Financial Derivatives (MFT706)

Leben Johnson Mannariat

7th January 2019

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 • Historical Perspective
– Metal Standard: 2,500 BC
– Coins: 700 BC
– Barter System: 12th Century
– Currency: 12th Century in China
– US Silver Dollar: 1518
– US Paper Dollar: 1862
– Derivatives: 12th Century in England and France

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 • Indian Financial System
– Regulatory Framework
• Companies Act 1956
• Securities Contracts (Regulation) Act 1956
– Reserve Bank of India (RBI)
• To promote the development of Financial Infrastructure
• To regulate overall money and credit for price stability in economy
• To ensure financial, monetary and payment stability
– Securities and Exchange Board of India (SEBI)
• Primary securities market
• Secondary securities market
• Mutual funds
• Investor protection measures
• Miscellaneous: FII, VCF

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 • Regulations of Financial Derivatives
– Screen Based Trading (1995)
• 99% of shares are dematerialized
• Clearing & Settlements cycle reduced from 14days to T+3, with daily netting.
• Listed securities: Cleared or Specified or Group-A: Weekly settlements with carry
forward.
• Other non-Specified or Group-B1: Same as A, but no carry forward.
• Group-C: Odd lots
• Group-Z: Scripts not-listed and entertaining investor complaints.
– Badla System
• Interests paid on carry forwards by buyer to next pay-date is called Badla or Contango.
• Interests paid by seller is called Anda-Badla or Backwardation.
• BSE abolished Badla system from 1993
– Securities and Exchange Board of India (SEBI)
• Primary securities market
• Secondary securities market
• Mutual funds
• Investor protection measures
• Miscellaneous: FII, VCF

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 Participants & Structure of Exchange

Stock Exchange

Governing Council Governing Board Clearing Council

Clearing House Clearing Bank

Clearing Member

Trade Guarantee
Fund
Trading Member

Investor Protection
Fund Client

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 Type of Financial Derivatives

Derivatives

Financials Commodities

Basics Complex

Forwards Futures Options Warrants & Convertibles

Swaps Exotics

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 Key Indian Economic Indicators:
- GDP: $2.074T in Dec 2015
- Per capita GDP $1806, 7% of World avg.
- CPI: 5.05% Aug 2016
- WPI: 3.74% Aug 2016
- Unemployment Rate: 4.9% 2014
- Foreign Exchange Reserves: $370B Sept2016
- Interest Rate: 6.25% (Repo Rate, 4Oct2016)
- Current Account Deficit: $0.3B 2Q2016 or 1.25% of GDP
- Exports: $21.5B Aug2016,
- Imports: $29.1B Aug 2016,
- Govt. Budget deficit: -12000Cr.
- Govt. Debt: 67.2% of GDP
- Govt. Revenues: INR 3.853T
- Fiscal Expenditure: INR 8.017T

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 Stock Exchange
-Primary Market: Mostly for IPO
- Secondary Market: For trading of an already issued
stock.
- 22 Exchanges in India
- BSE, NSEI, Kolkata, Delhi & Ahmedabad - 88% of
turnover.
Bombay Stock Exchange: National Stock Exchange of India:
- Established in 1875 - Established in June 2004
-Index: SENSEX – 30 Stocks from BSE, 35,357 -Index: NIFTY – 50 Stocks, 10,631
- 5,000 companies listed . - 2,858 companies.
- Market Capitalization: $1.06T - Market Capitalization: $1.4T
- Online System: BOLT - Online System: NEAT
- Clearing & Settlement: T+2 - Clearing & Settlement: T+2
- Avg daily trades: 1.5M - Avg daily trades: 10M
- Avg daily turnover: Rs.4,000 Cr - Avg daily turnover: Rs.2.58 Lakh Cr

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 Introduction
Derivative means an item/instrument/factor that derives its value based on its underlying asset.

Underlying Assets:
- Stocks
- Bonds
- Commodities
- Bullion
- Currency
- Livestock
- Etc.

Financial Derivatives:
- Forwards
- Futures
- Options
- Swaps
- Warrants

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 Market Participants

- Investors
- Long Speculator
- Short Speculator
- Long Hedger
- Short Hedger
- Arbitrageur

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 Forward:
Long Forward
A customized OTC contract between
two parties, to buy or sell an asset at a + Profit
certain time in the future at a pre-
determined price.
Break-even Price
Features:
- It is traded OTC
- Exposed to counter-party risks 0
- Customized unique product Spot Price
- 90% of forward contracts are
settled by delivery.
- Rest can take an off-set contract.
- It is non-fungible contract.
- Loss
- Forward = Current + Cost-of-carry
- No funds exchanged during Short Forward
execution. + Profit

Break-even Price

0
Spot Price

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 Futures:
Long Future
Like forward, a future contract is an
agreement buy or sell a specified + Profit
quantity of an asset at a specified price
and at a specified time and place.
Break-even Price

Features:
- It is exchange traded 0
- Counter-party risks non-existent Spot Price
- Standardized products
- Futures contracts are seldom
settled by delivery.
- Settled through Clearing House.
- Loss
- Expressed in currency unit.
- This is regulated through Short Future
exchange. + Profit

Break-even Price

0
Spot Price

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 Options: CALL Long Call
Option is a contract where a party
obtains the right, but not the + Profit
obligation, to buy or sell a product, at a
specified price on or before a specified
Break-even Price
date.

Features: 0
Option
- Call option gives the right to buy. Premium Spot Price
- Option holder or buyer is Long
- Option Seller or writer is Short Strike Price
- It is exchange traded
- Counter-party risks non-existent
- Loss
- Standardized products
Short Call
- European option is exercised on
expiration date. + Profit
- American option is exercised on or
before expiration/maturity date. Strike Price
- Settled through Clearing House.
- This is regulated through
exchange.
0
Spot Price

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 Options: PUT
Long Put
Option is a contract where a party
obtains the right, but not the + Profit
obligation, to buy or sell a product, at a
specified price on or before a specified
Break-even Price
date.
Strike Price
Features: 0
- Put option gives the right to Sell. Option
Spot Price
- Option holder or buyer is Long Premium
- Option Seller or writer is Short
- It is exchange traded
- Counter-party risks non-existent
- Loss
- Standardized products
- European option is exercised on Short Put
expiration date. + Profit
- American option is exercised on or
before expiration/maturity date.
- Settled through Clearing House. Option
- This is regulated through Premium
exchange.
0
Spot Price
Strike Price

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Option Risk & Rewards

Strategy Risk Reward

Long Call Premium Unlimited
Long Put Premium Almost Unlimited
Short Call Unlimited Premium
Short Put Almost Unlimited Premium
Long Future Almost Unlimited Unlimited
Short Future Unlimited Almost Unlimited

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Types of Risks

• Operational
– Manufacturing, Marketing, Operations, Human errors
• Financial
– Credit, interest rate, foreign exchange
• System
– Technology
• Market / Systemic / Undiversifiable
– Market collapse, economy

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