Derivatives — the ground floor

A contract that borrows its value

A derivative is a contract or product whose value is derived from the value of some other asset, called the underlying.

Underlyings can be almost anything:

• Metals — gold, silver, aluminium, copper, zinc, nickel, tin, lead
• Energy — crude oil and products, coal, electricity, natural gas
• Agri commodities — wheat, sugar, coffee, cotton, pulses
• Financial assets — shares, bonds, foreign exchange

Two legal definitions

Securities Contracts (Regulation) Act, 1956 [SC(R)A]. A derivative includes:

1. a security derived from a debt instrument, share, loan (secured or unsecured), risk instrument or contract for differences or any other form of security; and
2. a contract which derives its value from the prices, or index of prices, of underlying securities.

Because derivatives are securities under SC(R)A, their trading falls under the SC(R)A regulatory framework.

RBI Act, 1934 — Section 45U(a). A derivative is an instrument, to be settled at a future date, whose value is derived from changes in interest rate, foreign exchange rate, credit rating or credit index, price of securities, or a combination. It includes interest rate swaps, forward rate agreements, foreign currency swaps, foreign currency-rupee swaps, foreign currency options, foreign currency-rupee options and other instruments RBI specifies.

The four products

Forwards

A forward is an agreement made directly between two parties to buy or sell an asset on a future date, on terms decided today.

The workbook's gold example: on March 9, 2018, gold was ₹30,425 per 10 grams. Paying that and taking the gold is a cash market transaction at the spot price. Agreeing instead to pay ₹30,450 and take delivery after 1 month is a forward. No money or gold changes hands on the day. You are long forward; the goldsmith is short forward. Both must complete the deal whatever gold's price is later.

Forwards are bilateral over-the-counter (OTC) contracts. Price, quantity, quality, time and place are negotiated. The purpose is to fix the price and avoid price risk.

Limitations of forwards:

• Liquidity risk — tailor-made and not exchange-traded, so others may not want them.
• Counterparty risk — the other side may walk away. The rice example: A agrees to buy 100 kg at ₹20/kg from B in 6 months. If rice goes to ₹30, B may not deliver. If it falls to ₹15, A may buy from the market instead. This is also called default risk or credit risk.
• Also: lack of transparency and settlement complications.

The fix: move the contracts to a centralised trading platform. That is a future.

Futures

A futures contract is an agreement made through an organised exchange to buy or sell a fixed amount of a commodity or financial asset on a future date at an agreed price. Simply put, standardised forwards traded on an exchange.

• The exchange becomes counterparty to both sides through a clearing house.
• The clearing corporation guarantees settlement.
• Both buyer and seller have an obligation.
• The exchange decides all contract terms except price.
• Buyer = long; seller = short. The words are figurative — no money or asset changes hands when the deal is struck.

Features of futures: contract through the exchange; centralised platform; price discovery through free interaction of buyers and sellers; margins payable by both parties; quality and quantity standardised.

Options

An option gives the buyer a right but not an obligation to buy or sell the underlying on or before a stated date, at a stated price, for a premium.

• Buyer / holder = long. Seller / writer = short.
• The buyer exercises only when it is favourable. The writer is legally bound if the buyer exercises.
• Call option — right to buy. Put option — right to sell.

The workbook's example. Arvind buys a call on Nifty from Salim at 10,000, three months out, paying a premium of ₹100.

Intrinsic value is the excess of the current price over the strike price. Time value is what a buyer pays over and above intrinsic value, hoping the option gains value before maturity.

Option premium = Time value + Intrinsic value

In-the-money options have positive intrinsic value.

Swaps

A swap is a contract to exchange specified cash flows on future dates. Interest rate swaps and currency swaps are the most common.

The workbook's example: a borrower pays a floating rate (T-bill rate plus a spread) every quarter but wants to pay fixed. She enters a swap: pay fixed to the swap dealer, receive T-bill plus spread. The floating receipt pays off her floating loan, leaving a net fixed obligation.

The principal is agreed but never exchanged — only interest flows. That principal is the notional amount.

Swaps are OTC, but follow rules set by dealer associations. In India that is FIMMDA — Fixed Income Market and Derivatives Association of India, a voluntary body of commercial banks, financial institutions and primary dealers. Its objectives include being the principal interface with regulators, developing benchmark rates and new derivatives, training dealers, adopting international standard practices and a code of conduct, devising best market practices, arbitrating disputes between members, and standardising documentation.

Where derivatives trade in India

On stock exchanges: equity index options and futures; individual stock options and futures; currency options and futures on select pairs; interest rate futures; commodity futures for select commodities.

In OTC markets: forwards for agricultural commodities and interest rate swaps.

Why derivatives are used

Derivatives are typically used for three purposes:

• Hedging — protecting the value of an existing investment from future price movements.
• Speculation — a trade not backed by an existing investment; a bet on a price view. A futures buyer expects the price to rise and bears the cost of managing margins.
• Arbitrage — exploiting a price difference for the same asset in two markets. The law of one price says identical assets cannot trade at different prices in two markets. Arbitrage trades themselves close the gap. Prices can differ only by transaction costs — transport, storage, insurance, interest and similar.

Commodity and currency derivatives

Commodity derivatives help farmers, traders and processors hedge price volatility. Futures contracts specify quantity, quality, delivery time and place, and daily price limits. A biscuit maker wanting wheat later can buy wheat futures today.

Commodity futures trade only between members of an approved exchange, and exchanges need a certificate of registration from SEBI. The workbook names MCX, NCDEX, ICEX, NSE and BSE. Commodities fall into four groups: Bullion, Metals, Energy and Agriculture.

Commodity options in India devolve into commodity futures. The buyer gets a position in the futures contract, not the physical commodity. The workbook calls this an example of a derivative on another derivative — an exotic option.

Currency derivatives always involve a currency pair — you buy one currency and sell another. The underlying is an exchange rate. The workbook says currency derivatives are available on four currency pairs — USD, EUR, GBP and JPY — plus cross-currency futures and options on EUR-USD, GBP-USD and USD-JPY.

Core concepts

Zero sum game. Buyer and seller of a future have opposite views. At maturity only one gains, and net positions add to zero — assuming no taxes and no transaction costs.

Settlement. Cash settlement means paying the price difference, with no delivery. SEBI has mandated physical settlement for all individual stock derivatives and commodity derivatives. Index derivatives (Nifty, Bank Nifty) are still cash settled.

Margins. Funds or securities clearing members deposit as collateral before trading. Initial margin = SPAN margin + Extreme Loss Margin (ELM), both deposited before the trade. It should cover losses in 99 per cent of cases. More volatile stock = higher initial margin. Option buyers also pay a premium margin = premium × quantity purchased. SPAN (Standard Portfolio Analysis of Risk) is software developed by the Chicago Mercantile Exchange (CME).

Open interest. The total number of outstanding contracts not yet settled. It changes only when a new buyer and seller create a contract, or a buyer and seller close positions. It is not trading volume. Rising open interest = new money coming in; falling = money flowing out.

Derivatives in portfolio management

Portfolio managers may invest in derivatives, including for hedging and portfolio rebalancing, through recognised stock exchanges, on the terms in the Portfolio Management Agreement. The agreement must detail the quantum of exposure (absolute and as a percentage of other investments), instrument types, purpose, position types, valuation and liquidation terms, and prior permission from investors for any change.

The client's total derivatives exposure should not exceed his portfolio funds placed with the manager. If the agreement is violated, the portfolio manager is responsible. Disclosures go in the Disclosure Document. Portfolio managers may also participate in exchange-traded commodity derivatives for clients, subject to regulatory stipulations.