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Derivatives in Capital Market

Nimish.A.Chodankar 
on 24 September 2014

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Capital Market

Capital markets are financial markets for the buying and selling of long-term debt or Equity-backed financial instruments called securities. Capital markets help channelize surplus funds from savers to institutions which then invest them into productive use. Nowadays the term ‘capital markets’ is used in a more general context to refer to the market for stocks, bonds, derivatives and other investments.

Capital markets serve two purposes:

- Bringing together those holding capital (investors) and those seeking capital (companies and governments) through equity and debt instruments – Primary Markets

- Providing a secondary market where holders of these securities can exchange them with one another at market prices – Secondary Markets

Companies and governments use capital markets to raise funds for their operations. Investors purchase securities in the capital markets in order to extract a return and earn profit on the securities.

Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities (by Companies, governments or public sector institutions), whereas secondary market deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market.

Derivatives

Derivatives are one of the three main categories of financial instruments; the other two being equities and debt. Derivatives are contracts which derive their value from the performance of underlying security or set of securities. However, ownership of a derivative doesn't mean ownership of the asset. In simple terms, a derivative is anything that is valued based upon some other asset. Derivatives are contracts that originated from the need to limit risk.

On the basis of the way they are traded, derivatives can be classifies as:

OTC (Over the Counter) Derivatives: As the name suggests, these contracts are traded over the counter, i.e.   they are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Tailor-made derivatives, not traded on exchanges are traded in OTC derivatives markets.  or

ETDs (Exchange Traded Derivatives): These are the derivatives that, unlike OTC derivatives, are traded on derivatives or other exchanges where derivatives are in form of exchange defined standardized contracts.

Types of Derivatives – Key forms

Forwards

A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. They are bilateral contracts and hence exposed to counter-party risk. These are traded OTC and are unique in terms of contract size, expiration date and the asset type and quality. The contract has to be settled by delivery of the asset on expiration date.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets

Futures

Futures are financial contracts obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Options

Options are derivatives that represent a contract sold by one party (option writer) to another party (option holder). The contract offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon price (the strike price) during a certain period of time or on a specific date (exercise date).

Call options give the option to buy at certain price, so the buyer would want the stock to go up. While, Put options give the option to sell at a certain price, so the buyer would want the stock to go down.

The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

Swaps

A swap is a derivative in which two counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. An example is wherein if firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates.

Other Forms:

Other forms of derivatives include Caps, Floors, Collars, Credit Default Swaps, Warrants, etc.

Valuation and Risk Management

A few methods used to value derivatives are The Binomial Model , The stock price model, The black-scholes equation. The risks in options can be measured in terms  of option Greeks. The “Greeks” are sensitivities of option price to model inputs (Delta, Gamma, Theta, Rho, Vega). Option products value includes time value and intrinsic value whereas Lock products are valued at zero in the beginning and later as the prices of the underlying changes, their value too change and accordingly they can either be in-the-money (an asset) or out-of-the-money (a liability).

The two common measures of value of derivatives are:

1. Market Price – In case of exchange traded derivatives, this value is determined real time based on the bids and asks for the particular derivative under consideration. In case of derivatives traded over the counter, finding this value becomes difficult as trading is done manually and not on the exchange.

2. Arbitrage Free Price- Arbitrage Free price is the value such that no risk free profits (arbitrage) can be made given the price of the derivatives. The arbitrage price of futures and forwards can be found out easily since this is the price of the underlying with the cost of carry. However, in case of options, determining this price is complex and this is where the valuation models like the Black-Scholes Model, Binomial Options Model, etc are used.

Usage

As often is the case in trading, the more risk you undertake the more reward you stand to gain. Derivatives can be used on both sides of the equation, to either reduce risk or assume risk with the possibility of a commensurate reward.

- Hedging - Derivatives can be used  for hedging against risks by entering into a derivative contract whose value moves in the opposite direction to their underlying position that would help cancel part or all of the risk.

- Creating exposure to the underlying where it is not possible to trade in the underlying

- Taking exposure in the underlying with smaller amount invested, since only margin amount is to be invested Instead of the spot price of the securities/ underlying. This is called gearing / Leverage.

- Speculation – Derivatives are also used to make profits by speculation. Speculators make bets or guesses on where they believe the market is headed. However, speculation can be extremely risky

- Arbitrage – Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. Derivatives can also be used for for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset

Regulatory Framework in India

The term Derivative has been defined in Securities Contracts (Regulations) Act, as:

A Derivative includes:

a. a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;

b. a contract which derives its value from the prices, or index of prices, of underlying securities

SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their Clearing Corporation/House which lays down the provisions for trading and settlement of derivative contracts. SEBI also issues Circulars regarding Exchange Traded Derivatives. SEBI has also laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/ House.

Mr.Nimish.A.Chodankar

Reg. No.:WRO0455539

Email id: nimishchodankar3692gmail.com


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