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Derivatives

History

Financial derivatives came into the spotlight along with the rise in uncertainty of post-1970.

when the US announced an end to the Bretton Woods System of fixed exchange rates leading to introduction of currency derivatives followed by other innovations, including stock index futures but there eruption in India is off lately in June 2000.

There are still apprehensions about derivatives. There are also many myths though the reality is different especially for exchange-traded derivatives which are well regulated with all the safety mechanisms in place.

Understanding Derivatives
Margin-Requirements
Mark-to-Market-Margin
Initial-Margin
Non-Payment-of-Margin
Settlement

Understanding Derivatives

Derivatives are financial securities whose value is derived from another "underlying" financial security. Options, futures, swaps, swaptions, structured notes are all examples of derivative securities. Derivatives can be used hedging, protecting against financial risk, or can be used to speculate on the movement of commodity or security prices, interest rates or the levels of financial indices. The valuation of derivatives makes use of the statistical mathematics of uncertainty, which is very complex. The key to understanding derivatives is the notion of a premium. Some derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain some protection against a specific event, there are derivative products that have a payoff contingent upon the occurrence of some event for which you must pay a premium in advance.

The word 'derivative' originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying. For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on soybean depends on the price of soybean. Derivatives are specialized contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.

The contract also has a fixed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset. Futures & Options Segment is another new segment where trading on derivatives contract takes place. The Trading Member is, as in Stock Market segment, required to enter all the orders in the system. The Trading Member shall disclose to the Exchange at the time of order entry that the order is on his own account or on behalf of clients. The client is required to place his order to the Member in writing in the Order Placement Form specified by the Exchange in which the client will be required to specify the buy or sell orders as either an open order or a close order.

If the client requires an order to be modified after the order has entered the system but has not been traded, the Client is required to give the request in writing in the Modification Request Form specified by the Exchange.

If the client requires any of his order to be cancelled after the order has been entered in the system but has not been executed, the same shall be given in writing in the Order Cancellation Form specified by the Exchange.

The Trading Member shall provide the client with a copy of the trade confirmation slip as generated on the Trading System, forthwith on execution of the trade and with a contract note for the trade executed Orders entered into the Trading System by Trading Members shall be subject to various validation requirements as specified by the F&O Segment of the Exchange from time to time including trading parameters, turnover limits, exposure limits and/or other restrictions placed on traded derivatives contracts. Orders that do not meet the validation checks shall not be accepted by the Trading System. Orders in the Normal market shall be matched on price-time priority basis. The best buy order shall match with the best sell order. For trading on price, the best buy order would be the one with the highest price and the best sell order would be the one with the lowest price.

Trades generated on the system are irrevocable and ‘locked in’. The Trading Member shall make available to his client the system generated trade number through Trade Confirmation Slip. The Trading Member shall issue a contract note to his constituents for trades executed on his behalf. The contract note shall be signed by a Trading Member or his Authorised signatory or constituted Attorney and shall be time stamped with the time of receipt of order and the time of execution of order. The Brokerage charged to the client shall be indicated separately from the price, in the contract note.

Margin-Requirements

Every Trading Member is required to deposit a margin with F&O Segment of the Exchange/Clearing Corporation/Clearing Member on the outstanding position.

There are two types of margin levied on Derivatives Contracts. One is Initial Margin using the concept of Value at Risk and shall cover one-day loss that can be encountered on the position on 99 % of the days and the other is Mark–to–Market Margin. Initial Margin is collected upfront and Mark-to-Market Margin on T+1 basis.

Mark-to-Market-Margin

By way of Mark-to-Market Margin, there takes place Daily Settlement in the F&O Segment which means that any profit arising on the outstanding position at the futures closing price shall be paid out on T+1 day. Similarly any loss arising on the open position at the futures closing price will have to be paid to Exchange on T+1 day.

It is therefore mandatory for the Trading Members to collect from its clients the Margin Deposit which the member has to provide under these Trading Regulations in respect of the business done by the Members for such clients.

Initial-Margin

Initial Margins are collected upfront which means that the Trading Members will buy and/or sell derivatives contracts on behalf of the clients only on the receipt of margin of minimum such percentage as the relevant authority may decide from time to time, on the price of the derivatives contracts proposed to be purchased, unless the client already has an equivalent credit with the Trading Member.

At the time of calculating the initial margin, the outstanding position of a client is segregated into two – Spread Position and Non Spread Position. Spreading is a form of Speculative trading that involves the simultaneous purchase and sale of related contract. At present we have only Calender spread which is defined as having equal offsetting positions in 2 different expiry month contracs on the same underlying. For instance, long 200 index futures in July contract and short 200 index futures in August contract. Long Spread means long in the far month contract and Short spread means short in the far month contract. In the example quoted above it is short spread as it has short position in August contract and long position in July contract.

This spreading is usually with the aim to profit from a change in the differential (ie. Spread) between the two futures contracts. Since there is no much risk involved in spread positions, the initial margin on such positions are collected in much lesser quantity, say, 1%. Example for spread computation: Supposing one has 300 long June contract @ Rs.1000/-, 100 short July contract @Rs.1010 and 100 short August Contract @ Rs.1020. It is clear that out of the 300 long in June there are offsetting positions of 200 short in June as well as in July. Therefore the position of 300 long is segregated into 200 Spread Position and 100 Non Spread Position. The Total Spread Position Value is 100 * 1010 + 100 * 1020 = 2,03,000/- and the Total Non Spread Position is 100 * 1000 = Rs. 1,01,000/-. The total initial margin shall be 1% of Rs.2,03,000 plus 10% of Rs. 1,01,000/- where 10% is Initial margin.

On the expiry of June Contract, this spread position of 200 will automatically become non spread and will immediately attract the higher initial margin. In order to avoid a sudden jump in margin deposit, a procedure of gradual reduction of spread over the last few days of trading is adopted. On the fourth day prior to the expiry of the contract 20% of the total spread position is treated as non-spread and charged higher margin. On the next day 40% of the total spread is treated as non spread position, the next day 60% and on the expiry day 80% and then onwards 100%.

Non-Payment-of-Margin

In case of non-payment of daily settlement by the clients within the next trading day, the Trading Member shall be at liberty to close out transactions by selling or buying the derivatives contracts, as the case may be, unless the constituent already has an equivalent credit with the Trading Member. The loss incurred in this regard, if any, shall be met from the margin money of the client.

In case of open purchase position undertaken on behalf of constituents, the Trading Members shall be at liberty to close out transactions by selling derivatives contracts, in case the client fails to meet the obligations in respect of the open position within next trading day for the execution of the full contract within next trading day of the contract note having been delivered; unless the client already has an equivalent credit with the Trading Member. The loss incurred in this regard, if any, shall be met from the margin money of the client.

In case of open sale position undertaken on behalf of the clients, the Trading Member shall be at the liberty to close out transactions by effecting purchases of derivatives contracts if the client fails to meet the obligation in respect of the open position within next trading day of the transaction having being executed on the F&O Segment of the Exchange for the concerned settlement period. Loss on the transaction, if any, shall be deductible from the margin money of the client.

Settlement

At any point of time, three near month contracts will be available. For instance in the month of June, June Contract, July Contract and August Contract shall be available for trading. While entering the contract one has to specify the expiry month of the contract which will clearly indicate the contract life cycle. The last Thursday of the Expiry month shall be the day of Final Settlement of the contract. After the Final Settlement that contract shall get invalidated and a new contract gets introduced automatically.

Daily Settlement takes place daily at the end of the trading session. The outstanding positions are marked to market at the Daily Settlement Price to calculate the Mark to Market Value and the profit or loss, which is nothing but the difference between the Net Traded Value and Mark to Market Value, is calculated for each contract. The net profit or loss of all the contracts are credited or debited, as the case may be on the T+1 day. Daily Settlement Price is the futures closing price which is calculated by taking the half an hour weighted closing futures price. The outstanding positions are brought forward to the next working day at Daily Settlement Price.

For instance, Client A buys 200 Index Futures @ Rs.1000/-. Supposing he did not close this position. At the end of the Trading Day his outstanding position was 200 long @ Rs.1000/-. Say the closing index futures were Rs. 1010/-. The Net Trade Value is 200 * 1000/- = 2,00,000/- and the Mark to Market Value is 200 * 1010/- = 202000/-. The Net Profit of Client A is, therefore, Rs.2000/- which will be credited to his account and the outstanding position of 200 index futures shall be brought forward to the next trading day with his price to be reset at Rs. 1010/-

The Final Settlement takes place on the last trading day of the contract. Every last Thursday of the Contract Month is the last trading day of that contract. For final settlement the outstanding positions are closed out at the Final Settlement Price which the closing spot index and the closing futures index. The net difference is credited or debited, as the case may be, on the T+1 day. With this the whole settlement of that contract takes place.