Intro to derivatives
- 1. Section 2(ac) of Securities Contract Regulation Act (SCRA) 1956 defines Derivative as: 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”. • Underlying Asset in a Derivatives Contract As defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms: i. Commodities including grain, coffee beans, orange juice; ii. Precious metals like gold and silver; iii. Foreign exchange rates or currencies; iv. Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index vi. Short term securities such as T-bills; and vii. Over- the Counter (OTC) money market products such as loans or deposits. History: The Derivatives markets can be traced back to the middle Ages. They originally developed to meet the needs of farmers and merchants. The Chicago Board of Trade (CBOT) was the first derivatives market established in 1848 to bring farmers and merchants together. Initially, its main task was to standardize the quantities and qualities of the grains that were traded. Within a few years, the first futures type contract was developed. It was known as to-arrive contract. Speculators soon became interested in the contract and found trading the contract to be an attractive alternative to trading the gain itself. The Chicago Board of Trade now offers futures contracts on many different underlying assists, including corn, oats, soybeans, soybean oil wheat, silver, treasury bonds, and treasury notes. • The Chicago Mercantile Exchange: In 1874, the Chicago Produced Exchange was established. This provided a market for butter, eggs, poultry, and other perishable agricultural products. In 1898, the butter and egg dealers withdrew from this exchange to form the Chicago Butter and Egg Board. In 1919, this was renamed the
- 2. Chicago Mercantile Exchange (CME) and was reorganized for futures trading. Since then, the exchange has provided a futures market for many commodities including pork bellies (1961), live cattle (1964) live hogs (1966) and feeder cattle (1971). In 1982, it introduced a futures contract, and a Eurodollar futures contract on the S&P 500 Stock Index. The International Monetary Market (IMM) was formed as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. The currency traded on the IMM now include the British Pound, the Canadian futures Dollar, the Japanese Yen, the (Swiss Franc, the German mark) European Euro and the Australian dollar. The IMM also trades a gold futures contract, a treasury bill futures contract, and a Eurodollar futures contract. • Features of Derivates Market: 1. Derivatives are popular instruments traded globally. 2. Gain or loss depends on the underlying asset’s value. 3. Change in value of underlying asset will have effect on values of derivatives. 4. They are traded on exchange. 5. They are liquid and transaction cost is lower. • Kinds of Derivatives • Forward • Futures • Option • Swap • Forward Contract • A one to one bipartite contract, which is to be performed in future at the terms decided today. • Eg. A and B enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/- • Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties. • Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract. • Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges. • These markets are very liquid • In these markets, clearing corporation/house becomes the counter-party to all the trades or
- 3. provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house. • The key elements of a futures contract are: – Futures price – Settlement or Delivery Date Underlying Asset. •