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Derivatives

Derivatives

What are Derivatives?

The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anything else.

In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act, 1999, derivatives have been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act. The term ‘Derivative’ indicates that it has no independent value, i.e. its value is entirely ‘derived’ from the value of the underlying asset. The underlying asset can be securities, commodities, bullion etc.

What are the different types of Derivatives?

Forwards, Futures and Options are the different types of Derivatives.

What is meant by a Forward Contract?

A forward contract is a customized non-standardized contract between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price. These are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is a high counterparty risk i.e. a chance that a party may default on its side of the agreement.

What is meant by a Futures Contract?

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.

What is meant by an Option Contract?

Options Contract in trading is a type of Derivatives Contract which gives Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer/holder of the option purchases the right from the seller/writer for a consideration which is called ‘Premium’. The seller/writer of an option is obligated to settle the option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined.

What are the different types of Options?

  • Call Option: When any option contract grants the buyer the right to purchase the underlying asset from the writer or seller, it is called call option or simply "Call"
  • Put Option: When the option buyer has the right to sell the underlying asset to the writer, then it is called Put Option or "Put" An option contract can also be categorized on the basis of when the option buyer exercises it, as follows:
    • American Option: A contract with American option entitles buyer to exercise it any time up to expiry date
    • European Option: When an option can be exercised on only the expiration date, then it is called the European Option
    • Bermuda Option: An Option which can be exercised before the expiry date but only on certain specified dates, then that’s called a Bermuda Option

What is meant by a Strike Price?

The strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity.

What is meant by In-the-money, At-the-money and Out-of-the-money options?

  • In-the-money option is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.
  • At-the-money Option is an option that has intrinsic value. In the case of a call, an option whose exercise price is below the current underlying share price, or in the case of a put, an option whose exercise price is above the current underlying price.
  • Out-of-the-money Option is an option that has no intrinsic value. That is an option which theoretically, it would not be worthwhile to exercise immediately e.g. a call option whose exercise price is above the current underlying share price or a put option whose exercise price is below the current underlying share price.

Define Intrinsic Value of an Option?

The amount, if any, by which an option is currently in the money. An option that is not in-the-money has no intrinsic value.

Define Time Value of an Option?

The amount, if any, by which an option's premium exceeds its intrinsic value. If an option is not in the money, its premium consists entirely of time value.

What is meant by Open Interest?

It is the net long and short amount of outstanding positions in a particular contract.

Who is a Writer of Options?

The Writer is the seller of an option contract who is obliged to deliver or take delivery of the underlying instrument upon notification by the buyer (holder).

What is meant by a Straddle?

It is the simultaneous purchase (sale) of a call and put option in the same expiry month with the same exercise price.

What is meant by a Strangle?

It is the simultaneous purchase (sale) of a call option at one exercise price and a put option at a lower exercise price but with the same expiry date.

What are the different options Greeks?

Options traders often refer to the delta, gamma, vega and theta of their option positions. Collectively, these terms are known as the "Greeks" and they provide a way to measure the sensitivity of an option's price to quantifiable factors.

What is Delta in options trading?

(Delta) represents the rate of change between the option's price and a $1 change in the underlying asset's price – in other words, price sensitivity. Delta of a call option has a range between zero and one, while the delta of a put option has a range between zero and negative one. For example, assume an investor is long a call option with a delta of 0.50. Therefore, if the underlying stock increases by $1, the option's price would theoretically increase by 50 cents, and the opposite is true as well.

What is a delta hedge?

Delta hedging is an options strategy that aims to reduce, or hedge, the risk associated with price movements in the underlying asset, by offsetting long and short positions. For example, a long call position may be delta hedged by shorting the underlying stock.

What is Gamma in options trading?

(Gamma) represents the rate of change between an option portfolio's delta and the underlying asset's price - in other words, second-order time price sensitivity. Gamma indicates the amount the delta would change given a $1 move in the underlying security. For example, assume an investor is long one call option on hypothetical stock XYZ. The call option has a delta of 0.50 and a gamma of 0.10. Therefore, if stock XYZ increases or decreases by $1, the call option's delta would increase or decrease by 0.10.

What is Theta in options trading?

(Theta) represents the rate of change between an option portfolio and time, or time sensitivity. Theta indicates the amount an option's price would decrease as the time to expiration decreases. For example, assume an investor is long an option with a theta of -0.50. The option's price would decrease by 50 cents every day that passes, all else being equal. If three trading days pass, the option's value would theoretically decrease by $1.50.

What is Vega in options trading?

Vega represents the rate of change between an option portfolio's value and the underlying asset's volatility - in other words, sensitivity to volatility. Vega indicates the amount an option's price changes given a 1% change in implied volatility. For example, an option with a Vega of 0.10 indicates the option's value is expected to change by 10 cents if the implied volatility changes by 1%.

What is Rho in options trading?

(Rho) represents the rate of change between an option portfolio's value and a 1% change in the interest rate, or sensitivity to the interest rate. For example, assume a call option has a rho of 0.05 and a price of $1.25. If interest rates rise by 1%, the value of the call option would increase to $1.30, all else being equal. The opposite is true for put options.

Commodity Derivatives

Commodity Derivatives

What is a commodity?

A commodity is an article or product that is used for commerce, is movable, has a value, can be bought and sold and that is produced or used as a subject in a barter or sale. Commodities are traded in the physical markets and in future markets.

Who are the major participants of the commodity market?

Producers, Traders and Brokers, Processors, Distributors, Packagers, Wholesalers and Retailers are the major Participants.

Which is the oldest Commodity Exchange?

Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) are the oldest ones.

Who are Hedgers, Speculators and Arbitrageurs?

Hedgers protect themselves by buying and selling futures contracts to offset the risks of changing prices in the spot market. Speculators engaged in buying or selling to take advantage of price movements. While the objective of hedgers is to avoid risks, speculators are more willing to accept risks. Arbitrageurs capitalize on price differences between markets.

What is a Closing Out?

It is the opposite transaction effected to close out the original futures position. A buy contract is closed out by a sale and a sale contract is closed out by a buy.

What is an OTC?

OTC or Over-The-Counter is a market conducted directly between dealers and principals via a telephone and computer network rather than an Exchange trading floor. Unlike an Exchange, there is no automatic disclosure of the price of deals to other market participants, and the deals and traded instruments are not standardized.

What is a Commodity SWAP?

A derivative contract, where two counterparties exchange one stream of cash flows against another stream is known as SWAP. And a SWAP where exchanged cash flows are dependent on the price of an underlying commodity is known as Commodity Swap. This is commonly used to hedge against the price of a commodity. E.g. oil.

What is a Payoff?

A payoff is the profit or loss that is likely to be faced by the market participants with changes in the price of the underlying asset. Payoff diagrams are used to graphically represent these, with the price of the underlying being plotted on the X axis and the Profit or Loss on the Y axis.

How are Commodity derivatives differ from Financial derivatives?

Commodity derivatives differ from financial derivatives in terms of physical settlement, need for warehousing and the importance of the quality of the underlying commodities.

What is a Derivative contract & what is Commodity future?

A derivative contract is an enforceable agreement whose value is derived from the value of an underlying asset; the underlying asset can be a commodity, precious metal, currency, bond, stock, or, indices of commodities, stocks etc. Four most common examples of derivative instruments are forwards, futures, options and swaps/spreads.

Commodity future is a contract to buy or sell specific commodity, of a specific quality, at a specific price, for a specific future date on the exchange.

What is the difference between spot market and futures market?

In a spot market, commodities are physically bought or sold usually on a negotiable basis resulting in delivery. While in the futures markets, commodities can be bought or sold irrespective of the physical possession of the underlying commodity. The futures market trades in standardized contractual agreements of the underlying asset with specific quality, quantity, and mode of delivery whose settlement is guaranteed by regulated commodity exchanges.

What are the benefits of futures trading in commodities?

The biggest advantage of trading in commodity futures is price risk management and price discovery. Farmers can protect themselves against undesirable price movements and decide upon cropping pattern. The merchandisers avoid price risk. Processors keep control on raw material cost and decreasing inventory values. International traders also can lock in their prices.

What is hedging?

Hedging means taking a position in the futures or options market that is opposite to a position in the physical market. It reduces or limits risks associated with unpredictable changes in price. The objective behind this mechanism is to offset a loss in one market with a gain in another.

What are Short Hedges and Long Hedges?

When the cash commodities are sold, the open futures position is closed by purchasing an “equal number and type” of futures contracts as those initially sold. This is called short or a selling hedge. Long or purchasing hedge involves buying futures contracts to protect against a possible increase in the price of cash commodities in the future. At the time of purchase of the physical commodities, the futures position is closed by selling an “equal number and type” of futures contracts as those were initially purchased.

What is a Basis?

Basis is the difference between the futures price and the spot price. Generally for commodities, it is defined as spot price – futures price (S-F) as against the futures price – spot price (F-S) for financial assets.

What is arbitrage in commodity markets?

Arbitrage is making purchases and sales simultaneously in two different markets to profit from the price differences prevailing in those markets. The factors driving arbitrage are the real or perceived differences in the equilibrium price as determined by supply and demand at various locations.

Is an ISIN number also allotted to commodity like in equities?

Yes, the identifier is called as ICIN. Depending on the type of commodity, grade, validity, expiry date, name & location of warehouse, the exchanges allot ICIN to each commodity. ICIN differs from exchange to exchange.

What is cost-of-carry?

For physical commodities such as grains and metals, the cost of storage space, insurance, and finance charges incurred by holding a physical commodity.

What is Delivery in Commodity Derivatives?

The tender and receipt of the actual

What is the meaning of Basis?

Basis is the difference between the spot price of an asset and the futures price of the same asset underlying. The spot price is the ready price prevailing in the physical commodity market while the futures price is the price of any specific contract that is prevailing in the exchanges where it is traded.

What is meant by basis risk?

Generally, the spot price of a commodity and future price of the same underlying commodity do not change by the same amount during the life of the futures contract. This uncertainty in the variation of basis is known as basis risk.

What is “Contango” in commodity trading?

When the futures price is above the expected future spot price. Consequently the price will decline to the spot price before the delivery date.

What is initial margin?

It is the minimum percentage of the contract value required to be deposited by the members/clients to the exchange before initiating any new buy or sell position. This must be maintained throughout the time their position is open and is returnable at delivery, exercise, expiry or closing out.

What do you mean by delivery period margin?

It is the extra margin imposed by the exchange on the contracts when it enters the concluding phase i.e. it starts with tender period and goes up to delivery/settlement of trade. This amount is applicable on both the outstanding buy and sell positions.

What is Mark-to-market (MTM)?

Mark-to-market margins (MTM or M2M) are payable based on closing prices at the end of each trading day. These margins will be paid by the buyer if the price declines and by the seller if the price rises. This margin is worked out on difference between the closing/clearing rate and the rate of the contract (if it is entered into on that day) or the previous day's clearing rate. The Exchange collects these margins from buyers if the prices decline and pays to the sellers and vice versa.

What is meant by the term “tender period”?

The contract enters into the tender period a few days before the expiry. This enables the members to express their intention whether to give or take delivery.

What is meant by due date rate?

It is the rate at which the contract is settled on the expiry date. Usually it is the average of the spot prices of the last few trading days (as specified by the exchange) before the contract maturity.

What is meant by spread?

Spread is the difference between prices of two futures contracts of the same underlying commodity. Futures market can be a normal market or an inverted market. If the price of the far month futures contract is higher than the near month one, then it is referred to as “normal market”. On the other hand, if the price of a far month futures contract is lower than the near month one, then the situation can be referred to as “inverted market”.

What do you mean by rolling over of hedge positions?

Rolling over of hedge position means the closing out of existing position in the futures contract and simultaneously taking a new position in a futures contract with a later date of expiry.

What is calendar spread?

A calendar spread means taking opposite positions in futures contract of the same commodity with different expiry dates. It is also known as an intra-commodity spread.

What do you mean by convergence of futures price with spot price?

A movement in the price of a futures contract towards the price of the underlying cash commodity, as the contract nears expiration.

Currency Derivatives

Currency Derivatives

What is meant by Derivative?

A financial contract between two people or two parties that has a value determined by the price of something else (called the underlying).

Explain Currency Derivatives?

The term 'Derivatives' indicates it derives its value from some underlying i.e. it has no independent value. Underlying can be securities, stock market index, commodities, bullion, currency or anything else. From Currency Derivatives market point of view, underlying would be the Currency Exchange rate. Derivatives are unique product, which helps in hedging the portfolio against the future risk. At the same time, derivatives are used constructively for arbitrage and speculation too.

What is meant by an "Underlying" and how is it different than "Contract"?

A Currency exchange rate enabled for trading on futures is called an "Underlying" e.g. USDINR. There may be various tradable contracts for the same underlying based on its different expiration period. For example FUT-USDINR-27-Aug-2009, FUT-USDINR-28-Sep-2009 and FUT-USDINR-28-Oct-2009 are "contracts" available for trading in currency futures having USDINR Exchange rate as "underlying".

How can you define Currency Futures contract?

USDINR future contract expiring on 27 Aug, 2009 is defined as "FUT-USDINR-27-Aug- 2009". Wherein, "Fut" stands for Futures as currency derivatives product, "USDINR" for underlying currency exchange rate and "27-Aug-2009" for the expiry date.

Do I have to pay the full contract value on placing orders in Currency futures?

No. You will be required to place a certain % of order value as margin, while placing a buy/sell position in Currency Futures. With Currency Futures trading, you can leverage on your trading limit by taking buy/sell positions much more than what you could have taken in the Spot market. However, the risk profile of your transactions goes up.

Explain calendar spread?

Spread involving options of the same underlying, with same strike prices, but with different expiration months is known as Calendar Spread. They can be created with either all calls or all puts. E.g., you take Buy position for 1 lot of FUT-USDINR-28-Sep-2010 @ Rs.50 and sell position for 1 lot of FUT-USDINR-28-Oct-2010 @ Rs.51. 1 lot of buy position in FUT- USDINR-27-Sep-2010 and 1 lot of sell position in FUT-USDINR-28-Oct-2010 form a spread against each other and hence are called "Spread Position".

FPI

FPI

What is FPI?

FPI stands for Foreign Portfolio Investment. It is one of the two principal ways to invest in overseas markets, the other being FDI or Foreign Direct Investment. Under FPI, the investors are not the actual owners of the underlying financial securities or assets. Holdings in FPI’s include bonds, mutual funds, stocks, exchange-traded funds, ADR’s, etc.

Forex

Forex

What is meant by Forex / Forex Trading?

Forex stands for the Foreign Exchange market. Each country has its own regulated currency, and the Forex market is a place for trading in all such currencies. The trading of currencies happens in pairs, such as INR/USD, GBP/USD, EUR/USD, etc. to cite a few examples. It is the largest and most liquid market in the world.

What are Ask Price, Bid Price & Spread in Forex Trading?

Ask price is the price at which a FOREX trader buys a currency pair, whereas the Bid Price is the price at which a FOREX trader sells a currency pair. The difference between the Ask Price and the Bid Price is termed as “Spread”.
Thus, Spread = Ask Price – Bid Price.

Which are the different types of charting in Forex Charting?

There are three different types of charting as follows:- Horizontal Channel, Ascending Channel & Descending Channel.

What constitutes Major Currencies?

Currencies which have the maximum trading volumes against the US Dollar are referred to as the Major Currencies. These currencies are characterized by high liquidity and narrower spreads. USD, GBP & EUR are some prime examples of Major Currencies.

What is the meaning of Exotic Currency Pairs?

In stark comparison to the major currencies, Exotic Currency Pairs are those pairs which are relatively illiquid and have higher spreads.

Market Research

Market Research

What is the meaning of Fundamental Analysis?

Fundamental Analysis is a type of market research which involves measurement of the intrinsic value of a security in the backdrop of macro-economic, micro-economic and internal financial factors. It is a method of ascertaining a stock’s real or fair market value.

What is the meaning of Technical Analysis?

Technical Analysis is a type of market research which involves extensive use of charting principles and market indicators to examine and study past behaviours and suitably identify trends and patterns, wherein the future price directions of a security can be forecast.

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