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Module 11: Derivatives and Futures

Derivative Instruments & Derivative Markets

Derivatives are products whose value is derived from the value of one or more basic variables, which are called Underlying Assets. The underlying asset can be equity, index, foreign exchange (Forex), commodity or any other asset.  This means that any instrument that derives its value on its underlying equity, index, foreign exchange (Forex), commodity or any other asset, is a Derivative Instrument.

Please note that derivative products initially emerged as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. But after 1970s, the financial derivatives came into spotlight thanks to the growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two thirds of total transactions in derivative products.

Different Types of Derivatives

The derivatives can be Forwards or Futures or Options or Warrants.

Forward & Future Contract: A forward contract is a customized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today. Futures contracts are special types of forward contracts in the sense that they  are standardized exchange-traded contracts, such as futures of the Nifty index.

Options: An Option is a contract which gives the right, but not an obligation, to buy or sell the underlying at a stated date and at a stated price. While a buyer of an option pays the premium and buys the right to exercise his option, the writer of an option is the one who receives the option premium and therefore obliged to sell/buy the asset if the buyer exercises it on him.

Options are of two types – Calls and Puts options.

  • ‘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.
  • ‘Puts’ give the buyer the right, but not the obligation to sell a given quantity of underlying asset at a given price on or before a given future date. Please note that options generally have lives of up to one year. The majority of options traded on exchanges have maximum maturity of nine months. Longer dated options are called Warrants and are generally traded over-the counter.

Long forward and short forward contracts

We suppose that Suresh wants to buy a house in next year October. At the same time, Ramesh has a house worth Rs. 15 Lakh and he plans to sell it in October next year. Since the current price is Rs. 15 Lakh, Ramesh and Suresh enter into an agreement via which Suresh will buy that house in October 2013 in Rs. 17 Lakh. This would be called a Forward Contract. The price agreed upon would be called Delivery price. Since Suresh is buying it, for him, it would be called Long Forward Contract. On the other side, Ramesh is selling it; it would be called Short Forward Contract.

Spot contract

Now, we suppose that in next year October, instead of Rs. 17 Lakh, the market price of that house becomes Rs. 20 Lakh. Since Ramesh is already in contract with Suresh to sell him the house in Rs. 17 Lakh, Suresh would earn a profit of Rs. 3 lakh. Ramesh would lose Rs. 3 Lakh. Here we note that forward contract is in contrast with the Spot contract. Spot contract is an agreement to buy or sell an asset today.

Non-Deliverable Forward

There is one more term related to Forward Contracts called NDF or Non-Deliverable Forward. Non-deliverable forwards are over-the-counter transactions settled not by delivery but by exchange of the difference between the contracted rate and some reference rate such as the one fixed by the Reserve Bank of India. For example, if Ramesh pays Suresh Rs. 3 Lakh without delivering the actual house, it would be called NDF. The same is basic funda for commodity forward contracts and currency forward contracts.

Role of Future Markets in Economy

There are two important roles of the Futures markets.

  • Price Discovery: Price discovery is the process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. The forward markets provide the collective assessment of a large number of individual market participants about the direction and price trends of a commodity in future. The price discovery is affected by the internal knowledge about the likely production, crop size, weather projections etc of the buyers and sellers.
  • The benefit of forwards is that the producers of commodities such as farmers can plan production and to shift acreage or production facilities from one commodity to another. The fight for acreage between wheat, soya bean and corn is an example of the demand forecast given by futures against the backdrop of complex interplay of forces like by forces bio-fuel demand, meat consumption (giving rise to larger utilization of feed to animals- in turn larger demand) etc.
  • Hedging of price Risk: if a producer or buyer has a general sense of the likely future price, the he can lock the produce so that his risk of price or for that matter availability is mitigated.

However, Speculators are one of the biggest segment of future markets participants. The speculative investors pour their money into the futures markets and thus are held responsible for increased volatility in commodities.

In any case, the social utility of futures markets is considered to be mainly in the transfer of risk, and increased liquidity between traders with different risk and time preferences. However, it does not take much time to convert the hedger into a speculator.

Option Premium

At the time of buying an option contract, the buyer has to pay premium. The premium is the price for acquiring the right to buy or sell. It is price paid by the option buyer to the option seller for acquiring the right to buy or sell. Option premiums are always paid up front.

Commodity Futures

FCRA Forward Contracts (Regulation) Act, 1952 defines “goods” as “every kind of movable property other than actionable claims, money and securities”. Futures’ trading is organized in such goods or commodities as are permitted by the Central Government. At present, all goods and products of agricultural (including plantation), mineral and fossil origin are allowed for futures trading under the auspices of the commodity exchanges recognized under the FCRA.

Commodity derivatives market trade contracts for which the underlying asset is commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc or precious me tals like gold, silver, etc.

First Commodity Future Market in India

In our country, the Commodity Futures market dates back to more than a century. The first organized futures market was established in 1875, under the name of ‘Bombay Cotton Trade Association’ to trade in cotton derivative contracts. This was followed by institutions for futures trading in oilseeds, foodgrains, etc.

The futures market in India underwent rapid growth between the period of First and Second World War. As a result, before the outbreak of the Second World War, a large number of commodity exchanges trading futures contracts in several commodities like cotton, groundnut, groundnut oil, raw jute, jute goods, castorseed, wheat, rice, sugar, precious metals like gold and silver were flourishing throughout the country. In view of the delicate supply situation of major commodities in the backdrop of war efforts mobilization, futures trading came to be prohibited during the Second World War under the Defence of India Act.

After Independence, especially in the second half of the 1950s and first half of 1960s, the commodity futures trading again picked up and there were thriving commodity markets. However, in mid-1960s, commodity futures trading in most of the commodities was banned and futures trading continued in two minor commodities, viz, pepper and turmeric.

Commodity Exchange

Commodity Exchange is an association, or a company of any other body corporate organizing futures trading in commodities. In a wider sense, it is taken to include any organized market place where trade is routed through one mechanism, allowing effective competition among buyers and among sellers – this would include auction-type exchanges, but not wholesale markets, where trade is localized, but effectively takes place through many non-related individual transactions between different permutations of buyers and sellers.

Difference between Commodity and Financial derivatives

The basic concept of a derivative contract remains the same whether the underlying happens to be a commodity or a financial asset. However there are some features which are very peculiar to commodity derivative markets. In the case of financial derivatives, most of these contracts are cash settled. Even in the case of physical settlement, financial assets are not bulky and do not need special facility for storage. Due to the bulky nature of the underlying assets, physical settlement in commodity derivatives creates the need for warehousing. Similarly, the concept of varying quality of asset does not really exist as far as financial underlyings are concerned. However in the case of commodities, the quality of the asset underlying a contract can vary at times.

Badla System

Badla System is an outdated Indian term for a trading system with a mechanism for deferring either payment for shares purchased or delivery of shares sold. The system, discontinued by the Securities and Exchange Board of India (SEBI), from March 1994, was applicable to a group or ‘Specified’ shares.

Mutual Funds

A mutual fund is a fund that is created when a large number of investors put in their money, and is managed by professionally qualified persons with experience in investing in different asset classes-shares, bonds, money market instruments like call money, and other assets like gold and property.

The name of the mutual fund gives a good idea about what type of asset class a fund, also called a scheme, will invest in. For example, a diversified equity fund will invest in a large number of stocks, while a gilt fund will invest in government securities while a pharma fund will mainly invest in stocks of companies from the pharmaceutical and related industries.

Is SEBI approval necessary for Mutual Funds?

Yes. Mutual funds are compulsorily registered with the Securities and Exchange Board of India (Sebi), which also acts as the first wall of defence for all investors in these funds.

Who runs Mutual Fund?

A mutual fund is run by a group of qualified people who form a company, called an asset management company (AMC) and the operations of the AMC are under the guidance of another group of people, called trustees.

Both, the people in the AMC as well as the trustees, have a fiduciary responsibility because these are the people who are entrusted with the task of managing the hard-earned money of people who do not understand much about managing money.

How to Invest in Mutual Funds?

An investor willing to invest in a mutual fund can approach a fund house or a distributor working for the fund house (which could be an individual, a company or even a bank), and ask a person qualified to sell mutual funds to explain how to go about it.

After some regulatory requirement is fulfilled, the investor can fill up a form and write a cheque-the fund house or the distributor will take care of the process after that. Once the cheque is cleared by the investor’s bank, the fund house will allot what are called ‘units’ to the investor, at a price that is fixed through a process approved by Sebi.

This price is based on the net asset value (NAV), in simple terms which is the total value of investments in a scheme divided by the total number of units issued to investors in the same scheme.

In most mutual fund schemes, NAVs are computed and published on a daily basis. However, when a fund house is launching a scheme for the first time, the units are sold at Rs 10 each.

What are kinds of Mutual Funds?

There are three types of schemes in which an investor can invest in. These are open-ended schemes, closed-ended schemes, and exchange-traded funds (ETFs).

Open Ended Fund:

An open-ended fund is the one which is usually available from a mutual fund on an ongoing basis that is an investor can buy or sell as and when they intend to at a NAV-based price.

As investors buy and sell units of a particular open-ended scheme, the number of units issued also changes every day.

The value of the scheme’s portfolio also changes on a daily basis. So, the NAV also changes on a daily basis. In India, fund houses can sell any number of units of a particular scheme, but at times fund houses restrict selling additional units of a scheme for some time.

Close-ended Fund:

A close-ended fund usually issue units to investors only once, when they launch an offer, called new fund offer (NFO) in India.

Thereafter, these units are listed on the stock exchanges where they are traded on a daily basis. As these units are listed, any investor can buy and sell these units through the exchange.

As the name suggests, close-ended schemes are managed by fund houses for a limited number of years, and at the end of the term either money is returned to the investors or the scheme is made open-ended.

However, usually, units of close ended funds which are listed on the stock exchanges, trade at a high discount to their NAVs. But as the date for closure of the fund nears, the discount between the NAV and the trading price narrows, and vanishes on the day of closure of the scheme.

Exchange Traded Funds

ETFs are a mix of open-ended and close-ended schemes.

ETFs, like close-ended schemes, are listed and traded on a stock exchange on a daily basis, but the price is usually very close to its NAV, or the underlying assets, like gold ETFs.

What are Advantages and Disadvantages of Mutual Funds?

If one invests in a well-managed mutual fund scheme, the advantages outweigh disadvantages and in the long term, which is 10 years or more. There is a very high probability of investors making more money than by investing in other risk-free investments such as FDs, public provident fund, etc.

Advantages of investing in MFs include diversification, good investment management services, liquidity, strong government-backed regulatory help, professional service, and all these at a low cost. The disadvantages of mutual fund investing include lack of flexibility to sell or buy a stock or a portfolio of stocks of choice. The investor does not have any freedom relating to customize the fund’s portfolio. Another disadvantage is that although in the long term MFs give good returns, the returns are not as predictable as say in bank FDs and PPF.

Legislations that control the securities market

Major legislations that control the securities market  are the SEBI Act, 1992, the Companies Act, 1956, Securities Contracts (Regulation) Act, 1956, Depositories Act, 1996  & Prevention of Money Laundering Act, 2002. Please note that previously we had a British Era legislation Capital Issues (Control) Act, 1947, which has been repealed now.

When was SEBI established?

SEBI was established and empowered statutory powers for (a) protecting the interests of investors in securities, (b) promoting the development of the securities market, and (c) regulating the securities market.

Jurisdiction of SEBI extends over corporates in the issuance of capital and transfer of securities, in addition to all intermediaries and persons associated with securities market. It can conduct enquiries, audits and inspection of all concerned and adjudicate offences under the Act. It has powers to register and regulate all market intermediaries and also to penalise them in case of violations of the provisions of the Act, Rules and Regulations made there under. SEBI has full autonomy and authority to regulate and develop an orderly securities market.

What are key provisions of Securities Contracts (Regulation) Act, 1956?

This act provides for direct and indirect control of virtually all aspects of securities trading and the running of stock exchanges and aims to prevent undesirable transactions in securities. It gives Central Government regulatory jurisdiction over (a) stock exchanges through a process of recognition and continued supervision, (b) contracts in securities, and (c) listing of securities on stock exchanges. As a condition of recognition, a stock exchange complies with conditions prescribed by Central Government. Organised trading activity in securities takes place on a specified recognised stock exchange. The stock exchanges determine their own listing regulations which have to conform to the minimum listing criteria set out in the Rules.

What are key provisions of Depositories Act, 1996

Depositories Act, 1996 provides for the establishment of depositories in securities with the objective of ensuring free transferability of securities with speed, accuracy and security by (a) making securities of public limited companies freely transferable subject to certain exceptions; (b) dematerialising the securities in the depository mode; and (c) providing for maintenance of ownership records in a book entry form. In order to streamline the settlement process, the Act envisages transfer of  wnership of securities electronically by book entry without making the securities move from person to person. The Act has made the securities of all public limited companies freely transferable, restricting the company’s right to use discretion in effecting the transfer of securities, and the transfer deed and other procedural requirements under the Companies Act have been dispensed with.

What are key provisions of Companies Act, 1956?

It deals with issue, allotment and transfer of securities and various aspects relating to company management. It provides for standard of  disclosure in public issues of capital, particularly in the fields of company management and projects, information about other listed companies under the same management, and management perception of risk factors. It also regulates underwriting, the use of premium and discounts on issues, rights and bonus issues, payment of interest and dividends, supply of annual report and other information.

What are key provisions of Prevention of Money Laundering Act, 2002?

The primary objective of the Act is to prevent money-laundering and to provide for confiscation of property derived from or involved in money-laundering. The term money-laundering is defined as whoever acquires, owns, possess or transfers any proceeds of crime; or knowingly enters into any transaction which is related to proceeds of crime either directly or indirectly or conceals or aids in the concealment of the proceeds or gains of crime within India or outside India commits the offence of money laundering. Besides providing punishment for the offence of money-laundering, the Act also provides other measures for prevention of Money Laundering. The Act also casts an obligation on the intermediaries, banking companies etc to furnish information, of such prescribed transactions to the Financial Intelligence Unit- India, to appoint a principal officer, to maintain certain records etc.

Apart from the above legislations, government has framed rules under the SCRA, SEBI Act and the Depositories Act. SEBI has framed regulations under the SEBI Act and the Depositories Act for registration and regulation of all market intermediaries, and for prevention of unfair trade practices, insider trading, etc. Under these Acts, Government and SEBI issue notifications, guidelines, and circulars which need to be complied with by market participants.

Basics of Investments

What is the real return on investments?

The money which we earn is partly spent and the rest saved for meeting future expenses. Instead of keeping the savings idle we would like to use savings in order to get return on it in the future. This is called Investment. We invest because of many reasons. One important reason is that we want to meet the cost of Inflation.  The Inflation which is the rate, at which the cost of living increases, indicates the rate at which the prices of the goods and services we need are increasing.

If there is inflation, the money loses value, because it will not buy the same amount of a good or a service in the future as it does now or did in the past.

For example, we suppose that if there was a 6% inflation rate for the last 20 years, a Rs. 100 purchase in 1992 would cost Rs. 321 in 2012. So, whenever we make a long term investment strategy, we need to consider inflation. An investment’s real return is that return which is after deducting the inflation. This means that if the annual inflation rate is 6%, what we invest should earn more than 6% annually so that we get a positive real return.

What are Real Assets and Financial Assets?

A person can invest in Physical assets like real estate, gold/jewellery, and commodities etc or Financial assets such as fixed deposits with banks, small saving instruments with post offices, insurance/provident/pension fund etc. Apart from that an investor can invest in securities market related instruments like shares, bonds, debentures etc.

What are major Short Term Investment Options?

There are short term investment options such as savings bank account, money market/liquid funds and fixed deposits with banks.

  • Out of them the Savings Bank Account is often the first banking product people use, which offers low interest, making them only marginally better than fixed deposits.
  • In India, the interest rate on savings bank accounts is now deregulated as the banks themselves decide the interest rates.
  • The Money Market or Liquid Funds are a specialized form of mutual funds that invest in extremely short-term fixed income instruments and thereby provide easy liquidity.

There is a big difference between the Mutual Funds and Liquid Funds. Unlike most mutual funds, money market funds are primarily oriented towards protecting the investor’s capital and then, aim to maximise returns. Money market funds usually yield better returns than savings accounts, but lower than bank fixed deposits. Lastly, the Fixed Deposits with Banks can be long term as well as short term investment options as minimum investment period for bank FDs is 30 days. Fixed Deposits with banks are for investors with low risk appetite, and may be considered for 6-12 months investment period as normally interest on less than 6 months bank FDs is likely to be lower than money market fund returns.

What are Long Term Investment Options?

The Long term investments typically comprise the Post Office Savings Schemes, Public Provident Fund, Company Fixed Deposits, Bonds and Debentures, Mutual Funds etc.

Post Office Investments:

  • Post Office Monthly Income Scheme is a low risk saving instrument, which can be availed through any post office. It provides an interest rate of around 8% per annum, which is paid monthly.
  • Minimum amount, which can be invested, is Rs. 1,500/- and additional investment in multiples of 1,000/-.
  • Maximum amount is Rs. 3,00,000/- (if Single) or Rs. 6,00,000/- (if held Jointly) during a year. It has a maturity period of 6 years. Premature withdrawal is permitted if deposit is more than one year old. Post office also provides time deposits for 1, 2, 3, 5 years. The monthly scheme and term deposits of Post offices don’t provide any Tax benefits.

Public Provident Fund:

PPF is a long term savings instrument with a maturity of 15 years and interest payable at 8.25 % per annum (2011-12, it was  9.5 per cent paid in 2010-11) compounded annually. A PPF account can be opened through a nationalized bank at anytime during the year and is open all through the year for depositing money.

Tax benefits can be availed for the amount invested and interest accrued is tax-free. A withdrawal is permissible every year from the seventh financial year of the date of opening of the account and the amount of withdrawal will be limited to 50% of the balance at credit at the end of the 4th year immediately preceding the year in which the amount is withdrawn or at the end of the preceding year whichever is lower the amount of loan if any.

Corporate FDs

Corporate FDs or Company Fixed deposits are short-term (six months) to medium-term (three to five years) borrowings by companies at a fixed rate of interest which is payable monthly, quarterly, semi-annually or annually. They can also be cumulative fixed deposits where the entire principal along with the interest is paid at the end of the loan period. The rate of interest varies between 6-9% per annum . The interest received is after deduction of taxes.

Bonds

Bonds are fixed income instruments issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with a fixed rate of interest on a specified date, called the Maturity Date.

Mutual Funds

  • The Mutual funds are operated by an investment company which raises money from the public and invests in a group of assets (shares, debentures etc.), in accordance with a stated set of objectives. Mutual Funds are for those who are unable to invest directly in equities or debt because of resource, time or knowledge constraints.
  • Mutual Funds come with benefits such as professional money management, buying in small amounts and diversification. Mutual fund units are issued and redeemed by the Fund Management Company based on the fund’s net asset value (NAV), which is determined at the end of each trading session.
  • NAV is calculated as the value of all the shares held by the fund, minus expenses, divided by the number of units issued. Mutual Funds are usually long term investment vehicle though there some categories of mutual funds, such as money market mutual funds which are short term instruments.

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