DERIVATIVES MARKETS

DERIVATIVES MARKETS (Part 1)

• Definition of Derivatives: A derivative refers to a financial product whose value is derived from another, also called the underlying.
• Purpose of Derivatives: Derivatives are used as a risk management tool to manage risks arising from unknown future values of underlying assets.
• Key Characteristics of Derivatives:
  • Derivatives are created with reference to an underlying asset.
  • They can be used to hedge against potential losses or gains in the underlying asset.
  • Derivatives can be structured to enable a payoff and make good some or all of the losses if the underlying asset's price moves in a certain direction.

Key Concepts in Derivatives

• Forward Contracts: A forward contract is a type of derivative contract where two parties agree to exchange a specific good at a specific price, on a specific date in the future.
• Managing Risk with Derivatives: Derivative markets are formed when different players with different needs come together to manage their risks, by securing themselves from risky events that they fear in the future.
• Underlying Asset: The underlying asset is the asset whose value is used to determine the value of the derivative, such as gold, stocks, or currencies.

Structuring a Derivative Product

• Payoff Structure: A derivative product is defined by a set of payoffs, based on a specific set of criteria, such as the price of the underlying asset.
• Examples of Derivative Products:
  • Weather Derivatives: Used to manage risks related to weather conditions, such as crop loss due to monsoon failure.
  • Interest Rate Swaps: Used to manage risks related to interest rate fluctuations, by exchanging a floating interest rate for a fixed interest rate.
  • Currency Derivatives: Used to manage risks related to currency fluctuations, by fixing the exchange rate of one currency to another.
  • Index Derivatives: Used to manage risks related to stock market fluctuations, by receiving a payoff based on the value of a stock index.

Underlying Concepts in Derivatives

• Zero Sum Game: In a derivative contract, the counterparties have opposing views and needs, resulting in a zero sum game where one party's gain is equal to the other party's loss.
• Settlement Mechanism: Derivative contracts can be settled in cash or through physical delivery of the underlying asset.
• OTC and Exchange Traded Derivatives: Derivative contracts can be traded over the counter (OTC) or on an exchange, with exchange-traded derivatives being standardized and settled through a clearing corporation.
• Arbitrage: The process of buying and selling identical assets in different markets to profit from price differences, resulting in a single market price for the asset.

DERIVATIVES MARKETS (Part 2)

• Definition of Derivatives: Derivatives are contracts between two parties that specify the terms of a future transaction, including the price and underlying asset.
• Details of Forward Markets: Forward markets are informal agreements between known parties, relying on mutual trust and geographical concentration to mitigate counterparty risks.

Key Concepts in Derivatives

• Futures: Exchange-traded forwards with standardized terms, including trading unit, minimum order size, and delivery options.
• Options: Contracts that give buyers the right, but not the obligation, to buy or sell an underlying asset at a specified price.
• Swaps: Contracts that involve the exchange of cash flows between two parties, often used in interest rate and currency markets.

Types of Options

• Call Options: Give buyers the right to buy an underlying asset at a specified price.
• Put Options: Give buyers the right to sell an underlying asset at a specified price.

Structure of Derivative Markets

• Equity Derivatives: Include index options, index futures, individual stock options, and individual stock futures.
• Currency and Interest Rate Derivatives: Include options and futures on select currency pairs and interest rates.
• Commodity Derivatives: Include futures and options on select commodities.

Market Structure

• Fully Automated Trading Systems: Orders are placed anonymously and executed using automated order matching systems.
• Clearing and Settlement: Happens through a clearing corporation, with a rigorous risk management mechanism in place.

Derivative Products for Trading

• Futures and Options: Available on specific indices, such as the Nifty 50 index, and individual stocks.
• Contract Specifications: Include expiry date, trading lot, base price, and price steps.

Trading and Settlement Process

• Contract Specification: Includes underlying asset, expiry date, and other terms.
• Expiry Date: Monthly contracts expire on the last Tuesday or Thursday of every calendar month.
• Trading Cycle: New contracts are introduced on the maturity of a near-month contract.
• Trading Lot: Specified by the exchange, with a minimum value of Rs. 5 lakhs.

DERIVATIVES MARKETS (Part 3)

• Definition of Derivatives Market: A market where derivatives contracts are traded, with prices determined by buyers and sellers.
• Key Features:
  • Price Step (Tick Size): Re.0.05 for futures contracts, with price changes in multiples of 5 paisa.
  • Price and Quantity Freeze: Exchanges specify a range for price movement and a limit for order quantity to prevent errors in order entry.
  • Trading Hours: Monday to Friday, with normal market open time at 09:15 hrs and close time at 15:30 hrs.
  • Order Types: Regular lot order, stop loss order, immediate or cancel order, and day order.

Trading and Settlement Process

• Order Execution: Trades are executed electronically, with orders matched according to their type.
• Settlement: Trades are settled and cleared with the clearing corporations by the clearing member.
• Clearing Members: Trading member clearing member (TM-CM), professional clearing member (PCM), and self-clearing member (SCM).
• Settlement Types: Daily settlement (mark-to-market settlement) and final settlement.

Daily Settlement (Mark-to-Market Settlement)

• Definition: Settlement of derivative contracts on a T+1 basis, with the difference between the traded price and the daily settlement price computed.
• Daily Settlement Price: Weighted average price of the last 30 minutes of trading, announced by the exchange.
• Example: Purchase of Nifty Futures at Rs. 10000, with a settlement price of Rs. 9900, resulting in a loss of Rs. 100.

Final Settlement

• Definition: Settlement of a futures contract on its expiry date, with all open positions closed.
• Final Settlement Price: Closing price of the relevant underlying index or security in the cash market on the final trading day.

Options: Trading and Settlement Process

• Option Type: European option (can be exercised only on expiry date) and American option (can be exercised any time before or on expiry date).
• Strike Price: Specified for the option contract, with the market trading the premium to be paid for the given option.
• Settlement System: Similar to futures, with daily settlement for the premium amount and final settlement on the expiry date.

Risk Management in Derivative Markets

• Tools: Setting capital adequacy requirements, imposing margin requirements, position limits, online monitoring, and automatic disablement from trading.
• Base Capital and Liquid Net Worth: Members must maintain a specified amount of capital and net worth, with a portion in liquid assets.
• Margins: Represent the amount collected by the clearing corporation to ensure trades settle without default, with initial and exposure margins collected in the futures market segment.

DERIVATIVES MARKETS (Part 4)

• Margins: Margins are collected by clearing members based on trades executed and open positions of clients and trading members. SEBI has a monitoring mechanism for verification of upfront collection of margins from clients.
• Margins for Options: The margining system for options is similar to futures, with initial margins levied on premium value and exposure margin on notional contract value. Premium margins and assignment margins are also collected.
• Position Limits: Position limits are defined by exchanges as a percentage of market-wide position limits or in terms of contract value. These limits are used to prevent settlement risks and are monitored in real-time.
• Application of Derivatives Products in Risk Management: Derivatives are used for hedging, speculation, and arbitrage. Hedging involves protecting an open position from future price movements, while speculation involves taking a view on future prices without an underlying position. Arbitrage involves exploiting price differences between markets.
• Benefits and Costs of Derivatives: Derivatives provide benefits such as enabling hedging and better risk management, enhancing liquidity, and reducing trading costs. However, they also involve costs such as counterparty risk and liquidity crises.
• Market Indicators: Market indicators include open interest, which represents outstanding positions in the market, and put-call ratio, which is the ratio of outstanding put options to outstanding call options.
• Key Terms:
  • Open Interest: The sum of all incomplete contracts in the market.
  • Put-Call Ratio: The ratio of outstanding put options to outstanding call options.
  • Hedging: Protecting an open position from future price movements.
  • Speculation: Taking a view on future prices without an underlying position.
  • Arbitrage: Exploiting price differences between markets.

DERIVATIVES MARKETS (Part 5)

• Basis: The difference between the cash price (or spot price) of a security and its futures price. It is crucial in hedging as changes in the relationship between cash and futures prices affect the values of using futures as a hedge.
• Basis Point: One hundredth of a percentage point, used to measure small changes in interest rates and bond yields.
• Basis of Allotment: The pattern used to allocate securities among different categories of applicants in an initial public offering (IPO).
• Bear: An investor who expects the market to decline and may sell securities they do not own, hoping to buy them back at a lower price later.
• Bear Market: A market characterized by a decline in security prices, often accompanied by a lack of buyer interest.
• Benchmark Index: A standard index used to evaluate the performance of a portfolio or investment strategy.
• Beta: A measure of the volatility of a security relative to the overall market, with a beta of 1 indicating average risk, less than 1 indicating lower risk, and greater than 1 indicating higher risk.
• Bid: The price at which a buyer is willing to purchase a security.
• Bid-Ask Spread: The difference between the bid price (the price at which a buyer is willing to buy) and the ask price (the price at which a seller is willing to sell).
• Block Trading: The purchase or sale of a large quantity of securities, often used for portfolio restructuring or liquidation.
• Blue Chip: High-quality securities with a history of stable earnings and a strong reputation.
• Bonus Shares: Additional shares issued by a company to its existing shareholders, typically as a way to distribute profits.
• Book Building Process: A method used to determine the price of a security by gathering bids from potential investors.
• Book Closure: The period during which a company's register of members and transfer books are closed to determine shareholder entitlements to dividends or other rights.
• Book Runner: The lead merchant banker responsible for managing the book-building process and maintaining the book of orders.
• Book Value: The net value of a company's assets, liabilities, and equity as recorded in its financial statements.
• Boom: A period of rapid economic growth and rising security prices.
• Breadth of the Market: The number of securities traded on a market, indicating its overall activity and liquidity.
• Break: A sudden and significant decline in a security's price.
• Broker: An intermediary who buys and sells securities on behalf of clients.
• Brokerage: The commission paid to a broker for their services.
• Broker-Dealer: A firm that acts as both a broker and a dealer, buying and selling securities for its own account and on behalf of clients.
• Bubble: A speculative price increase that is not supported by fundamental factors and is likely to collapse.
• Bull: An investor who expects the market to rise and may buy securities in anticipation of higher prices.
• Bull Market: A market characterized by rising security prices, often accompanied by high investor optimism.
• Bulk Deal: A large transaction in securities, typically exceeding 0.5% of the company's total equity shares.
• Business Day: A day on which the stock exchange is open for trading.
• Buy Back: The repurchase of a company's own shares by the company itself.
• Buy on Margin: The purchase of securities using borrowed funds, which must be repaid with interest.
• Cash Market: A market where securities are traded for immediate delivery, as opposed to futures markets.
• Cash Settlement: The payment of the difference between the settlement price and the exercise price of an option or futures contract, rather than physical delivery of the underlying security.
• Churning: Excessive trading in a client's account by a broker to generate commissions.
• Circuit Breaker: A mechanism used to halt trading in a security or market when prices move beyond a certain threshold, aimed at reducing volatility.
• Circular Trading: A fraudulent scheme where buy and sell orders are entered by a person who knows that the same number of shares will be traded at the same time and price, without a genuine change in ownership.
• Clearing: The process of determining which market participants are due to deliver or receive securities on the settlement date.
• Clearing Corporation: An entity that provides clearing and settlement services for trades and manages associated risks.
• Clearing Member: A member of a clearing corporation who clears and settles transactions in securities.
• Closing Price: The price at which the last transaction in a security is executed before the close of trading hours.
• Co-Location: The placement of computer servers of trading members in the same premises as the exchange's servers to reduce latency.
• Confirmation Process: The procedure for verifying trade details with a counterparty.
• Contract Note: A document issued by a broker to a client, detailing the trade, including the number of securities, price, time, and date.
• Counterparty Risk: The risk that a counterparty to a transaction may fail to perform their obligations.
• Cross-Margin Benefit: A reduction in total margin payable on offsetting positions in the cash and derivatives segments.
• Custodian: An organization that holds and safeguards securities and other assets on behalf of mutual funds and other institutional investors.
• Daily Margin: The amount that must be deposited at the stock exchange on a daily basis for the purchase or sale of a security.
• Day Order: An order that is valid for execution only during one trading session and is automatically cancelled if not executed.
• Delisting of Securities: The permanent removal of a company's securities from a stock exchange, resulting in the securities no longer being traded on that exchange.
• Delivery: The presentation of securities with transfer deeds to fulfill a transaction.
• Dealer: A firm that acts as a counterparty on both sides of a market in one or more products.
• Dematerialize: The process of converting physical securities into electronic form through a depository participant.
• Depository: A system that maintains records of securities deposited by its depositors, which may be physical or electronic.
• Depository Participant (DP): An agent of the depository who interfaces with investors and provides depository services.
• Depreciation: A decrease in the value of a security, index, or currency.
• Depth of Market: The number of shares that can be bought or sold at the best bid or offer price.
• Direct Market Access: An electronic facility that allows institutional investors to place orders directly on the exchange's order book.
• Exchange-Traded Derivative: A derivative that is listed and traded on an organized market, often with standardized contracts and central clearing facilities.
• Exchange-Traded Fund (ETF): A security that tracks an index and can be traded like a stock.
• Ex-Dividend Date: The date on or after which the buyer of a security is not entitled to the dividend already declared.
• Ex-Right Date: The date on which the official quotation for a share is marked "ex-rights," indicating that the buyer is not entitled to the rights issue.
• Face Value: The value that appears on the face of a security, also known as the nominal or par value.
• Firm Allotment: An allotment of securities made on a firm basis to certain categories of investors, such as institutions or employees.
• Float: The number of shares issued and outstanding of a company's stock.
• Floating Rate Coupon: A coupon rate that varies with a standard market benchmark or index.

DERIVATIVES MARKETS (Part 6)

• Floating Stock: The fraction of the paid-up equity capital of a company which normally participates in day-to-day trading.
• Green Shoe Option: An option of allotting equity shares in excess of the shares offered in the public issue as a post-listing price stabilizing mechanism.
• Hedge Funds: Private investment pools that invest aggressively in all types of markets.
• High-Frequency Trading: A type of trading that uses computer programs to place a high number of orders in fractions of a second.
• Insider Trading: The practice of corporate agents buying or selling their corporation’s securities without disclosing significant information to the public.
• Institutional Investors: Organizations that invest, including insurance companies, depository institutions, pension funds, investment companies, and endowment funds.

Key Concepts

• Interoperability of Clearing Corporations: A mechanism that allows the clearing house of one stock exchange to clear and settle trades executed on another stock exchange.
• ISIN (International Securities Identification Number): A unique identification number allotted for each security in the depository system by SEBI.
• Limit Order: An order to buy or sell a specified number of shares when a specified price is reached.
• Listed Company: A company which has any of its securities offered through an offer document listed on a recognized stock exchange.
• Listing: Formal admission of a security into a public trading system.
• Listing Agreement: An agreement which has to be entered into by companies when they seek listing for their shares on a Stock Exchange.

Market Terms

• Long Position: A position showing a purchase or a greater number of purchases than sales in anticipation of a rise in prices.
• Margin: An advance payment of a portion of the value of a stock transaction.
• Marked-to-Market Basis: The process whereby the book value or collateral value of a security is adjusted to reflect current market value.
• Market Capitalization: The market value of a company, calculated by multiplying the number of shares issued and outstanding by their current market price.
• Market Maker: A member firm who gives two-way quotations for particular security(ies) and who is under an obligation to buy and sell them subject to certain conditions.

Trading Terms

• Matched Transaction: A check is carried out on the computer to find out whether purchases and sales as reported by the members match.
• Merchant Banker: Any person who is engaged in the business of issue management either by making arrangement regarding selling, buying or subscribing to securities.
• MIBOR: Mumbai Interbank Offer Rates, calculated by the average of the interbank offer rates based on quotations at nearly 30 major banks.
• Odd Lot: Anything less than the standard unit of trading.
• Offer Document: A red herring prospectus, prospectus or shelf prospectus, as applicable, referred to under the Companies Act, 2013.

Regulatory Terms

• Open Interest: The number of contracts outstanding for a given option or futures contract.
• Open Order: An order to buy and sell a security that remains in effect until it is either cancelled by the customer or executed.
• Order Book: An ‘electronic book’ that shows the demand and supply of the shares of the company at various prices.
• OTC (Over the Counter): A financial transaction that is not made on an organized exchange.
• Pari Passu: A term used to describe new issue of securities which have same rights as similar issues already in existence.

Settlement Terms

• Pay-in / Pay-out: The days on which the members of a Stock Exchange pay or receive the amounts due to them.
• Position Limit: The maximum number of listed option contracts on a single security which can be held by an investor or group of investors acting jointly.
• Price Band: The range within which the price of a security or the index of a currency is permitted to move within a given period.
• Price Discovery: A general term for the process by which financial markets attain an equilibrium price, especially in the primary market.
• Price Sensitive Information: Any information which relates directly or indirectly to a company and which if published is likely to materially affect the price of securities of the company.

Shareholder Terms

• Proxy: One who votes for and on behalf of a shareholder at a company meeting.
• Record Date: A date on which the records of a company are closed for the purpose of determining the stockholders to whom dividends, proxies, rights etc., are to be sent.
• Regulatory Sandbox: A framework set up by a regulator to enable FinTech start-ups to conduct live experiments of innovations in a controlled manner.
• Rights Issue/Rights Shares: The issue of new securities at a pre-decided price to the existing shareholders in a fixed ratio to those already held.
• Rolling Settlement: The practice of settling a transaction within a fixed number of days after the trade is agreed.

Trading Mechanisms

• Screen Based Trading: A form of trading that uses modern telecommunication and computer technology to combine information transmission with trading in financial markets.
• Secondary Market: The market for previously issued securities or financial instruments.
• Securities Lending and Borrowing Mechanism: A platform provided by stock exchanges for online, anonymous borrowing and lending of securities with settlement guaranteed by the exchange.
• Settlement Date: The date specified for delivery of securities between securities firms.
• Short Position: In futures, the short has sold the commodity or security for future delivery; in options, the short has sold the call or the put and is obligated to take a futures position if he or she is assigned for exercise.

Stock Market Terms

• Stock Splits: A distribution of company’s own capital stock to existing stockholders with the purpose of reducing the market price of the stock.
• Trading Member: A member of the derivatives exchange or derivatives segment of a stock exchange who settles the trade in the clearing corporation or clearing house through a clearing member.
• Transfer Agents: An agent designated by the company to carry out the function of transfer of shares.
• Underwriting: An agreement with or without conditions to subscribe to the securities of a body corporate when the existing shareholders of such body corporate or the public do not subscribe to the securities offered to them.
• Value at Risk (VaR): VaR is the maximum loss over a target horizon such that there is a low, pre-specified probability that the actual loss will be larger.
• Vanilla Issue: A straight fixed rate issue which has terms and conditions usually accepted as being conventional to a particular securities market.
• Volume of Trading: The total number of shares which changes hands in a particular company’s securities.
• Voluntary Delisting: Delisting of securities of a body corporate voluntarily by a promoter or an acquirer or any other person other than the stock exchange.
• Voting Rights: The entitlement of a shareholder to exercise vote in the general meeting of a company.