All about futures and options

Market worth more than $516 trillion It's a market in which the lead protagonists have flourished in the derivatives boom. But it's a market that is set to come to a crashing halt – the Great Unwind has begun. Worried investors pulling out their cash for safer climes Investment banks selling billions of dollars worth investments to clients as a way to off-load or manage market risk

Deustche Bank has reported a loss of $400 million on equity derivatives Caisse d'Epargne, a French bank, has sustained a loss of euro 600 million, also in trading equity derivatives Major losses on currency derivatives have also been reported from Latin America and Hong Kong Commercial Mexicana, the third largest retailer in Mexico, has declared bankruptcy after sustaining a loss of $1 billion on currency derivatives

Process of selecting investments with higher risk in order to profit from an anticipated price movement A speculator always aims at high returns over a short period by taking extraordinary risks Speculation need not be treated as an anathema to the smooth and efficient functioning of a market.

What are the Importance of Derivatives

There is a debate going on in the Indian financial circles on the issue of introduction of derivatives. World over, in developed financial markets, these instruments have been in vogue for quite some time now. The arguments in favor are as follows: A tool for hedging Risk management Better avenues for raising money Price discovery Increasing the depth of financial markets Derivatives market on Indian underlying elsewhere

Arguments against derivatives are as follows: Speculation Market efficiency Volatility Counter party risk Liquidity risk

What do you mean by “HEDGING”?

Protecting existing or anticipated physical market exposure from an adverse move Both hedgers and speculators can benefit by knowing how to properly utilize a foreign currency hedge Changes in the international economic and political landscape This uncertainty leads to volatility and the need for an effective vehicle to hedge the risk

Not just a simple risk management strategy, it is a process A number of variables must be analyzed and factored in before a proper currency hedging strategy can be implemented Learning how to place a foreign exchange hedge is essential to managing foreign exchange rate risk

What are different types of hedging?

Risk Mitigation Measures Natural Hedging Hedging by Contracts Currency denomi-nation Netting and offsetting Leading and lagging Definition FORWARDS OTHERS OPTIONS FUTURES

PARTICIPANTS in the derivatives market

Trading participants: Hedgers Speculators Arbitrageurs Intermediary participants: Brokers Market markers and jobbers Institutional framework: Exchange Clearing house

1. Trading participants Hedgers:- Individuals or firms who manage their risk with the help of derivative products To reduce the volatility of a portfolio by reducing the risk

Speculators do not have any position on which they enter into futures and options Market Consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. They take risk in turn from high returns Essential in all markets

Simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets A prominent position in the futures world Objective is simply to make profits without risk May not be as easy and costless as presumed

Brokers: Brokers perform an important function of bringing buyers and sellers together All persons hedging their transaction exposures or speculating on price movement need not be and for that matter cannot be members of futures or options exchange A non-member has to deal in futures exchange through member only

His presence benefits the entire economy Members are responsible for final settlement and delivery Activity of a member is price risk free because he is not taking any position in his account

Every deal cannot get the counter party immediately Takes the purchase or sale by other members in their books and then square off on the same day or the next day When volatility in price is more, the spread increases They decide the market price considering the demand and supply of the commodity or asset

A buyer or seller of a particular futures or option contract can approach that particular jobbing counter In automated screen based trading best buy and sell rates are displayed on screen Provide liquidity and volume to any futures and option market

Exchange: Exchange provides infrastructure to trade Exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions Makes available real time information online and also allows them to execute their orders

Performs clearing of transactions executed in futures and option exchanges Separate company or it can be a division of exchange It guarantees the performance of the contracts It ensures solvency of the members by putting various limits on him It is an important institution for futures and option market

The forward transaction is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency by the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the Forward Exchange Rate and the market for forward transactions is known as the Forward Market.

The foreign exchange regulations of various countries, generally, regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions.

Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations by entering into an appropriate forward exchange contract. The Forward market can be divided into two parts-Outright Forward and Swap market.

The Outright Forward market resembles the Spot market, with the difference that the period of delivery is much greater than 48 hours in the Forward market. A major part of its operations is for clients or enterprises who decide to cover against exchange risks emanating from trade operations.

The Forward Swap market comes second in importance to the Spot market and it is growing very fast The currency swap consists of two separate operations of borrowing and of lending That is, a Swap deal involves borrowing a sum in one currency for short duration and lending an equivalent amount in another currency for the same duration US dollar occupies an important place on the Swap market. It is involved in 95 per cent of transactions

The forward exchange rate is determined mostly by the demand for and supply of forward exchange. Naturally, when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and, conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par.

The Forward market primarily deals in currencies that are frequently used and are in demand in the international trade, such as US dollar, Pound Sterling, Deutschmark, French franc, Swiss franc, Belgian franc, Dutch Guilder, Italian lira, Canadian dollar and Japanese yen.

There is little or almost no Forward market for the currencies of developing countries. Forward rates are quoted with reference to Spot rates as they are always traded at a premium or discount vis-à-vis Spot rate in the inter-bank market. The bid-ask spread increases with the forward time horizon.

It is ‘tailor-made’ . It is a perfect (exact) hedge . It is most suitable for genuine traders with real underlying transaction. Not available to all Not cancellable Not tradable (lack of liquidity) Forward contract cannot be sold to a 3 rd party for 2 reasons Not suitable for uncertain transactions These limitations lead to another form of contract called as ‘futures’. Pros Cons

Currency Futures were launched in 1972 on the International Money Market (IMM) at Chicago. It is to be noted that commodity Futures had been in use for a long time. Currency Future markets developed at Philadelphia (Philadelphia Board of Trade), London (London International Financial Futures Exchange (LIFFE)), Tokyo (Tokyo International Financial Futures Exchange), Sydney (Sydney Futures Exchange), and Singapore International Monetary Exchange (SIMEX).

Volumes traded are much smaller Holds a very significant position in USA and UK While a futures contract is similar to a forward contract, there are several differences between them The contract size and maturity dates Can be traded only on exchanges and competitively Margins

Participants of futures contract

Three types of participants on the currency futures market: Floor-traders Floor-brokers Broker-traders

Operate for their own accounts. They are the speculators. Representatives of banks or financial institutions which use futures to supplement their operations on Forward market. Enable the market to become more liquid.

Floor-traders: Representing the brokers' firms, operate on behalf of their clients and, therefore, are remunerated through commission. Broker-traders: Operate either on the behalf of clients or for their own accounts.

Enterprises pass through their brokers and generally operate on the Future markets to cover their currency exposures. They are referred to as hedgers. They may be either in the business of export-import or they may have entered into the contracts for borrowing or lending.

BUYER (TRADER) SELLER (TRADER) BROKER (MEMBER) BROKER (MEMBER) CLEARING HOUSE TRANSACTION PURCHASE ORDER SALES ORDER

Trading is done on trading floor. A party buying or selling future contracts makes an initial deposit of margin amount. If the rate moves in its favour, it makes a gain. This amount (gain) can be immediately withdrawn or left in the account. However, in case the closing rate has moved against the party, margin call is made and the amount of 'loss' is debited to its account. As soon as the margin account falls below the maintenance margin, the trading party has to make up the gap so as to bring the margin account again to the original level.

Standardization Organized Exchanges (LIFFE, TIFFE, SIMEX, Chicago Board of Trade) Minimum Variation (0.01 % or 0.0001 dollar per unit of currency) Clearing House Margin Marking to Market

High liquidity Low investment (Only margin money and brokerage) No counterparty risk Suitable for uncertain transactions Imperfect Hedge in terms of value and date Speculative Price Movements Cons Pros

Nature & Size of Contracts Mode of Trading Liquidity Deposits/ Margins Risk of Default/ Settlement Risk Actual Delivery

A contract (agreement) Giving a right to buy/ sell A specific asset At a specific price Within a specific time period

Put Option Call Option The right to sell a specified amount of currency at a specified rate The right to buy a specified amount of currency at a specified rate

Premium The price of an option ( price paid for buying an option) Expiry Date The date at which right can be exercised Exercise Price The rate at which the right can be exercised (also known as strike price )

European Option American Option Bermudan Option In this the right can be exercised only on a fixed date in the contract; i.e. Option only exercisable on the expiry date. In this the right can be exercised on or before a fixed date in the contract, i.e. Option exercisable at any time until expiry date. This has pre-specified dates during its life till maturity, on which it can be exercised.

Purchaser (trader) Has right to exercise (may exercise or may not exercise) Writer/ seller (dealer or speculator) Has obligation to perform (when purchaser exercises the right)

An Indian importer is required to pay British £ 2 million to a UK company in 4 months time. To guard against the possible appreciation of the pound sterling, he buys an option by paying 2 per cent premium on the current prices. The spot rate is Rs 77.50/£. The strike price is fixed at Rs 78.20/£. The Indian importer will need £ 2 million in 4 months. In case, the pound sterling appreciates against the rupee, the importer will have to spend a greater amount on buying £ 2 million (in rupees).

Therefore, he buys a call option for the amount of £ 2 million. For this, he pays the premium upfront, which is: £ 2 million x Rs 77.50 x 0.02 = Rs 3.1 million Then the importer waits for 4 months. On the maturity date, his action will depend on the exchange rate of the £ vis-à-vis the rupee. There are three possibilities in this regard, namely £ appreciates, does not change and depreciates.

Pound Sterling Depreciates Pound Sterling Exchange rate does not Change Pound Sterling Appreciates

Intrinsic value (American option) = Spot rate -Exercise price Intrinsic value (European option) = Forward rate – Exercise price

On the OTC market, premia are quoted in % of the amount of transaction. The payment may take place either in foreign currency or domestic currency. The strike price (exercise price) is at the choice of the buyer. The premium is composed of: (1) Intrinsic Value, and (2) Time Value. Thus, we can write the Option price as given by the equation: Option price = Intrinsic value + Time value

Intrinsic value of an Option is equal to the gain that the buyer will make on its immediate exercise. On the maturity, the only value of an Option is the intrinsic one. If, on that date, it does not have any intrinsic value, then, it has no value at all.

Intrinsic value of Call Option:- Intrinsic value of American call Option is equal to the difference between Spot rate and Exercise price, because the option can be exercised any moment. The equation gives the intrinsic value of an American call Option. Intrinsic value = Spot rate - Exercise price

Likewise, the intrinsic value of a European call Option is given by the equation: Intrinsic value = Forward rate - Exercise price The intrinsic value of a European Option uses Forward rate since it can be exercised only on the date of maturity. The intrinsic value of an Option is either positive or nil. It is never negative.

Intrinsic value Put Option:- Intrinsic value of a put Option is equal to the difference between exercise price and spot rate (in case of American Option) and between exercise price and Forward rate (in case of European Option). Figure graphically presents the intrinsic value of a put Option. Equations give these values. Intrinsic value of American put Option = Exercise price - Spot rate Intrinsic value of European put Option = Exercise price - Forward rate

An Option is said to be in-the-money when the underlying exchange rate is superior to the exercise price (in the case of call Option) and inferior to the exercise price (in case of put Option). Likewise, it is said to be out-of-the-money when the underlying exchange rate is inferior to the exercise price (in case of call Option) and superior to exercise price (in case of put option). Similarly, it is at-the-money when the exchange rate is equal to the exercise price.

An American type call Option that enables purchase of US dollar at the rate of Rs 42.50 (exercise price) while the spot exchange rate on the market is Rs 43.00 is in-the-money. If the US dollar on the spot market is at the rate of Rs 42.50, then the call Option is at-the-money. Further, if the US dollar in the Spot market is at the rate of Rs 42.00, it is obviously out-of-the-money. It is evident that an Option-in-the-money will have higher premium than the one out-of-the-money, as it enables to make a profit.

Time value or extrinsic value of Options is equal to the difference between the price or premium of Option and its intrinsic value. Equation defines this value: Time value of Option = Premium - Intrinsic value

Suppose a call option enables purchase of a dollar for Rs 42.00 while it is quoted at Rs 42.60 in the market, and the premium paid for the call option is Re 1.00, then, Intrinsic value of the option = Rs 42.60 - Rs 42.00 = Re 0.60 Time value of the option = Re 1.00 - (42.60 - 42.00) = Re 0.40

Period that remains before the maturity date Differential of interest rates of currencies for the period corresponding to the maturity date of the Option Forward discount or premium Type of Option Volatility of the exchange rate of underlying (foreign) currency

Different strategies of options may be adopted depending on the anticipations of the market as regards the evolution of exchange rates and volatility.

Buying of a call Option may result into a net gain if market rate is more than the strike price plus the premium paid. Call option will be exercised only if the exercise price is lower than spot price. The profit profile will be exactly opposite for the seller (writer) of a call Option.

Strategy with call Option. Spot rate Gain (+)/Loss (-) for the buyer of call option $ 0.6000 - $ 0.02 $ 0.6200 -$0.02 $ 0.6400 - $ 0.02 $ 0.6500 - $ 0.02 $ 0.6600 - $ 0.02 $ 0.6700 -$0.02 $ 0.6800 -$0.02 $ 0.6900 -$0.01 $ 0.7000 $0.00 $0.7100 + $0.01 $0.7200 + $ 0.02 $ 0.7400 + $ 0.04 $ 0.7600 + $ 0.06

Buying of a put Option anticipates a decline in the underlying currency. The profit profile of a buyer of put Option is given by the equation. A put Option will be exercised only if the exercise price is higher than spot rate. The opposite is the profit profile for the seller of a put Option.

Strategy with put Option. S t Gain(+)/loss (-) 1.6050 +0.050 1.6150 +0.040 1.6250 +0.030 1.6350 +0.020 1.6450 +0.010 1.6500 +0.005 1.6550 +0.000 1.6600 -0.005 1.6650 -0.010 1.6750 -0.020 1.6850 -0.030 1.6950 -0.040 1.7050 -0.050 1.7150 -0.060 1.7250 -0.060 1.7350 -0.060

A straddle strategy involves a combination of a call and a put Option. Buying a straddle means buying a call and a put Option simultaneously for the same strike price and same maturity. The straddle strategy is adopted when a buyer is anticipating significant fluctuations of a currency, but does not know the direction of fluctuations.

On the contrary, the seller of straddle does not expect the currency to vary too much and hopes to be able to keep his premium. He anticipates a diminishing volatility. His profit is maximum if the spot rate is equal to the exercise price. In that case, he gains the entire premium amount. The gains for the buyer of a straddle are unlimited while losses are limited.

Spread refers to the simultaneous buying of an Option and selling of another in respect of the same underlying currency. Spreads are often used by traders in banks.

When a call option is bought with a lower strike price and another call is sold with a higher strike price, the maximum loss in this combination is equal to the difference between the premium earned on selling one option and the premium paid on buying another. This combination is known as bullish call spread. The opposite of this is a bearish call.

The other combination is to sell a put Option with a higher strike price of and to buy another put Option with a lower strike price of Maximum gain is the difference between the premium obtained for selling and the premium paid for buying. This combination is called bullish put spread while the opposite is bearish put . The strategies of spread are used for limited gain and limited loss.

All about futures and options

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