Equity and bonds are two types of investments:
1. **Equity**: Equity represents ownership in a company. When you buy equity (such as
stocks), you become a partial owner of the company. Your returns come from the
company's profits and stock price appreciation. However, equity investments can be risky as
stock prices can fluctuate significantly.
2. **Bonds**: Bonds, on the other hand, are loans made to governments or corporations.
When you buy a bond, you are essentially lending money to the issuer. The issuer pays you
periodic interest payments, and when the bond matures, you receive the principal back.
Bonds are generally considered safer than stocks because they offer fixed returns and are
less affected by market volatility.
"Mark-to-Market," a valuation process that assesses the current market value of a financial
instrument or asset.
Derivative: This is a financial product whose value is derived from some underlying asset.
This underlying asset can be index, stock, commodity, currency, etc.
Index derivatives: Index derivatives are derivative contracts which have the index as the
underlying.
Sock derivatives: Stock derivatives are derivative contracts which have the stock as the
underlying.
Forward: A forward contract is a customized contract between two parties to buy or sell an
asset on a specified date for a specified price.
Future: A futures contract is a standardized contract between two parties to buy or sell an
asset at a certain time in future at a certain price.
These are basically exchange traded, standardized contracts.
Options Contracts: Options give the buyer (holder) a right but not an obligation to buy or
sell an asset in future.
Options are of two types - calls and puts.
Call Option: Calls give the buyer the right but not the obligation to buy a given quantity of
the underlying asset, at a given price on or before a given future date.
Put Option: Puts give the buyer the right, but not the obligation to sell a given quantity of
the underlying asset at a given price on or before a given date.
Participants in a Derivative Market
The derivatives market is similar to any other financial market and has following three broad
categories of participants:
Hedgers: These are investors with a present or anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the derivatives markets primarily for price risk
management of assets and portfolios.(to avoid the risk you enter in contract )
Speculators: These are individuals who take a view on the future direction of the markets.
They take a view whether prices would rise or fall in future and accordingly buy or sell
futures and options to try and make a profit from the future price movements of the
underlying asset.
Arbitrageurs: They take positions in financial markets to earn riskless profits. The
arbitrageurs take short and long positions in the same or different contracts at the same
time to create a position which can gener ate a riskless profit.
Distinction between Futures and Forwards
Futures Forwards
Trade on an organized exchange OTC in nature
Standardized contract terms Customised contract terms
More liquid Less liquid
Requires margin payments No margin payment
Follows daily settlement Settlement happens at end of period
Futures Terminology
Spot price: The price at which an underlying asset trades in the spot market.
Futures price: The price that is agreed upon at the time of the contract for the delivery of an
asset at a specific future date.
Contract cycle: It is the period over which a contract trades. The index futures contracts on
the NSE have one-month, two-month and three-month expiry cycles which expire on the
last Thursday of the month. Thus a January expiration contract expires on the last Thursday
of January and a February expiration contract ceases trading on the last Thursday of
February. On the Friday following the last Thursday, a new contract having a three-month
expiry is introduced for trading.
Expiry date: is the date on which the final settlement of the contract takes place.
Contract size: The amount of asset that has to be delivered under one contract. This is also
called as the lot size.
Basis: Basis is defined as the futures price minus the spot price. There will be a different
basis for each delivery month for each contract. In a normal market, basis will be positive.
This reflects that futures prices normally exceed spot prices.
Cost of carry: Measures the storage cost plus the interest that is paid to finance the asset
less the income earned on the asset.
Initial margin: The amount that must be deposited in the margin account at the time a
futures contract is first entered into is known as initial margin.
Marking-to-market: In the futures market, at the end of each trading day, the margin
account is adjusted to reflect the investor’s gain or loss depending upon the futures closing
price. This is called marking-to-market.
Maintenance margin: Investors are required to place margins with their trading members
before they are allowed to trade. If the balance in the margin account falls below the
maintenance margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on the next day.
Arbitrage: Overpriced futures: buy spot, sell futures
As we discussed earlier, the cost-of-carry ensures that the futures price stay in tune with the
spot price. Whenever the futures price deviates substantially from its fair value, arbitrage
opportunities arise.
If you notice that futures on a security that you have been observing seem overpriced, how
can you cash in on this opportunity to earn riskless profits? Say for instance, ABC Ltd. Trades
at Rs.1000. One-month ABC futures trade at Rs.1025 and seem overpriced. As an
arbitrageur, you can make riskless profit by entering into the following set of transactions.
1. On day one, borrow funds, buy the security on the cash/spot market at 1000.
2. Simultaneously, sell the futures on the security at 1025.
3. Take delivery of the security purchased and hold the security for a month.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.
5. Say the security closes at Rs.1015. Sell the security.
6. Futures position expires with profit of Rs. 10.
7. The result is a riskless profit of Rs.15 on the spot position and Rs.10 on the futures
position.
8. Return the borrowed funds.
If the cost of borrowing funds to buy the security is less than the arbitrage profit possible, it
makes sense for you to arbitrage. In the real world, one has to build in the transactions costs
into the arbitrage strategy.
Arbitrage: Underpriced futures: buy futures, sell spot
Whenever the futures price deviates substantially from its fair value, arbitrage opportunities
arise. It could be the case that you notice the futures on a security you hold seem
underpriced. How can you cash in on this opportunity to earn riskless profits? Say for
instance, ABC Ltd. trades at Rs.1000. One-month ABC futures trade at Rs. 965 and seem
underpriced. As an arbitrageur, you can make riskless profit by entering into the following
set of transactions.
1. On day one, sell the security in the cash/spot market at 1000.
2. Make delivery of the security.
3. Simultaneously, buy the futures on the security at 965.
4. On the futures expiration date, the spot and the futures price converge. Now unwind the
position.
Say the security closes at Rs.975. Buy back the security.
6. The futures position expires with a profit of Rs.10.
7. The result is a riskless profit of Rs.25 on the spot position and Rs.10 on the futures
position.
If the returns you get by investing in riskless instruments is more than the return from the
arbitrage trades, it makes sense for you to arbitrage. This is termed as reverse-cash-and
carry arbitrage. It is this arbitrage activity that ensures that the spot and futures prices stay
in line with the cost-of-carry. As we can see, exploiting arbitrage involves trading on the spot
market. As more and more players in the market develop the knowledge and skills to do
cash and- carry and reverse cash-and-carry, we will s see increased volumes and lower
spreads in both the cash as well as the derivatives market.
Options:
Option Terminology
Index options: Have the index as the underlying. They can be European or American.
They are also cash settled.
Stock options: They are options on individual stocks and give the holder the right to buy or
sell shares at the specified price. They can be European or American.
Buyer of an option: The buyer of an option is the one who by paying the option premium
buys the right but not the obligation to exercise his option on the seller/writer.
Writer of an option: The writer of a call/put option is the one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer exercises on him.
There are two basic types of options, call options and put options.
Call option: It gives the holder the right but not the obligation to buy an asset by a certain
date for a certain price.
Put option: It gives the holder the right but not the obligation to sell an asset by a certain
date for a certain price.
Option price/premium: It is the price which the option buyer pays to the option seller. It is
also referred to as the option premium.
Option Premium = Intrinsic Value + Time Value
Factors affecting the option price-
1. Spot Price
2. Strike Price
3. Time to maturity
4. Implied Volatility
5. Interest
6. Dividend
For Calls-
In the money (ITM) – Spot Price > Strike Price
At the money (ATM) - Spot Price = Strike Price
Out of the money (OTM) - Spot Price < Strike Price
For Puts-
In the money (ITM) – Strike Price > Spot Price
At the money (ATM) - Strike Price > Spot Price
Out of the money (OTM) - Strike Price < Spot Price
Comparison between Futures and Options
Futures Options
Exchange traded Same as futures.
Exchange defines the product Same as futures
Price is zero, strike price
moves Strike price is fixed, price moves
Price is zero Price is always positive
Linear payoff Nonlinear payoff
Both long and short at risk
Only Only short risk
