MBA Introduction Derivatives Market Definition Long Sample Paper Question Answer
MBA Introduction Derivatives Market Definition Long Sample Paper Question Answer
Introduction to derivatives market; Definition, Evolution and features of derivatives, Types of derivatives, Forward, future and Options market, Forward market transactions, Forward contracts, Forward market in India, Hedging with forwards.
Qus.1. Describe the evolution of derivatives.
Ans. Evolution of Derivatives
Although generally thought of as a high tech trading tool, derivatives have been around for quite a while. Over 1,00,000 years ago, it is known that people bartered for goods and services. The problem with bartering is that it is hard to trade between items that are harvested at different times of the year. Items that are perished quickly are difficult to trade.
The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralized location to negotiate forward contracts. From ‘forward’ trading in commodities emerged the commodity ‘futures’. The first futures type contract was called ‘to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first ‘exchange-traded’ derivatives contracts, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations,
The Chicago Mercantile Exchange (CME), a spin-off of CBOT was formed in 1919 though it did exist before in 1874 under the names of ‘Chicago Produce Exchange’ and ‘Chicago Butter and Egg Board. The first financial futures to emerge were the currency futures in 1972 in the US. The first foreign currency futures contracts were traded on May 16, 1972 on the International Monetary Market (IMM), a division of the CME. The currency futures traded on the IMM were the British pound, the Canadian dollar, the Japanese yen, the Swiss franc, the German mark, the Australian dollar and the Euro-dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.
The market for futures and options grew at a rapid pace in the 1980s and 1990s. The collapse of the Breton Woods regime of fixed parities and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives, which served as effective risk management tools to cope with market uncertainties.
Evolution of Indian Derivatives Market
India is one of the most successful developing countries in terms of a vibrant market for derivatives. This reiterates the strengths of the modern development of India’s securities markets, which are based on nationwide market access, anonymous electronic trading and a predominantly retail market. There is an increasing sense that the equity derivatives market is playing a major role in shaping price discovery.
Equity derivative trading started in India in June 2000, after regulatory proves which stretched over more than four year. In July 2001, the equity spot market moved to rolling settlement. Thus, in 2000, the Indian equity market reached the logical conclusion of the reforms programmed which began in 1994. It is important to learn about the behavior of equity market as well as investors towards equity market in new regime.
India’s experience with launch of equity derivatives market has been extremely positive, by world standards. NSE is now one of the prominent exchange amongst all emerging markets, in terms of equity derivatives turnover. There is an increasing sense that the derivatives market is playing a major role in shaping price discovery.
Qus.2. Explain the types of derivatives.
Ans. Types of Derivatives
Broadly derivatives can be classified into the following categories:
- On the Basis of Underlying Assets
Underlying asset is a term used in derivatives trading, such as with options. A derivative is a financial instrument whose price is based (derived) from different assets. The underlying asset is the financial instrument (e.g. stock, futures, commodity, currency, index) on which a derivative’s price is based.
- Equity Derivatives: An equity derivative is a derivative instrument with underlying assets based on equity securities. An equity derivative’s value will fluctuate with changes in its underlying asset’s! equity, which is usually measured by share price. Options are the most common equity derivatives because they directly grant the holder the right to buy or sell equity at a predetermined value. More complex equity derivatives include equity index swaps, convertible bonds or stock index futures.
Examples of equity derivatives are:
(a) Warrants: A warrant, like a call option, is a right to buy a share of a specified company at a certain price during a given time period. While the call option is issued by an individual, the warranties issued by the company and its proceeds are a part of equity. If a warrant is exercised, it increases the number of shares of the company and thus dilutes the equities of its shareholders.
- b) Convertible Bonds: Convertible bonds mean that these variants are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights, In other cases, there is automatic convertibility into a specified number of shares.
- Interest Rate Derivatives: An Interest Rate Futures (IRF) is a financial derivative with an interest-bearing instrument as the underlying asset. Interest rate futures means a standardized interest rate derivative contract traded on a recognized stock exchange to buy or sell a notional security or any other interest bearing instrument or an index of such instruments or interest rates at a specified
future date, at a price determined at the time of contract. Interest rate futures are relatively new! financial statement. It is one of the most successful financial futures instrument in the world. Interest rate futures trade in several maturities, currencies and different markets such as mortgages, federal issuance and short-term commercial paper.
- Foreign Exchange Derivative: Any financial instrument that locks in a future foreign exchange rate is foreign exchange derivative. These can be used by currency or fore traders, as well as large multinational corporations. The latter often uses these products when they expect to receive large amounts of money in the future but want to hedge their exposure to currency exchange risk. Financial instruments that fall into this category include currency options contracts, currency swaps, forward contracts and futures contracts.
- Commodity Derivatives: In case of commodity derivatives, underlying asset can be commodities like wheat, gold, silver, etc., whereas in case of financial derivatives, underlying assets are stocks, currencies, bonds and other interest rates bearing securities, etc. Thus, option or swaps on gold, sugar, jute, determined by the default risk pepper, etc. are commodity derivatives.
- Credit Derivatives: These are structured based on credit instruments or loans where the pay off is decided based on a credit event. These contracts are linked to a third party reference asset. Credit default swaps, credit default options, collateralized bond obligations, etc. are examples of credit derivatives.
- On the Basis of Financial Derivatives
Such derivatives can be:
- Forwards: Forward contract is a cash market transaction in which delivery of the instrument is deferred until the contract has been made.
- Futures: A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price.
- Options: An option represents the right (but not the obligation) to buy or sell a security or other asset during a given time for a specified price (the ‘strike’ price). Options are of two types: call and put option.
- Swaps: A swap is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first. Both payments take place on specified dates. Different formulas are used to determine what the two sets of payments will be. The different types of swaps used are interest rate swaps, currency swaps, commodity swaps and equity swaps.
III. On the Basis of Market in Which They Trade
Such derivatives include:
- Exchange Traded Derivative Market: As the word suggests, derivatives that trade on an exchange are called exchange traded derivatives. In the exchange traded derivatives market exchange acts as the main party and by trading of derivatives actually risk is traded between two parties. One party who purchases a future contract is said to go ‘long’ and the person who sells the future contract is said to go ‘short’.
Exchange traded are standardized contracts with predetermined exercise prices and standard expiration months (March, June, September and December). The principal centers are Philadelphia Stock Exchange and Mercantile Exchange, Chicago. Access to the market is through brokers who impose commissions for each contract traded. The market operates on the floor of the exchange where the brokers gather to reflect their client’s orders with market makers. The markets have specified opening and closing times for each currency market.
Exchange traded derivative market has the following features:
(a) Full transparency,
(b) Use of computers for order matching,
(C) Centralization of order flow,
(d) Lower costs of intermediation,
(e) Settlement guarantee,
(f) Better risk management,
(g) Enhanced regulatory discipline,
(h) Price-time priority for order matching,
(I) Large investor base,
(j) Wide geographical access, and
(k) An electronic exchange mechanism and emphasis on anonymous trading, etc.
- OTC Derivatives Markets: A security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, etc. The phrase ‘over-the-counter’ can be used to refer to stocks that trade via a dealer network as opposed to on a centralized exchange. It also refers to debt securities and
alike other financial instruments such as derivatives, which are traded through a dealer network. The dealer acts to bring the counterparties together but have no part in the transaction itself.
A fee is levied on both counterparties by the broker for such deals. Trades concluded directly are commission fee.
In general, the reason for which a stock is traded over-the counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as ‘unlisted stock, these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.
The main participants of OTC market are the Investment Banks, Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds.
The OTC derivatives markets have the following features as compared to exchange traded derivatives:
(a) There are no formal centralized limits on individual positions, leverage, or margining.
(b) The OTC contracts are generally not regulated by a regulatory authority and the exchange’s self-regulatory organization, although they are affected indirectly by national legal systems, banking supervision and market surveillance.
(c) The management of counter-party (credit) risk is decentralized and located within individual institutions.
(d) There are no formal rules for risk and burden-sharing.
(e) There are no formal rules or mechanisms for ensuring market stability and integrity, and for safeguarding the collective interests of market participants.
- On the Basis of Complexity
Such derivatives include:
- Hybrid/Exotic/Sophisticated Derivatives: Exotic derivatives are a specific type of financial assets. These are derivatives (assets whose value depends on another underlying asset) that do not have a standard pay-off, as is the case for a regular call option. It refers to any derivative security which is not a European or American vanilla call or put on a single underlying security. These options are more complex than options that trade on an exchange and generally trade over the counter.
For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the option is a put or call at a certain point during the option’s life. Because this type of option can change over the holding period, it is apparent that this type of option would no be found on a regular exchange that is why it is classified as an exotic option,
Other types of exotic options include:
(a) Barrier options, (b) Asian options
(C) Digital options, and
(d) Compound options.
- Weather Derivatives: Weather derivatives are financial products that enable an organization to offset the financial risk due to a weather variable. They allow companies to control the effects of weather on demand for their products. This hedging reduces the volatility of future revenue to a more predictable cash flow. A degree-day is the deviation of a day’s average temperature from the reference temperature. This was found to be a useful measure that the energy suppliers could use to hedge their supply in adverse temperature conditions. The common forms of weather derivatives are call options, put options, caps, floors, collars and swaps. Some of the exotic varieties like one-touch, digitals, barrier and basket options are also structured to meet the specific needs.
Qus.3. What do you understand by forward contract and what are the terminologies used in it?
A forward contract is a popular investment tool used by large corporations and small investors alike. Forward market is a market dealing in commodities currencies and securities for future (forward) delivery at prices agreed-upon today.
A forward contract is a simple customized contract between two parties to buy or sell an asset at a certain time in the future for a certain price. Unlike future contracts, they are not traded on an exchange, rather traded in the over-the-counter market, usually between two financial institutions or between a financial institution and one of its clients. In other words, it is a privately negotiated contract that is not conducted in an organized marketplace or exchange. Both parties to a forward contract expect to make or receive delivery of the commodity on the agreed-upon date. It is difficult to get out of a forward contract unless the other party agrees. All forward contracts specify quantity, quality and delivery periods.
It is important to distinguish between ‘price’ and value-this is important for all instruments.
- Forward Value: This is what one can sell something for or what one must pay to acquire something. Valuation, thus, is the process of determining the value of an asset/the amount of money that would be paid to engage in transaction.
- Forward Price: This is the fixed price or rate at which the transaction is scheduled to occur at expiration. Pricing, thus, is to determine the forward price/rate.
Thus, a forward contract is an agreement to buy (or sell) an asset at a preset price on a future date. At maturity, if the actual price (spot price) is higher than the contracted price, the forward buyer makes a profit. If the price is lower, the buyer suffers a loss. The pay-off to the seller is opposite to that of the buyer.
Terminologies Used in Forward Contract
The important terminologies used in forward contract are described below:
- Underlying Asset: This refers to the asset on which forward contract is made, i.e. the long position holder buys this asset in future and the short position holder sells this asset in future. The various underlying assets are equity shares, stock indices, commodity, currency, interest rate, etc,
- Long Position: The party that agrees to buy an underlying asset (e.g. stock, commodity, stock index, etc.) in a future date is said to have a long position.
- Short Position: The party that agrees to sell an underlying asset (e.g. stock, commodity, indices, etc.) in future date is said to have a short position.
- Spot Position: This is the quoted price of the underlying asset for buying and selling at the spot time or immediate delivery.
- Future Spot Price: This is the spot price of the underlying asset on the date the forward contract expires and it depends on the market condition prevailing at the expiration date.
- Expiration Date: This is the date on which the forward contract expires or it is also referred to as the maturity date of the contract.
- Delivery Price: The pre-specified price of the underlying assets at which the forward contract is settled on expiration is said to be the delivery price.
Qus.4. Describe the various categories of forward contract.
Ans. Classification/Categories of Forward Contract
For the governance of forward contract in India, Forward Contract (regulation) Act, 1952 was enacted. As per this Act, forward contracts are of the following five categories:
- Fixed Term and Optional Term Forward Contract: Both buying and selling forward exchange contracts may be either fixed or optional term contracts.
(a) Fixed Term Contracts: Fixed term contracts allow the customer to specify the date when the delivery of the overseas currency will occur. Earlier delivery is usually an option, however, a marginal adjustment to the Forward Contract Rate may be required.
(b) Optional Term Contracts: Optional term contracts allow the customer to enter into an agreement for a specific period, where the customer declares a certain period within which they would like the delivery to be made this normally occurs for periods shorter than one month),egg. a customer may enter a contract for a six month period while having the option of receiving a delivery anytime during the final week. In both cases, there is a contract that affects delivery for both parties—the customer and the bank An optional delivery contract does not exempt the customer from this obligation to deliver the forward exchange contract. The optional delivery contract exclusively affects the period in which the delivery will occur, making it optional. Forward rates are applicable for transactions in which settlement is expected to occur for two or more business days following the transaction date. Forward contract rates are made up of the spot rate for the currency being traded which is Range POS slightly adjusted due to the relative Forward Margin.
- Hedge Contracts: These are freely transferable contracts contract that protects buyers which do not require specification of a particular lot size, quality or delivery standards for the underlying assets. Most of these are necessary to be settled through delivery of underlying assets.
- Transferable Specific Delivery Forward Contracts: Apart rate from being freely transferable between parties concerned, these forward contracts refer to a specific and predetermined lot size and variety of the underlying asset. It is compulsory for delivery of the underlying assets to take place at expiration of contract.
- Non-transferable Specific Delivery Forward Contracts: These contracts are normally exempted from the provision of regulation under Forward Contract Act, 1952 but the Central Government reserves the right to bring them back under the act when it feels necessary. These are contracts which cannot be transferred to another party. The contracts, the consignment lot size and quality of underlying asset are required to be settled at expiration through delivery of the assets.
- Other Forward Contracts: It includes the following:
(a) Forward Rate Agreement (FRA): Forward contracts are commonly arranged on domestic
interest-rate bearing instruments as well as on foreign currencies. In forward rate agreement, no actual lending or borrowing is affected. Only it fixes the rate of interest for a futures transaction
(b) Range Forwards: These instruments are very much popular in foreign exchange markets.
Under this instrument, instead of quoting a single forward rate, a quotation is given in terms of a range, i.e. a range may be quoted for Indian rupee against US dollar at 64 to 68. It means there is no single forward rate rather a series of rates ranging from 64 to quoted. This is also known as flexible forward contracts.
Qus.5. Explain pay-offs and pricing in forward contract.
Ans. Pay-offs in Forward Contract
A forward contract is usually traded between two financial institutions or between a financial institution and one of its clients. One of the parties to a forward contract assumes a long position and it agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and it agrees to sell the asset on the same date for the same price.
The pay-off from a forward position at maturity, depends on the relationship between the delivery price (K) and the underlying price (S) at that time. The pay-off from a long position in a forward contract on one unit of an asset is equal to the excess of the underlying price on maturity over the delivery price. Thus, if the spot price on maturity date is more than the delivery price, the buyer stands to gain while if the spot price is less than it, he stands to lose. For the party having a short position, the pay-off would be exactly opposite to that of the long position. Symbolically, the pay-off from a forward contract on one unit of an asset can be given as:
- For a long position, pay-off is: fro=S-K
- For a short position, it is: fro=K-ST.
where, K= Delivery price,
ST = Price of asset at contract maturity.
These pay-offs can be positive or negative. Since, it costs nothing to enter into a forward contract, the pay-off from the contract is also the
Pricing of Forward Contract
The price of a forwards contract can be described as:
- Underlying Providing No Income: This is the easiest forward contract for valuation. In order! that there is no arbitrage opportunities, the forward price Of should be:
(a) In the case of annual risk-free interest rater,
Of = So (1+r)
(b) In the case of continuously compounded risk-free interest rater,
Of = Sort
where, Of = Forward price, So = Spot price, and t = Time of the contract.
Example: A forward contract on a non-dividend paying share which is available at * 70, to mature in 3-months’ time. If the risk-free rate of interest be 8% per annum compounded continuously, find the price of the contract.
Sol. The contract price is given as Of = Sue’s
= * 70 x 1.0202
Contract price = 71.41.
- Known Income from Underlying: If the underlying asset on which the forward contract is entered into provides an income with a present value, I, then the forward contract would be valued as:
Example: A 10-month forward contract on a stock with a price 50. We assume that the risk-free rate of interest (continuously compounded) is 8% per annum for all maturities. We also assume the dividends of 0.75 per share are expected after 3 months, 6 months and 9 months. What is the price of the forward today?
Sol. The present value of the dividends is
I=0.75e-0.08 x 3/12 +0.75e-0.08*6/12 +0.75e-0.08%9/12 = 2.162
The forward price is given as,
Of= (50 – 2.162)e0.08x 10/12 = 51.14.
Known Yield from Underlying: If the underlying asset on which the forward contract is entered into provides a continuously compounded yield, q then the forward contract would be valued as:
where, q = Continuous % of return on the asset divided by the total asset price.
Example: The stocks underlying an index provide a dividend yield of 4% per annum, the current value of the index is 520 and that the continuously compounded risk-free rate of interest is 10% per annum. Find the value of a 3-month forward contract.
Sol. Here, So = 520, r=0.10, q=0.04 and t=3/12 = 0.25.
The forward price Of is given as,
Of=520e(0.10 – 0.04) 0.25
= 520 x 1.0151 = 527.85