WHAT ARE DERIVATIVES

For a trade to take place, what you need is two people- one with some goods to sell and the other to buy it. The process of the trade will consist of both these parties expressing their individual interests- one to buy and the other to sell – and then they get into an auction process so as to decide the price. Once there is an agreement on the price, the two shake hands and a transaction is complete. Where multiple buyers and sellers congregate and multiple trades begin to occur, is called a market. There are two ways that a trade can take place. One, the goods are physically exchanged for money (like in a retail shop) or Two, there could be a transaction in a “promise” to deliver the goods at a future point of time for a price agreed upon in the present. This kind of transaction was the norm where the goods were expected to arrive or be ready for shipment after a while – such as in Crops or commodities that were imported or exported from other lands. The people dealing in such items would be either the producer of it or a consumer of it. For example, a wheat farmer would be quite interested in ensuring that he gets a good price for his crop – when he is ready with it – from the bread manufacturer (who is the consumer of his product).
In the same fashion, the bread manufacturer is equally interested in tying up good and consistent supply of wheat so that he can produce his goods (i.e. bread) uninterrupted. This need of both parties is met by the formation of the “Forward Market” or a market that deals in the present for value to be settled at some point of time in the future.
Such Forward markets have existed ever since trade began. They had some imperfections within them and this led the traders to form what came to be known subsequently as the Futures markets.

Background of Indian Financial Markets
Financial markets in India have been largely synonymous with the Stock markets. There were several reasons for this. Being a largely agrarian based economy, the farming community was a completely protected one and the socialistic policies followed by successive governments led to the image that trading in commodities was something that was almost “un-Indian”. Therefore, commodity-trading exchanges were never ever encouraged. To this day, the vast majority of the trading taking place in the different commodity markets in the country is all dominated by forward contracts between actual producers and wholesalers/exporters etc. Further, the Indian economy being a closed one, foreign exchange trading was something entirely, well, foreign. We also had some kind of protectionism in the Gold and Silver markets and there was a ban, until recently, on any kind of export or import of these metals. Therefore, this market too could not develop like their counterparts in the other parts of the world. This left only the Stock Markets as an arena where man could express one of his natural instincts to trade. The rapid industrialization and the continued socialistic policies of the seventies led to the Fera dilution which was the major impetus to this market, led to greatly increased public interest in the markets. The era of the IPO (initial public offering) was born and the stock market became the place for investment.

As the markets grew, slowly, a need for some kind of a hedging mechanism was felt by the players of the stock markets, now that the game had gotten a lot bigger than it ever was. The BSE Index during this period had risen from the sedate 200-300 ranges of the early eighties to 4500 in the mid nineties. This was a huge rise and the decline that set in from there was also much, much larger than what had been experienced by the players until then. By then the Mutual Fund industry had also got established in the Indian markets.

The only known hedging mechanism in the market was a system known as “badla”. This system functioned well when stocks had to be sent for transfer and the financier was protected from any adverse stock price moves by taking a position in the budla market. This system was imperfect but served the purposes of most traders and financiers. But since mutual funds were not allowed to participate in this market, it remained the fiefdom of brokers and traders. This led to periodic abuses of the system by different brokers and market operators, the most recent one being the manipulation of the budla market at the CSE by Ketan Parekh and his coterie.

SEBI, which had come into existence by 1993, was slowly flexing its muscles over the years, trying to bring some kind of discipline into the market and relaxing the stranglehold that the brokers and operators had over the stock markets. With every passing year, SEBI gathered more and more teeth and finally, in the year 2000, they managed to get the exchanges to start a Futures and Options segment. The markets started trading in Futures in 2000 and in 2001, the options market also began. This was a landmark event in the evolvement of our financial markets to world standards.

The Need for Derivative Markets

The word derivative means “derived from” or an “offshoot of” some other item. The need for derivative products arose out of the basic need to hedge or control risks in financial trades. The futures markets evolved out of business people’s need to transfer the risk of carrying inventory to the speculators who were willing to bear that risk, hoping to profit by a gain in the value of the commodity or stock. Before proceeding further, therefore, it is necessary to understand the nature of risk. In the stock markets, there are two kinds of risks:
The stock related risk – that which relates to the performance of the company, its industry, and
The market related risk – that which is connected with factors other than the company but which impact the market as a whole.
While it is agreed that most of the stocks purchased by investors and mutual funds would be (or should be) as a result of adequate research into the fundamentals of the stock and its industry, it would be very difficult to account for all the factors that go to affect the market as a whole. The numbers of variables, which affect the market as a whole, are too numerous even to list! Hence, any stock positions carries with it an element of the market as, being a part of the market, it would represent the entire market as a microcosm. If one wanted to have a situation where the outcome of the stock’s price was a function of its individual performance within that industry alone, then it is obvious that there has to be some way of eliminating the risks associated with the market as a whole. This was done through the use of financial futures and options.
Hence, the concept of a derivative product on the stocks and indices (and in the rest of the world, commodities and currencies) arose with an idea of shifting the risk to people who were willing to accept them. Every market needs an element of speculation. It is undeniable that speculation intrinsic of man’s nature. But it plays a very useful function in the markets by increasing or providing the much needed liquidity, without which, most markets would become quite volatile and price stability a mirage. Hence, in order to encourage the flow of volumes, financial re-engineering in the form of Futures and Options on stocks and indices were invented.
Futures and Option Contract Details
The Index futures commenced trading in June 2000. The exchanges commenced Options trading in June 2001 with options on Index and in July 2001 with options on individual stocks. The sensex and nifty are the two designated indices for Futures and Options trading. 31 leading stocks have been designated for options trading. These have been selected on the basis of some stringent conditions and parameters laid down by Sebi.

The Sensex futures contract trades with a 50 multiple while the Nifty contract has a 200 multiple. Translated, this means that one futures contract of the Sensex would mean 50 Sensex while one Nifty contract would get you 200 Nifty. Hence every point move in the sensex would mean a 50-point change in the value of the contract and 200 in the nifty contract. Or, in other words, if one is long index futures, for every one point move of the sensex, one would get a profit or loss of Rs.50 and it would be Rs.200 for the nifty.

It should be realized that derivative products have a short life. They are designated by the time when they are said to “expire”. That is, the date of expiry is the last day of trading. After that date, a new contract has to be entered into. The exchanges have standardized the life of the contracts on both futures and options to three months. We have therefore futures and options on indices as well as stocks for the current month and the next two months. In the jargon, they are referred to as the Near month, the mid month and the far month contracts. Hence we would have July Nifty future, August Nifty and September Nifty (or Sensex) at the moment as the three contract months trading.

The Index option gives the right (without the obligation) to the buyer to either buy or sell the index at a certain price and at a certain time. The contracts are designated by the month and the price. The price here is referred to as the “Strike” price. So when we say “July 1060” what it means is Index option for July at a price of 1060. One can have several strike prices for the same month. So for July we have July1020 or July 1080 or July1100 etc each of which designates the month and the price. In the Nifty options, the strike rates change at an interval of 20 points while in the Sensex, they change at an interval of 50 points (July3500, July3550, August3500, August3450 etc). Stocks are also designated similarly and the change in the strike prices would depend upon the price of the underlying stock. For example, Infosys options have strikes which are 100 points apart i.e. July3500, July3600 etc while Reliance strikes move at 20 points and Digital strikes are spaced 30 points apart. The strikes are decided by the Exchanges and as prices move, new strikes are introduced for trading. It must be understood that each strike is a distinct trading instrument in itself. In other words, July320 for Reliance is a separate instrument for trading, as is July340 or July300. The exchanges have decided that at any given point of time, there would be a minimum of 5 strikes traded.
Types of Players
The market is composed of all types of players with all kinds of strategies and desire for the end outcome. While everyone is engaged in either buying or selling, it is motive or the strategy behind the buying or selling that differentiates the players. Accordingly, we can make the following classifications
Traders or Speculators have a definite view about the directionality of the market for the future. Hence they take up positions that will benefit them from the movement of the underlying. In the futures markets, traders would take up long positions or buy the futures at current rates with an expectation that it would move up in the coming days and give them profits before the contract expires. If their view were bearish, then they would sell the futures contract at current prices and expect it to decline as the market goes lower and then would buy it back and make a profit out of the difference. This process is called short selling. In the options markets, speculators would buy Call options (the right to buy) if they felt the market would rise or buy Put options (the right to sell) if they felt the market would decline. They can then either hold the position until expiry or they could square off the deal if some profits are available before the expiry date. The difference between the purchase and sale price of the future or the option contract would determine the profit or loss in the transaction.
For example, if one is bullish on the market, one can buy an August Future which, say, is currently quoting at 1065 (current index level is 1060) if one expects that the index would be moving up by August. If this supposition is correct and the index moves up to, say, 1100, the August futures would be salable around 1105 or s. Thus the buyer of the future contract would net a gain of about 40 points less the transaction costs. Since each point move on the nifty index is equal to Rs.200, this would be a profit of Rs.8000 on every contract of nifty that is purchased. If one is bearish on the nifty and thinks that the level of nifty in September would be 1000, then one can sell the September future contract currently trading at 1070. If the view is correct and the nifty level in September is indeed 1000, then the September future contract by that time would also have declined to around 1005 or so. One can then buy back what is sold and net a gain of 65 points amounting to Rs.13000 per contract. Of course, if one is wrong in the view and the market rises, say to 1120 by September, then the contract would be trading around 1125 and one would then incur a loss of 55 points or about Rs.11000 per contract.

Hedgers: This is one of the most common usages of the futures and options contracts. This is done by players who hold stocks, like Mutual Funds, and who would like to protect the value of the portfolio during the times when the market is bearish. Typically, they would look to participate in the futures-options markets during bearish times. If the market were expected to fall, then a mutual fund manager would seek to sell the Index future of a value equivalent to his portfolio. Why should one do this? Because the law relating to mutual funds requires that the money raised should be deployed in equities up to a certain minimum percentage. Thus, a fund would always remain invested to that extent and only the balance portion would be held in non-equity instruments. If the market falls, the fund would then take a hit in the values of its holding. By selling index futures and buying them back at a later, lower price, the fund has recouped its losses on the equity side with a profit made on the futures trade. Thus the value of the fund is saved (to a large extent) from eroding. This protects the Net Asset Value (NAV) of the fund and thereby the investor in that mutual fund (people like you and me) are also protected from erosion of their own net worth.
Alternatively, the fund manager can also buy Puts on the index or the individual stocks that he holds and thereby participate in the decline of the market without selling out his holding. Again, the loss in equities value is made up by the profits in the Put options.
It is to be noted here that Hedging does not make profits. It only contains the losses.

Arbitragers: These are set of players who try to take advantage of mispricing that periodically occur in the market due to different sets of reasons. There could be a difference in pricing between the underlying asset and what is known as the “fair value” of the future instrument (either Futures or Options). There could be a mispricing between different futures instruments themselves owing to changes in volatility of the market or temporary supply-demand changes. There are multiple reasons why mispricing will occur. Arbitragers keep a keen watch on the prices and take advantage of the situation by buying and selling the two instruments simultaneously to lock in the difference. For example, if the current index level is 1060 and the fair value of July Nifty is 1080 but it is currently quoting at 1090, then an arbitrager would quickly sell the future contract at 1090 and buy the cash index at 1060. This is because he sees that the correct spread between the two should be 20 points while currently it has expanded to 30 for some reason. He will then square off the transaction when the nifty returns to the “normal” spread of 20 points and thereby net a profit of 10 points. Similarly, one can also spot the mis pricing in option contracts and seek to profit from this. The trading of this kind is almost a risk free venture but requires a keen eye and quick action. Arbitragers impart a great amount of liquidity to the system.

Economic Relevance of Futures Markets

The most important role that the futures markets perform is in aiding the process of proper price discovery. Since several different types of players are engaged in trading the futures markets with different intentions, it leads to a correct pricing of the asset. This has important fall out, especially in the commodity and currency markets. It prevents incorrect extension of trends that would be harmful to the general public and thereby leads to a greater market efficiency. The presence of a larger number of tradable instruments also leads to a more complete market, one where every type of player can have the maximum number of features which will permit him to participate to the fullest extent in the markets. The proper design of the futures products and the framework of trading help to contain the risks in investments for different players. This leads to a more reliable and longer lasting system.

Summary
The advent of the futures and options markets in India is a welcome addition to the number of instruments that is currently available to the individual trader and investor as well as the institutional players. One need no longer bemoan the lack of hedging facilities in the market and this is one of the most bullish developments for the long term. The Indian stock markets can now begin attracting entirely newer set of players who were hitherto hesitant to enter the stock markets because of the absence of risk containing measures. The world over, the experience has been that the cash market has multiplied several fold with the introduction of the Futures markets, particularly, options. The same may be expected to happen in India too. We are therefore set for very exciting times ahead of us in the markets. The entire face of the stock markets as we knew it, is set to change. Truly, we are now about to catch up with the rest of the world.

Suggested Reading and Surfing
1.Futures-Options and the Investor by Dr.CK.Narayan
2.Introduction to Futures and Options Markets by John Hull
3. Complete guide to Futures markets by Jack Schwaeger.
www.cboe.com
www.numa.com
www.optionetics.com
Sources:http://www.chartadvise.com