Exploring and analyzing the exchange of derivatives - Free Essay Example

Derivative is a financial asset which derives its value from specified underlying asset. A derivative does not have any physical existence but emerges out of a contract between two parties. It does not have any value of its own but its value, in turn, depends on the value of other physical assets which are called underlying asset. These underlying assets may be shares, debentures, tangible commodities, currencies, or short term or long term financial securities. Securities Contracts (regulation) Act, 1956 defines a derivative as a security derived from a debt instrument, share loan and contract which derive their value from price or index of prices of underlying securities. The value of derivative may depend upon any of these underlying assets. The parties to the contract of derivatives are the parties other than the issuer or dealer in underlying asset. Some of the basic features of derivatives are: As the derivatives are not the physical assets, the transactions in the derivative are settled by the offsetting/squaring transaction in the same derivative. The differences in the value of the derivative is cash settled There is no limit on number of units transacted in the derivative market because there is no physical asset to be transacted. The derivative markets are usually the screen based computerized exchanges as against the trading markets for physical asset. Derivatives are only secondary market securities and cannot help in raising funds to a firm. In fact derivatives arise only when the shares and debentures are already issued by the companies. The derivative market is quite liquid and transactions can be effected easily. The derivatives provide a hedging of price risk of financial transactions over a certain period. It is a contract to be settled in future, by cash payment of difference in price. A derivative price must be distinguished from the underlying assets though the value of derivative and the underlying assets are related Types of Derivatives Commodity Derivatives and Financial derivatives: Derivatives contracts may be entered into for different type of commodities such as sugar, jute, pepper, jiggery, castor seeds etc. on the other hand the derivatives in currencies, gilt edged securities, shares, share indices etc are known as Financial derivatives. These are transacted all over the world. In India Stock Index futures, Stock Index Option, Stock Options, and Stock futures can be traded at BSE and NSE. Basic Derivative and Complex Derivative: The basic derivative are derivatives on underlying assets. Futures and options are two basic derivatives. However there are certain other derivatives such as swaps which may be classified as complex derivatives. Participants in Derivative Market In the derivative market, different types of parties participate. The derivatives are the hedging instrument participants with the objective also trade in the derivatives. Various participants may be classified into: Hedgers: derivatives have come upto the needs of the hedgers. Derivatives help both the parties to hedge. In case of commodity future contract farmers want to lock in the price for their produce and the merchants want to lock in the price they want to pay for the produce. Futures contract enable both the parties to hedge. Hedgers can use option contract also. Option protect the hedgers against the price movements while still allowing them to benefit from favourable price movements. So the hedgers have risk exposure which they offset by a derivative. Hedgers seek to protect themselves against price changes in an asset in which they have an interest. Speculators: Speculators are participants who are ready to take a risk for some return. They take position in the market either by betting that price will go up or by betting that the prices will go down. A participant will can speculate in futures or options. Speculators potential gain or loss is very large in case of futures, however loss may be limited and gain will be unlimited in case of options. Speculators are major player in derivative market. Arbitrageurs: Arbitrageurs are another group of participant in the derivative market. The arbitrage refers to locking in to risk less profit by simultaneously entering into two transactions in two different markets. The profit opportunities appear because of differences in price of the same asset in different markets. Types of Financial derivatives Forwards: Transaction agreements in assets can be broadly classified as Steady or Ready delivery contracts: where the asset is to be physically delivered immediately or within few days and payment is made in cash Future Delivery Contract: where the physical delivery of the asset is slated for the future date and the payment to be made as agreed. The futures delivery can be further classified as: Non transferable future delivery contract, where the contract must be performed by the parties as per the terms and condition mentioned. Transferable future delivery contract, when the parties to the contract can transfer the rights and obligation under the contract to the third party. The first one is known as forward contract and the second one is known as future contract. A Forward contract is agreement between two parties to buy or sell an asset at a future date at an agreed price today. Futures: A future is a contract to buy or sell the stated quantity of a commodity or a financial claim at a specified price at a future specified date. The parties to the future have to buy or sell the asset regardless of what happens to its value during the intervening period or what shall be the price on the date for which the contract is finalized. The futures are transferrable future delivery contract. Both the parties to the future have the right to transfer the contract by entering into an offsetting futures contract. It is not transferred until the settlement date then they have obligation to fulfill the terms and condition of the contract. Futures are traded on the exchanges and the terms of the futures contract are standardized by the exchange with reference to quantity, date, unit of price quotation, minimum change in price etc. futures can be of commodities such as agricultural products, oil gas, gold, silver etc. Or of financial claims such as shares, debentures, treasury bonds, share index, foreign exchange etc. Option: these are contracts which provide the holder the right to sell or buy a specified quantity of an underlying asset at a fixed price on or before the expiration of the option date. Options provide a right and not the obligation to buy or sell. The holder of the option can exercise the option at his discretion or may allow the option to lapse. As the option provide the right to buy or sell, these are the two types of option: The Call Option: A call option provides to the holder a right to buy a specified assets at a specified price on or before a specified date. The Put Option: A put option provides to the holder a right to sell specified assets at specified price on or before a specified date Swap: A swap is a contract in which two parties agree to exchange their respective cash flows. These are private arrangements between the parties to exchange cash flows accordingly to some pre arranged terms. The parties to the swap contract are known as counter parties. In swap one party agrees to exchange his set of pre-determined cash flows with the pre-determined cash flows of the other party. The swaps are of two types: Currency Swaps: A currency swap is transaction between two parties in which one promises to make a series of payment to other party at a specific date in exchange for a payment from the other party in different currencies. So in swaps the cash flows of different currencies are swapped Interest Rate Swap: these are the agreement between two parties in which each party makes a series of interest payment to the other party at pre-determined dates. At least one the interest rate is variable, i.e. floating rate in the sense that at which the interest payments will be made at the later date is known. The most common interest rate swap is known as Plain Vanilla swap in which one rate is fixed and other rate is floating History of Derivatives The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk. The first organized commodity exchange came into existence in the early 1700s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit risk and to provide centralized location to negotiate forward contracts. From forward trading in commodities emerged the commodity futures. The first type of futures contract was called to arrive at. Trading in futures began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982. T he first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984. Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the SP 100 and the SP 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include SP 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange. Derivatives in India (Now) At present Derivatives Trading has been permitted by the SEBI on the derivative segment of the BSE and the FO segment of the NSE. The nature of derivative contracts permitted are: Index Futures contracts introduced in June 2000 Index Option introduced in June 2001 Stock Option introduced in July 2001 Currency Futures and options introduced in 2008 Interest rate futures introduced in August 2009 The minimum contract size for a derivative contract is Rs 2 Lakh. Besides the minimum contract size, there is a stipulation for lot size of a derivative contract. The lot size refers to number of securities underlying in one contract. The lot size of the underlying individual security should be in multiples of 100 and fractions. Commodity Exchanges In India there are 25 recognized future exchanges, of which there are three national level multi commodity exchanges. After a gap of almost three decades, Government of India has allowed forward transactions in commodities through Online Commodity Exchanges, a modification of traditional business known as Adhat and Vayda Vyapar to facilitate better risk coverage and delivery of commodities. The three exchanges are: National Commodity Derivatives Exchange Limited (NCDEX) Multi Commodity Exchange of India Limited (MCX) National Multi-Commodity Exchange of India Limited (NMCEIL) All the exchanges have been set up under overall control of Forward Market Commission (FMC) of Government of India. National Commodity Derivatives Exchange Limited (NCDEX) National Commodity Derivatives Exchange Limited (NCDEX) located in Mumbai is a public limited company incorporated on April 23, 2003 under the Companies Act, 1956 and had commenced its operations on December 15, 2003.This is the only commodity exchange in the country promoted by national level institutions. It is promoted by ICICI Bank Limited, Life Insurance Corporation of India (LIC), National Bank for Agriculture and Rural Development (NABARD) and National Stock Exchange of India Limited (NSE). It is a professionally managed online multi commodity exchange. NCDEX is regulated by Forward Market Commission and is subjected to various laws of the land like the Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act and various other legislations. Multi Commodity Exchange of India Limited (MCX) Headquartered in Mumbai Multi Commodity Exchange of India Limited (MCX), is an independent and de-mutulised exchange with a permanent recognition from Government of India. Key shareholders of MCX are Financial Technologies (India) Ltd., State Bank of India, Union Bank of India, Corporation Bank, Bank of India and Canara Bank. MCX facilitates online trading, clearing and settlement operations for commodity futures markets across the country. MCX started offering trade in November 2003 and has built strategic alliances with Bombay Bullion Association, Bombay Metal Exchange, and Solvent Extractors. Association of India, Pulses Importers Association and Shetkari Sanghatana. National Multi-Commodity Exchange of India Limited (NMCEIL) National Multi Commodity Exchange of India Limited (NMCEIL) is the first demutualized, Electronic Multi-Commodity Exchange in India. On 25th July, 2001, it was granted approval by the Government to organise trading in the edible oil complex. It has operationalized from November 26, 2002. Central Warehousing Corporation Ltd., Gujarat State Agricultural Marketing Board and Neptune Overseas Limited are supporting it. It got its recognition in October 2002 Research Methodology Correlation Analysis Correlation analysis is a statistical technique used to measure the magnitude of linear relationship between two variables. Correlation analysis cannot be used in isolation to describe the relationship between variables. It can be used along with regression to determine the relationship between two variables. Thus it can be used as the basis for further analysis. There are two prominent correlation coefficients i.e. Pearson Product Correlation Coefficient and Spearmans Rank Correlation Coefficient. But in this report we have used the Pearsons method to compute the correlation. Pearson Product Correlation Coefficient It measures the strength of the linear relationship between two variables. This is also known as simple correlation coefficient and is denoted by r. The r value ranges from -1 to +1. If the r value is -1 than it indicates that there is the perfect negative relationship between the two variables. If the value is +1 than it indicates the perfect positive relationship between the two variables. If the value is 0 it indicates that there is no relationship between the two variables. It can be calculated as follows https://mathbits.com/mathbits/tisection/statistics2/IntroS7.gif Where r = correlation coefficient for the variables X and Y Regression Analysis Regression analysis is another statistical tool for measuring the association the between the two variables. It is the technique used to predict the nature and closeness of relationship between two or more variables. This method is different from correlation analysis. It helps to evaluate the causal effect of one of the dependent variable based on the information about one or more independent variables. Regression analysis that involves two variables is termed bi-variate linear regression analysis. Regression analysis that involves more than two variables is termed as multiple regression analysis. The bi-variate linear regression involves analyzing the straight line relationship between the two continuous variables. The bi-variate linear regression can be expressed as: Y=  Ãƒâ€šÃ‚ ¡ + ÃÆ'Ã… ½Ãƒâ€šÃ‚ ²x Y represents the dependent variable X represents the independent variable  Ãƒâ€šÃ‚ ¡ and ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² are the two constants which are known as regression coefficients ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² is the slope coefficient i.e. ÃÆ'Ã… ½Ãƒâ€šÃ‚ ² is the change in the value of Y with the corresponding change in 1 unit of X.