options.

Longs & Shorts The buyer of a forward, futures, or options contract is known as the Long. He is said to have taken a Long Position. The seller of a forward, futures, or options contract, is known as the Short. He is said to have taken a Short Position. In the case of options, a Short is also known as the option Writer.

Comparison of Futures/Forwards versus Options Instrument Nature of Long’s Commitment Nature of Short’s Commitment Forward/Futures Contract Obligation to buyObligation to sell Call OptionsRight to buyObligation to sell Put OptionsRight to sellObligation to buy

Swaps A swap is a contractual agreement between two parties to exchange specified cash flows at pre-defined points in time. There are two broad categories of swaps – Interest Rate Swaps and Currency Swaps

Interest Rate Swaps In the case of these contracts, the cash flows being exchanged, represent interest payments on a specified principal, which are computed using two different parameters. For instance one interest payment may be computed using a fixed rate of interest, while the other may be based on a variable rate such as LIBOR.

Interest Rate Swaps (Cont…) There are also swaps where both the interest payments are computed using two different variable rates – For instance one may be based on the LIBOR and the other on the Prime Rate of a country. Obviously a fixed-fixed swap will not make sense.

Interest Rate Swaps (Cont…) Since both the interest payments are denominated in the same currency, the actual principal is not exchanged. Consequently the principal is known as a notional principal. Also, once the interest due from one party to the other is calculated, only the difference or the net amount is exchanged.

Currency Swaps These are also known as cross-currency swaps. In this case the two parties first exchange principal amounts denominated in two different currencies. Each party will then compute interest on the amount received by it as per a pre-defined yardstick, and exchange it periodically.

Currency Swaps (Cont…) At the termination of the swap the principal amounts will be swapped back. In this case, since the payments being exchanged are denominated in two different currencies, we can have fixed-floating, floating-floating, as well as fixed-fixed swaps.

Assets Underlying Futures Contracts Till about two decades ago most of the action was in futures contracts on commodities. But nowadays most of the action is in financial futures. Among commodities, we have contracts on agricultural commodities, livestock and meat, food and fibre, metals, lumber, and petroleum products.

Food grains & Oil seeds Corn Oats Soybeans Wheat

Food & Fibre Cocoa Coffee Cotton Sugar Rice Frozen Orange Juice Concentrate

Metals Copper Silver Gold Platinum Palladium

Petroleum & Energy Products Crude Oil Heating Oil Gasoline Propane Electricity

Assets Underlying Options Contracts Historically most of the action has been in stock options. Commodity options do exist but do not trade in the same volumes as commodity futures. Options on foreign currencies, stock indices, and interest rates are also available.

Mechanics of Future

A future contract is a contract for delivery of a standard package of a standard commodity or financial instrument at a specific date and place in future but at a price that is agreed when the contract is taken out. The future price= Spot price + cost carrying Cost of carrying includes Storage Insurance Transport cost Finance cost

2.36 Futures Contracts Available on a wide range of underlyings Exchange traded Specifications need to be defined: – What can be delivered, – Where it can be delivered, & – When it can be delivered Settled daily

2.37 Margins A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract

2.38 Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 – contract size is 100 oz. – futures price is US$400 – margin requirement is US$2,000/contract (US$4,000 in total) – maintenance margin is US$1,500/contract (US$3,000 in total)

2.39 A Possible Outcome DailyCumulativeMargin FuturesGain AccountMargin Price(Loss) BalanceCall Day(US$) ,000 5-Jun397.00(600) 3, Jun393.30(740) (1,340) 2,6601, Jun387.00(1,260) (2,600) 2,7401, Jun ,060 (1,540) 5, = 4,000 3,000 + = 4,000 <

2.40 Other Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

2.41 Collateralization in OTC Markets It is becoming increasingly common for contracts to be collateralized in OTC markets They are then similar to futures contracts in that they are settled regularly (e.g. every day or every week)

2.42 Delivery If a futures contract is not closed out before maturity, it is usually settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash

2.43 Some Terminology Open interest: the total number of contracts outstanding – equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day – used for the daily settlement process Volume of trading: the number of trades in 1 day

2.44 Convergence of Futures to Spot Time (a)(b) Futures Price Futures Price Spot Price

2.45 Questions When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?

2.46 Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

2.47 Accounting & Tax It is logical to recognize hedging profits (losses) at the same time as the losses (profits) on the item being hedged It is logical to recognize profits and losses from speculation on a mark to market basis Roughly speaking, this is what the accounting and tax treatment of futures in the U.S.and many other countries attempts to achieve

2.48 Forward Contracts A forward contract is an OTC agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement (unless a collateralization agreement requires it). At the end of the life of the contract one party buys the asset for the agreed price from the other party

2.49 Profit from a Long Forward or Futures Position Profit Price of Underlying at Maturity

2.50 Profit from a Short Forward or Futures Position Profit Price of Underlying at Maturity

2.51 Foreign Exchange Quotes Futures exchange rates are quoted as the number of USD per unit of the foreign currency Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.