- Why use derivatives and not just cash instruments?
- What is the difference between derivatives and shares?
- What is a futures contract?
- Forward contracts v/s Future contracts
- Standardized terms in futures
- Every futures contract is a forward contract
- Commodity V/s Financial Futures
- What’s an Index?
- What’s a Stock Index?
- What are the different kinds of market indices?
- What’s the financial theory behind the market index being a good barometer for the overall market?
- Why do we need an Index?
- What does the number mean?
- But why a portfolio? Why not the entire market?
- How are the stocks in the portfolio weighted?
- Market Capitalisation Method
- Price Weighted Method
- Equal Weightage Method
- What is the better weighing option?
- Who owns the index? Who computes it?
- Who decides what stocks to include? How?
- Selection Criteria
- Industry Representation
- Market Capitalisation
- Liquidity or Impact Cost
- What is a Benchmark Index?
- What are the popular indices in India?
- What are Sectoral indices?
- What are the uses of an Index?
- What are Index Futures?
- Concept of basis in futures market
- Life of the contract
- Pricing Futures
- Relationship between forward & future markets
- What are stock specific futures?
- What do you mean by closing out contracts?
- Risk management through Futures
- Hedge terminology
- Some specific uses of Index Futures
- Margining in Futures market
- Liquid assets and Broker’s net worth
- Basis for calculation of Gross Exposure
- What are general hedging strategies?
- Accounting of Index Futures
- Commonly followed international accounting practices
- Hedge Accounting
- Trading Transactions
- Indian Conditions
Derivatives are financial securities whose value is derived from another “underlying” financial security i.e. it derives its value from some underlying. Options, futures, swaps, swaptions, structured notes are all examples of derivative securities. Derivatives can be used for 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.
A derivative financial product is a contrived instrument, the value of which depends indirectly on the price of a cash instrument. The price of the cash instrument is referred to as the “underlying” price, quite often. Examples of cash instruments include actual shares in a company, physical stocks of commodities, cash foreign exchange, etc.
a) Why use derivatives and not just cash instruments?
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.
b)What is the difference between derivatives and shares?
The difference is that while shares are assets, derivatives are usually contracts (the major exception to this are warrants and convertible bonds, which are similar to shares in that they are assets).
We can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually be fairly standardised and governed by the property or securities laws in an appropriate country.
On the other hand, a contract is merely: an agreement between two parties, where the contract details may not be standardised.
Due to their great flexibility, many different types of investors use derivatives. A good toolbox of derivatives allows the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all combinations thereof.
|What is a futures contract?|
A futures contract is an exchange-traded contract to buy or sell a pre-determined quantity and quality of a physical commodity or financial instruments (quality is not applicable to futures) on a pre-determined future date at a pre-determined price.
a)Forward contracts v/s Future contracts
- A forward contract is one to one bi-partite contract, to be performed in the future, at the terms decided today. (E.g. forward currency market in India).
- Forward contracts offer tremendous flexibility to the parties to design the contract in terms of the price, quantity, quality (in case of commodities), delivery time and place.
- Forward contracts suffer from poor liquidity and default risk.
- Not traded on exchanges but are traded over the counter
- Contract Specifications differ from trade to trade as they are individually agreed between two counter parties.
- Counter party Risk exists
- Liquidation Profile: Poor Liquidity as contracts are tailor maid contracts.
- Price Discovery: Poor; as markets are fragmented
- Future contracts are organized / standardized contracts, which are traded on the exchanges.
- These contracts, are standardized by the exchanges are very liquid in nature.
- In futures market, clearing corporation/ house provides the settlement guarantee.
- Counter party risk exists, but is assumed by the Clearing Corporation/ house reducing the risk to almost nil.
- Liquidation Profile: Very high Liquidity as contracts are standardized contracts.
- Price Discovery: Better; as fragmented markets are brought to the common platform whereby the price is much more transparent due to the standardization and market reporting of volumes and prices.
- Where a forward contract can only be reversed with the same counter party with whom it was entered into, a futures contract can be reversed with any member of the exchange.
b)Standardized terms in futures
- Quantity of the underlying
- Quality of the underlying (not required in financial futures)
- The date and month of delivery
- The units of price quotation (not the price itself) and minimum change in price (tick size)
c)Every futures contract is a forward contract
- are entered into through exchange, traded on exchange and clearing corporation/house provides the settlement guarantee for trades.
- are of standard quantity; standard quality (in case of commodities).
- have standard delivery time and place.
d)Commodity V/s Financial Futures
Examples of Commodity Futures:
- Orange juice
- Crude oil
- Natural gas
- Pork bellies, etc.
Examples of Financial Futures:
- Foreign exchange
- Deposits, etc.
Note: quality matters in the former, not in the latter.
Whats an Index?
An Index is a number used to represent the changes in a set of values between a base time period and another time period.
a) Whats a stock index?
A Stock Index is a number that helps you measure the levels of the market. Most stock indices attempt to be proxies for the market they exist in.
Returns on the index thus are supposed to represent returns on the market i.e. the returns that you could get if you had the entire market in your portfolio.
b) What are the different kinds of market indices?
Broad-based index is geared to provide overall picture of stock markets movements. Examples of these indices are S&P 500, Value Line Index and NYSE Composite. In addition to specialized indices like sector specific ones, track the performance of individual sectors. Similarly different types of indices can be created depending on the companies included in the set.
Example: S&P Midcap 400 represents companies in the U.S.A. whose value is in the middle range of all firms and does not include any stock, which is part of S&P 500.
c) What’s the financial theory behind the market index being a good barometer for the overall market?
Stock prices get impacted by two separate factors, which include:
- Company specific events like results bonus announcements, product launches, accidents, tie-ups, etc.
- Events that impact overall economy or sector like diesel price hike, tax rates, etc.Deposits, etc.
To elucidate suppose the government announces a corporate tax hike, we expect the index to be negatively impacted.
On the same day, if a company announces financial results much better than expected, its stock price should increase. In practice the price movement in the companies stock is a combination of its news of better financial results and the disappointing news about the performance of the economy. The role of an effective index is to reflect only that component which affects the state of the overall market.
d) Why do we need an index?
Students of Modern Portfolio Theory will appreciate that the aim of every portfolio manager is to beat the market. In order to benchmark the portfolio against the market we need some efficient proxy for the market. indices arose out of this need for a proxy; they act as an effective barometer, which gauges the prevalent market sentiment and behaviour.
e) What does the number mean?
The index value is arrived at by calculating the weighted average of the prices of a basket of stocks of a particular portfolio.
This portfolio is called the index portfolio and attempts a high degree of correlation with the market.
indices differ based on the method of assigning the weightages to the stocks in the portfolio.
f) But why a portfolio? Why not the entire market?
This is because for someone who wishes to replicate the return on the market it is infinitely more expensive to buy the whole market and for small portfolio sizes it is almost impossible.
The alternative is to choose a portfolio that has a high degree of correlation with the market.
g)How are the stocks in the portfolio weighted?
There are basically three types of weighing :
o Market Capitalisation weighted
o Price weighted
o Equal weighted