Derivatives & Index Basics - Chapter 1

Derivatives & Index Basics - Chapter 1

Understanding derivatives and derivatives markets

Derivatives are contracts (not assets) whose value is derived from the value of an underlying asset. This asset could be an equity share, a bond, an index, gold, agricultural commodities like sugar, industrial metals like copper, energy products like oil and gas etc. the price of the derivative contract moves based on the movement in the price of the underlying. That is how the word derivative comes into existence.

Derivatives markets are where such derivative contracts are traded. While we shall get into greater detail about the nuances of derivative products later in this chapter, let us quickly look at the history of derivative markets in India. Globally, derivatives markets are nearly 900 years old, although the markets were more informal at that point of time. Even in India, derivatives have existed for over 100 years. While futures started in the CBOT more than 150 years ago, options trading started only in 1973. That was just after the Black & Scholes model was discovered by Nobel Laureates; Fischer Black and Myron Scholes. This gave a basis for pricing options and subsequently led to the geometric growth of options market across the world.

While India has traded informal commodity futures and rupee forward contracts for a long time, the first official step was the formation of the L.C. Gupta Committee in 1996. Based on the report submitted in 1998, SEBI appointed the J R Verma Committee to recommend risk management measures for trading in derivatives. This formed the basis for derivatives trading in India. The actual exchange traded futures and options on equities and indices were launched by SEBI only in 2001 while exchange traded currency derivatives were launched in 2008. In between MCX launched derivatives in commodities in 2003. The organized history of derivatives in India is quite brief.

Forwards, futures, options and swaps

Broadly, there are four products under derivatives that are traded extensively. Let us look at the four products in greater detail.

Forwards

A forward is a contractual agreement between two parties to buy or sell an underlying asset at a fixed future date for a fixed price that is pre-decided on the date of contract. In case of forwards, both the parties are obliged to honour the transaction. Forwards are over-the-counter (OTC) products as they are private contracts and not traded on an exchange platform. This makes forwards non-standardized and hence risky and illiquid.

Futures

Structurally, a futures contract is similar to a forward contract (agreement to buy or sell). However, unlike forwards, futures are traded on an organized exchange and regulated by SEBI. In the Indian context, exchange traded futures are standardized in terms of lot sizes and strike prices and all futures transactions are counter guaranteed by the clearing corporation of the stock exchange. Hence there is no risk of counterparty default.

Options

Like futures, options are also exchange traded contracts but they are structurally different. An Option is a contract that gives the right, but not an obligation, to buy or sell the underlying on or before a stated date and at a stated price. It is this right (without obligation) that gets traded in the market at a premium. The buyer of the options gets the right and for that they pay the option premium to the seller of the option. The seller of the option has the obligation without the right and just earns the premium.

Swap

Swaps represent an agreement between two parties to exchange cash flows in the future according to a prearranged formula. You can either exchange fixed rate interest for floating rates or you can also exchange one currency for another. Swaps are yet to become popular in Indian markets.

Major players in the derivatives market

Broadly, there are 3 types of players in the derivatives market with different levels of risk appetite and return requirements.

  • Hedgers are the players who have an underlying exposure to price risk. For example, a paint company that buys crude oil as an input needs to protect against price rise. A copper producer like Vedanta would want to protect against a fall in copper prices. An investor holding Reliance would want to protect against fall in the stock price. They are hedgers because their intent is to just protect their underlying exposure.
  • Speculators are routine trades who trade in futures and options as the margins payable are lower than in the equity market. For speculators, futures and options are an alternative to borrowing in the market and trading. Speculators create volatility in the market, but they also create volumes and liquidity. They take risk to earn profit by buying low and selling high, or by first selling high and later buying low.
  • Arbitrageurs are the safe players who arbitrage the difference between the spot cash market and the futures market. If RIL is quoting at Rs.1000/- in the spot market and Rs.1010 in the near month futures, then the spread of Rs.10/1000 = 1% becomes the assured return for the arbitrageur. Their returns are closer to debt returns. He typically makes his profit by buying low in one market and selling high in another.

 Important role of derivatives market

The derivative market plays a very significant role in the overall market system as well as for the macro-economy. Here is why the derivatives market has an important role to play.

  • Derivatives market enable price discovery based on actual valuations and expectations. In fact spot prices are based on expected future prices and that missing link for pricing is provided by the derivatives market
  • Perhaps, the most important role that derivatives play in the stock markets is that they enable transfer of various risks from those who are exposed to risk but have low risk appetite to other players with high risk appetite and are willing to share risk for a price.
  • Derivatives markets help to move speculative trades from unorganized market to organized market. Unlike the informal OTC markets, the exchange traded derivatives markets are better regulated and trades are also guaranteed.
  • Derivatives are an important tool for managing risk and businesses can reduce their risk and enhance valuations by managing their risk better. Options are also flexible enough to structure hybrid trades for limited risk, earning income, reducing cost etc.
  • Cash futures arbitrageurs provide finer quotes, narrow the spreads and the lower bid-ask spreads makes the market more liquid.

One must be conscious that derivatives are leveraged products and hence losses can be magnified just as profits can get magnified. Hence capital protection must always be the driving force in derivatives trading. Derivatives in India are available on stocks and on major indices like Nifty and Bank Nifty. In fact, derivative volumes on index futures and index options form a substantial share of derivatives trading. Hence we shall look at the concept of indices in greater deal.

What exactly is an index?

You must have normally referred to the Nifty and the Sensex as representative of the stock market as a whole. In technical parlance, these are called indices and they are a representative barometer of the market as a whole. So what exactly is an index? An Index is a statistical indicator that measures changes in the economy in general or in particular areas. In case of financial markets, an index is a portfolio of securities that represent a particular market or a portion of a market. The Nifty is a portfolio of 50 stocks while the Sensex is a portfolio of 30 stocks selected on a predetermined set of criteria.

There are different approaches to calculating an index but the common feature is that all indices are based on a base year. For example, the Sensex uses 1979 as a base year with a base value of 100 while the Nifty uses 1995 as the base year with a base value of 1000. Any Nifty and Sensex value you see on a daily basis is with reference to this base year. So Nifty at 12,000 means the portfolio has appreciated 12 times since 1995. Similarly the Sensex value of 40,000 represents that the portfolio has appreciated 400 times since 1979.

 Why are Indices so important?

Indices have a variety of practical real-life applications. Here are a few of them.

  • A stock index is an indicator of the performance of overall market. There are also specific indices like Bank Index, IT Index, Mid-Cap index etc.
  • Index is a benchmark for portfolio performance for active portfolios. Portfolio managers are measured based on whether they outperform or underperform the index.
  • You can trade futures and options on the index, so such indices can also be used to hedge your overall equity portfolio through a process called Beta Hedging.
  • Indices can be representative of the overall market, specific sectors, specific themes, specific capitalization classes etc. This allows for better benchmarking.
  • It helps to select the right stock for investment and also helps to differentiate among various companies listed on exchange.
  • It an overall indicator of the performance of country’s economy

Free-Float Market Capitalization Index and its attributes

What is Free Float Market Cap?

In free float market capitalization, the value of the company is calculated by excluding shares held by the promoters. These excluded shares are the free float shares. For example if a company has issued 10 lakh shares of face value Rs 10, but of these, four lakh shares are owned by the promoter, then the free float market capitalization is Rs 60 lakh.

Here we shall focus on Free-Float market cap indices because both the Nifty and the Sensex belong to that category. Here the weightage is allotted to each stock based on the free float (non-promoter holding) and then weighted by market. So a high value company like HDFC Bank with a large free float will have a big impact on the index.

Let us finally look at the attributes of a good index measure:

  • An index should ideally reflect the market behaviour. That means it reflects the sectors with the largest representation in the economy (banking / IT / FMC)
  • For indices to be credible, they must be managed independently with an expert committee reviewing stock selection, stock rejection etc.
  • It should be maintained using high standards of professional integrity and be absolutely objective in its creation and maintenance
  • Indices must have low impact cost so that large orders don’t distort the index and they can be used as an underlying for futures, options and ETFs
  • The futures and options on these indices must be actively traded to give a proper gauge of secondary market demand for the index