Basics of Derivatives

1What a derivative is

A derivative is a contract whose value comes from another asset, the underlying. Underlyings include metals (gold, silver, copper, zinc and others), energy (crude oil, coal, electricity, natural gas), agricultural commodities (wheat, sugar, coffee, cotton, pulses) and financial assets (shares, bonds, foreign exchange).

Remember

• No underlying, no derivative: the value always depends on something else.

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2How derivatives evolved worldwide

• 12th century: European fair sellers promised future delivery.
• 13th century: English monasteries sold wool up to 20 years ahead.
• 1634–1637: Tulip mania in Holland, a speculative boom and bust in tulip futures.
• Late 17th century: rice futures at Dojima, near Osaka, Japan.
• 1848: the Chicago Board of Trade (CBOT) began forward trading; in 1865 it listed the first exchange-traded futures.
• 1919: the Chicago Butter and Egg Board became the Chicago Mercantile Exchange (CME).
• 1972: CME's International Monetary Market started currency futures.
• 1973: CBOE became the first exchange for listed options.
• 1975: CBOT's T-bill futures, the first successful interest rate futures; 1977 T-bond futures; 1982 CME Eurodollar futures.
• 1982: Kansas City Board of Trade launched the first stock index futures.
• 1983: CBOE introduced index options (S&P 100 and S&P 500).

Growth drivers: more volatile asset prices, global integration of markets, cheaper communication technology, better understanding of risk management, and constant product innovation.

Remember

• First exchange-traded futures: CBOT, 1865. First listed options: CBOE, 1973. First index futures: Kansas City, 1982.

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3Derivatives in India

• 18 November 1996: SEBI set up the L. C. Gupta Committee (24 members) to design a regulatory framework. Its report (17 March 1998) recommended that derivatives be declared "securities".
• June 1998: the J. R. Varma group was set up on risk containment; it reported in October 1998 on margins, initial margin methodology, membership, net worth, deposits and real-time position monitoring.
• 1999: the SCRA was amended to include derivatives in "securities".
• March 2000: the government withdrew a three-decade-old ban on forward trading in securities.
• June 2000: index futures on Nifty and Sensex began on NSE and BSE.
• June 2001: index options. July 2001: stock options. November 2001: stock futures.
• February 2013: MSEI started derivatives trading.

The four basic products:

• Forward: a customised OTC agreement to buy or sell at a fixed future date and price; both sides are bound.
• Future: a standardised forward traded on a regulated exchange.
• Option: the right but not the obligation to buy or sell at a set price on or before a date. The buyer pays a premium; the writer receives it and takes the obligation.
• Swap: an agreement to exchange future cash flows by a formula; essentially a series of forwards, used for interest rate, currency and commodity risk.

Exam trap Index futures came first (June 2000); stock futures came last (November 2001), after index and stock options.

Remember

• L. C. Gupta: framework, derivatives as securities. J. R. Varma: risk containment and margins.

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4Who takes part

• Hedgers use derivatives to reduce an existing risk (companies, institutions, banks).
• Speculators (traders) take positions based on their view of prices; they prefer derivatives for leverage, lower cost and speed in size.
• Arbitrageurs profit from price differences between markets; their trades quickly close the gaps.

One person can play different roles at different times.

Remember

• Hedgers give away risk; speculators take it on; arbitrageurs remove mispricing.

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5OTC versus exchange-traded markets

The OTC market is a network of dealers trading by phone and electronic links, mostly banks, institutions, hedge funds, companies and wealthy individuals. Compared with exchanges:

• contracts are tailor-made;
• counterparty risk is managed by each institution separately;
• there are no central limits on positions, leverage or margins;
• no formal market-wide risk management;
• trades are private, with little disclosure.

Exchange-traded contracts are standardised, priced through an anonymous auction platform, and performance is guaranteed by a clearing corporation.

Remember

• OTC = customised, private, decentralised risk. Exchange = standard, transparent, guaranteed.

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6Why derivatives matter

Derivatives:

• improve price discovery;
• transfer risk from those who want less of it (hedgers) to those willing to bear it (traders);
• move speculation from unorganised to organised markets, where risk management and surveillance add stability.

Remember

• Three functions: price discovery, risk transfer, organised speculation.

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7Risks of trading derivatives

Derivatives are leveraged, so they carry: counterparty risk (default), price risk (losses from adverse moves), liquidity risk (cannot exit), legal or regulatory risk (contract not enforceable) and operational risk (fraud, poor documentation, wrong execution, inadequate disaster planning). They may not suit people with limited money, little experience or low risk tolerance.

Every client should read the Model Risk Disclosure Document that brokers give at account opening, before trading in cash or F&O.

Remember

• Operational risk = people, process and system failures (including poor disaster planning).

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