Derivative Markets — forwards, futures, options and swaps

Where this chapter sits

Chapter 6 carries 10% of the paper — the same weight as Chapter 1, and the last chapter of the Securities Markets Foundation syllabus. The paper is 120 minutes, 100 marks, 60% to pass, and there is no negative marking.

Most marks here come from definitions and settlement rules. The arithmetic is light.

What a derivative is

A derivative refers to a financial product whose value is derived from another. A derivative is always created with reference to the other product, also called the underlying.

A derivative is a risk management tool used commonly in transactions where there is risk due to an unknown future value. The workbook's opening example: a buyer of gold faces the risk that gold prices may not be stable. The fluctuating price of gold represents risk. If it were possible to fix today the price for a transaction on a later date in future, such risks can be managed better.

The underlying is subject to risk that is being managed using the derivative. Therefore, the derivative, its price and value, is intricately linked with the underlying.

The gold forward — the whole idea in one example

A derivative market is formed when different players with different needs, to manage their risks, come together and try to secure themselves from the respective risky events that they fear in the future.

Consider both sides. If the buyer is worried about buying gold at a higher price when the need arises, the seller is worried about gold prices falling in the future. Both of them face the risk of the unknown future price of gold. But one is negatively affected by a fall in price; the other is negatively affected by a rise in price.

The buyer and the seller are then "counterparties" to the contract, meaning they represent opposing interests. Such a contract gives comfort to both parties but one party's loss will be the other's gain.

A forward is a derivative contract where two parties agree to exchange a specific good at a specific price, on a specific date in the future.

Worked: the parties agree to exchange 10 grams of gold at a price of ₹30,000 one year from now.

It is clear that one of the two parties tends to lose, while the other gains. This is because both of them did not accurately know what the price of gold would be in the future.

Structuring a derivative

A derivative product is defined by a set of payoffs, based on a specific set of criteria. A forward pays off the difference between the current price and the agreed forward price, irrespective of whether the price is higher or lower. Some derivative contracts can be set up to payoff only if there is rise in price, or a fall in price, but not both.

The primary objective in a derivative contract is to transfer the risk from one party to another.

Four examples, each with a different underlying:

Three underlying concepts

1. The zero-sum game

In a derivative contract, the counterparties who enter into the contract have opposing views and needs. The seller of gold futures thinks prices will fall; the buyer of gold futures thinks prices will rise. The sum of the two positions is zero.

In a derivative market, there is a "long" position of a buyer, and there is a corresponding "short" position of a seller. So by definition, the net economic value of all derivative positions should be zero.

And the sentence that explains why derivatives are not investments in the ordinary sense: there is no new asset or no new underlying created because of derivative contracts on the underlying asset.

2. Settlement mechanism

Cash settlement is a settlement method where upon expiration or exercise of the derivatives contract, the counterparties settle their position through exchange of the price differentials and do not deliver the actual (physical) underlying asset.

Since October 2019, SEBI has mandated physical settlement — settlement by delivery of underlying stock — for all stock derivatives, meaning all positions in futures and options on individual securities which remain open on the expiry date of the contract are to be settled by physical delivery only.

However, Index futures and Index options contracts continue to be settled in cash.

That split is one of the most reliably tested facts in the chapter: stock derivatives — physical; index derivatives — cash.

3. OTC versus exchange-traded

And arbitrage

The law of one price states that two goods that are identical cannot trade at different prices in two different markets. It is easy to buy from the cheaper market and sell at the costlier market, and make riskless profits. But such buying and selling itself will reduce the gap in prices — the demand in the cheaper market will increase prices there and the supply into the costlier market will reduce prices, bringing the prices in both markets to the same level.

Arbitrageurs are specialists who identify such price differential in two markets and indulge in trades that reduce such differences in price. Prices in two markets for the same tradable good will be different only to the extent of transaction costs — which can include transportation, storage, insurance, interest costs and any other cost that impacts the activities of buying and selling.

Applied to derivatives: the underlying asset is the same as it is in the cash market. But the price to buy the same asset in the derivative market can be different from that of the cash market due to the presence of other costs such as physical warehousing or interest costs. The pricing of derivatives includes these costs.

The four products

Forwards

Forwards are over the counter (OTC) derivatives that enable buying or selling an underlying on a future date, at an agreed upon price. The terms of a forward contract are as agreed between counterparties.

The workbook's example: a farmer agrees to sell his produce of wheat to a miller, 6 months later when his crop is ready, at a price that both counterparties agree today. The settlement terms such as quantity and quality of wheat, the price and payment terms are as decided by the counterparties.

A forward contract is a non-standard futures contract. It carries counterparty risk if either one fails to honor their side of the contract. It is therefore always entered into between known parties, and leans on informal protection mechanisms to ensure that the contract is honored.

An observation about Indian markets worth carrying: the concentration of commodity futures trading in certain geographical locations, or between a few communities, is to ensure such informal protection against counterparty risks. The forward markets in commodities in several parts of India are based on mutual trust and are functional despite the risks involved.

Futures

Futures are exchange-traded forwards. A future is a contract for buying or selling a specific underlying, on a future date, at a price specified today, and entered into through a formal mechanism on an exchange. The terms of the contract are specified by the exchange.

The workbook's MCX wheat futures specification shows what "specified by the exchange" means:

Another important feature of an exchange-traded futures contract is the clearing corporation. The counterparty for each transaction is the clearing corporation. Buyers and sellers are required to maintain margins with the clearing corporation, to ensure that they honor their side of the transaction. The counterparty risks in a futures contract are eliminated using the clearing corporation mechanism.

Options

An Option is a contract that gives its buyers the right, but not an obligation, to buy or sell the underlying asset on or before a stated date/day, at a stated price, for a price.

The party taking a long position i.e. buying the option is called buyer/holder of the option and the party taking a short position i.e. selling the option is called the seller/writer of the option.

The asymmetry is the whole point: the option buyer has the right but no obligation with regards to buying or selling the underlying asset, while the option writer has the obligation in the contract. So the option buyer/holder will exercise his option only when the situation is favourable to him, but when he decides to exercise, the option writer would be legally bound to honour the contract.

Option which gives buyer a right to buy the underlying asset is called a Call option, and the option which gives buyer a right to sell the underlying asset is called a Put option.

The worked example — learn every label:

Arvind buys a call option on the Nifty index from Salim, to buy the Nifty at a value of ₹10,000, three months from today. Arvind pays a premium of ₹100 to Salim.

• Arvind is the buyer of the call option
• Salim is the seller or writer of the call option
• ₹10,000 is the price Arvind is willing to pay for Nifty. This is called the strike price or exercise price
• Arvind may or may not exercise the option. But if Arvind exercises the option, Salim is under the obligation to sell Nifty at ₹10,000 to Arvind
• ₹100 is the option premium. This is also called the price of the option

If on the settlement date Nifty is at ₹10,200, Arvind's option is "in-the-money". He can buy the Nifty at ₹10,000, by exercising his option. Salim earned ₹100 as premium, but lost as he has to sell Nifty at ₹10,000 while the market price was ₹10,200.

If on the settlement date the Nifty is at ₹9,800, Arvind's option will be "out-of-the-money". There is no point paying ₹10,000 to buy the Nifty when the market price is ₹9,800. Arvind will not exercise the option. Salim will pocket the ₹100 he collected as premium.

Swaps

A swap is a contract in which two parties agree to a specified exchange on a future date. Swaps are common in interest rate and currency markets.

The workbook's interest rate swap: a borrower has to pay a quarterly interest rate defined as the Treasury bill rate on that date, plus a spread, but prefers to pay a fixed rate of interest. So he enters a swap to:

• Pay a fixed rate to the swap dealer every quarter
• Receive T-bill plus spread from the swap dealer every quarter

The principal amount on which the interest will be computed is agreed upon between counterparties. Only the interest rate on this amount is exchanged on each settlement date between counterparties.

The borrower will use the floating rate that he has received from the swap market and pay the floating rate dues on his borrowing. These two legs are thus cancelled, and his net obligation is the payment of a fixed interest rate to the swap dealer. By using the swap market, the borrower has converted his floating rate borrowing into a fixed rate obligation.

Though swap transactions are OTC, they are governed by rules and regulations accepted by swap dealer associations.

The Indian derivative market

Available on Indian stock exchanges: equity index options · equity index futures · individual stock options · individual stock futures · currency options and futures on select currency pairs · interest rate futures · interest rate options · commodity futures and options for a select set of commodities.

Apart from these, forward markets for agricultural commodities and swap markets for interest rates are available in the OTC markets.

The history: derivative contracts in the Indian stock exchanges began trading in June 2000, when index futures were introduced by the BSE and NSE. In 2001, index options, stock options and futures on individual stocks were introduced.

Two facts worth remembering: India is one of the few markets in the world where futures on individual stocks are traded; and in the Indian markets, volume and trading activity in derivative segments is far higher than volumes in the cash market for equities.

Market structure. Equity derivative markets in India are fully automated, nationwide screen-based trading systems. Orders are placed anonymously and electronically and executed using an automated order matching system. Clearing and settlement happens through the clearing corporation, and derivative trades are guaranteed for settlement through a rigorous risk management mechanism that includes capital adequacy norms, intra-day monitoring of position limits and margins.

Transactions must be routed through the registered members of the stock exchange. Participants can be individuals or institutions, who have to trade through a trading member. Trading members settle their transactions through clearing members.

On costs: transaction costs are levied based on value of contract for futures and amount of premium for options, and may be collected from both parties. Securities transaction tax at the rate fixed by the government is also payable on derivative transactions conducted on the exchange.

Which underlyings qualify: futures and options are available on specific indices such as Nifty 50, Nifty Bank Index, S&P BSE Sensex, and on specific listed stocks chosen by the exchange. The specifications mostly pertain to size (market capitalization) and trading volume so that the derivatives are liquid and can be traded at lower costs. SEBI issues guidelines and circulars for eligibility criteria. Exchanges choose stocks and indices using these criteria. They may also impose more stringent criteria than advised by the regulator.

Contract specifications

Expiry date. Monthly contracts expire on the last Tuesday or last Thursday of every calendar month depending on the choice made by the respective stock exchanges, and expiries of all equity derivatives contracts of an exchange will be uniformly limited to either Tuesday or Thursday.

At any time there would be three contracts available to trade:

• The NEAR month contract — expiring on the last Tuesday or Thursday of the current month
• The NEXT month contract — the last Tuesday or Thursday of the next month
• The FAR month contract — the last Tuesday or Thursday of the third month

If the Tuesday or Thursday of a month is a trading holiday, the contract expires on the previous trading day.

Trading cycle. Beyond the three near contracts, the exchange also specifies contracts for three quarterly months of the cycle March, June, September and December, and 8 following semi-annual months of June and December. These are long maturity contracts that do not trade very frequently. New contracts are introduced on the maturity of a near month contract.

For weekly index options, seven weekly expiry contracts excluding the expiry week of the monthly contract are made available for trading. A new serial weekly options contract is introduced after the expiry of the respective week's contract.

Trading lot. The trading lot for a futures contract is specified such that the value of the lot at the time of introduction is not less than ₹5 lakhs. So the trading lot is different for each contract and can also vary over time depending on the value of the underlying, especially for single stock futures.

Base price and tick size. When a contract is introduced for the first time, its base price is given by the exchange — usually the theoretical futures price based on the price of the underlying and implied interest cost for the period until the expiry date. On subsequent days, the base price is the daily settlement price of the contract.

The price step, also called the tick size, for futures contracts is ₹0.05. So if one trade was executed at 5610.50, then the next trade cannot be executed at 5610.52, but at 5610.55 or 5610.45.

Price and quantity freeze. Prices are freely determined by buyers and sellers. However, to ensure that any error in order entry does not create problems in the market, exchanges specify a range for price movement and a limit for order quantity. The trading member has to confirm to the exchange that there was no error and it was a genuine order. The exchange may not allow an order under quantity freeze if it exceeds the exposure limit of the member, or the traded volume for the contract is too low.

Trading

Derivatives can be traded on all weekdays (Monday to Friday). On the NSE:

• Normal market open time: 09:15 hrs
• Normal market close time: 15:30 hrs
• Trade modification end time: 16:00 hrs

Order types: regular lot order · stop loss order · immediate or cancel order · day order.

A regular lot order can be a market or limit order. A market order is executed at the prevailing price. A limit order is executed only if the indicated price or better is available in the market. Orders remain passive until they are matched by another order and executed. All unmatched orders, even if they are partially unmatched, are cancelled at the end of the trading day. An order placed as immediate or cancel is cancelled if not executed immediately.

A stop loss order is triggered only when the desired price at which the trade should be executed is reached. It is a sell order against a buy order already executed and aims to protect from adverse movement in price that an investor may not notice. Placing a buy order along with a stop loss ensures that the position is closed before the loss becomes steeper.

A spread order is placed when two positions are simultaneously managed and is defined for triggering a trade execution when the difference (spread) between the two positions reaches a specified level.

Corporate action adjustments follow the same principle as in the cash market: the exchange will carry out adjustments to traded price, on the last day on which a security is traded on cum basis in the underlying equities market, after the close of trading hours. The principle used in adjusting the prices is that the value of a position on the cum and ex dates remain the same.

Settlement

Three types of clearing members:

There are two types of settlements in a derivative contract: daily settlement (mark-to-market) and final settlement.

Daily settlement

All derivative contracts are settled on T+1 basis by computing the difference between the traded price and the daily settlement price.

The daily settlement price is announced by the exchange. It is the weighted average price of the last 30 minutes of trading.

The net position of a member is only in terms of funds, and is either a profit (pay-out) or loss (pay-in).

Worked: purchase of Nifty futures at ₹10,000; settlement price ₹9,900. The buyer ends up with a loss of ₹100 per unit of the index, so with a lot size of 50 there is a pay-in obligation of ₹5,000. He has to credit the clearing bank account of the clearing member with this amount.

Clearing members paying-in must have clear funds in their primary clearing account before stipulated time on the settlement day. The pay-out is credited to the primary clearing account of those with receiving positions at stipulated time.

Final settlement

The final settlement of a futures contract happens on its expiry date when all open positions are closed. The only difference between the MTM settlement and final settlement is the price. The final settlement happens at the closing price of the relevant underlying index or security in the cash market on the final trading day of the futures contract.

Clearing bank. A designated bank empaneled by the clearing corporation to receive and make payments for settlement of securities transactions. Every clearing member has to open a specific clearing account with the clearing bank, at specific branches as designated by the clearing corporation, and these clearing accounts have to be used only for the purposes of settlement with the clearing corporation.

Options: what differs

Equity option contracts are specified by the exchange in the same manner as futures contracts, on the same indices and stocks on which futures are available, with the same expiry dates. But two additional features are specified:

Option type. A European option can be exercised only on expiry date; an American option can be exercised any time before or on the expiry date. In the Indian markets only European options are traded at this time. A contract specified as CE is a Call European option; PE is a Put European option.

Strike price. The option contract is specified for the strike price. The market trades the premium to be paid for the given option.

Other specifications: the trading lot is set so that the value of the lot at the base price at the time of introduction is not below ₹5 lakhs; the price step is ₹0.05; and the base value is computed as the theoretical price of the option, using MIBOR as the interest rate, when the contract is introduced.

One important difference: the price band for an option is computed by the exchange and announced every day. It is not a fixed percentage or quantity-based freeze as in the case for futures.

Settlement of options differs from futures in two ways:

• Daily settlement is for the premium amount and is settled on T+1 basis. The premium due is paid to the clearing bank on the next trading day and is settled into the account of the seller
• On the expiry date, all options that are exercised come up for settlement. They are settled at the in-the-money strike price at close of trading hours on the expiry date. Long positions are assigned at this strike price to all short positions. All exercised options are aggregated client-wise, trading member-wise and assigned to the clearing member for settlement

Risk management

Since derivative contracts are settled into the future, exchanges put in place risk management systems to ensure that counterparties honor their contracts. Any default in a large and interconnected market can impact a large number of people.

The five tools:

• Setting capital adequacy requirements for members
• Imposing and maintaining stringent margin requirements
• Imposing and maintaining position limits based on capital
• Online monitoring of member positions
• Automatic disablement from trading when limits are breached

Base capital and liquid net worth

The rules and bye-laws of the Exchange and the Clearing Corporation require the amount of capital and net worth that members have to maintain. A part of the net worth and margin requirements has to be in liquid assets including cash and cash equivalents. This is called the liquid net worth. The rest of the capital is called base capital.

The clearing corporation can use these assets to settle any obligations of the member. This mechanism increases the capital and funding requirement for members, and enables the exchange to guarantee the settlement of all trades executed on the exchange.

Depending on their settlement volumes and obligations, members can request a release of collaterals, managed through an electronic interface so that a balance is achieved between funding all settlements and the cost to members from keeping assets idle.

Margins

Margins represent the amount the clearing corporation will collect from its members to ensure that trades settle without default. The chain runs: clients pay margins on their positions to trading members, and trading members to clearing members, who in turn pay the margins to the clearing corporation.

In the futures market segment, two kinds of margin are collected:

• Initial margin — collected using a formula that estimates the risk to an open position over a 2-day horizon
• Exposure margin — collected as a percentage of the notional value of an open position

Both initial and exposure margins are payable in advance by clearing members, before they enter into trading positions. Not paying the margin requirement attracts penalties including suspension of trading facility, disciplinary action, or closing out of open positions.

Clearing members have to send a daily report to the clearing corporation with the details of margins due and collected by them, and SEBI has issued a detailed monitoring mechanism for verification of upfront collection of margins from clients.

Margins for options work the same way except for the following:

On what the margins are levied. The initial margins are levied on the premium value of open option positions. The exposure margin is levied on notional contract value computed in terms of value of underlying representing the option position, and crucially exposure margin is collected only on short option positions (sellers).

Two additional margins.

• Premium Margin means premium amount due to be paid to the Clearing Corporation towards premium settlement, at the client level. Premium margin is levied till the completion of pay-in towards the premium settlement
• Assignment margin is collected for the final settlement obligation of the option. It is levied till the completion of pay-in towards the exercise settlement

Position limits

A clearing member's open position is computed after aggregating the open positions of all trading members, clients, or custodial participants who clear through such clearing member. Positions have to be separately grossed for proprietary trades of members and those of their clients, and the open position is arrived at after setting off sells against buys, within each category, and grossed at the clearing member level.

The exchange defines the limits to open positions for various derivative contracts. These are defined as percentage of market wide position limits, or in terms of contract value.

As limits approach: alerts are sent to avoid further trades, or fresh positions are not allowed to be taken; only existing positions can be reduced by squaring off. The trading terminal is inactivated if the position limit is hit. The exchange also imposes penalties for violation of margins or position limits.

The purpose: to ensure that no single client, trading member, or clearing member, or the market as a whole reaches a risky level of open positions that may pose a settlement risk.

What derivatives are used for

Derivatives are typically used for three purposes: hedging, speculation and arbitrage.

Hedging. When an investor has an open position in the underlying, he can use the derivative markets to protect that position from the risks of future price movements. This is particularly true when the underlying portfolio has been built with a specific objective in mind, and unexpected movements in price may place those objectives at risk.

Speculation. A speculative trade in a derivative is not supported by an underlying position in cash, but simply implements a view on the future prices of the underlying, at a lower cost. A buyer of a futures contract has the view that the price of the underlying would move up and he would gain having bought it at a lower price, earlier. The cost of this long position is the margin.

Arbitrage. Arbitrageurs are specialist traders who evaluate whether the difference in price is higher than the cost of borrowing. If yes, they would exploit the difference by borrowing and buying in the cheaper market, and selling in the expensive market. If they settle both trades on the expiry date, they will make the gain less the interest cost, irrespective of the settlement price on the contract expiry date, as long as both legs settle at the same price.

Benefits and costs

The benefits:

• Enabling hedging and better risk management by providing various alternative ways to structure symmetrical and asymmetrical pay offs
• Enhancing the liquidity of underlying markets and reducing the overall costs of trading for cash and derivatives. The availability of derivatives increases participation, information dissemination and price discovery

The cost, stated plainly by the workbook: over the counter contracts and poorly regulated derivative markets have led to several instances of liquidity crises and counterparty risks when large positions are sought to be unwound at short notice, after the risk surfaces.

Beyond the book, from the workbook's own footnote: a SEBI study published on 25 January 2023 revealed that 9 out of 10 individual traders in the equity Futures and Options segment incurred net losses. That is the single most important number in the chapter for anyone actually advising a client — the leverage that makes speculation cheap also makes it ruinous.

Two market indicators

Open interest

Contracts in the derivative markets are settled on a future date, and until then the contract remains open and unsettled. Such incomplete or outstanding positions in the derivative markets are called "open interest".

Open interest is defined as the sum of all incomplete contracts in the market, represented as one-sided positions of trading members and their clients.

Why "one-sided" matters — the workbook's illustration: if A sold a futures contract to B, there is both an open long and an open short position in the market. If A buys a futures contract a few days later from C, with the intention to square the earlier position off, A has no open positions. But at a market level, there is no change in open positions, because against the short position of B, there is a long position of C, instead of A.

Open interest is not the same as the market volume in derivatives, which can be higher or lower than the open interest.

Reading it: the larger the open interest as a percentage of traded volume, the greater is the liquidity in the market. An increase in open interest is seen as an indicator of liquidity as it means fresh money is flowing into those contracts. Higher liquidity reduces the transactional costs of a trade and ensures smoother movement in prices.

Put-call ratio

The ratio of outstanding put options to outstanding call options is called the put-call ratio (PCR).

PCR = Number of Put options outstanding ÷ Number of Call options outstanding

If the number of call options is higher than the number of put options, the PCR is less than one. If the PCR is greater than one, the number of puts is greater than the number of calls. Traders interpret these signals in various ways, to interpret whether the signals are bullish or bearish.