20-11-2012, 06:08 PM
ONLINE TRADING DERIVATIVES
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Introduction :
In our present day economy, finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium or small, needs finance to carry on its operations and to achieve its targets in fact; finance is so indispensable today that it is rightly said that it is the lifeblood of an enterprise.
The term ‘ownership securities’ also known as ‘capital stock ‘ represents shares. Shares are the most universal forms of raising long-term funds from the market. Every company, except a company limited by guarantee, has a statutory right to issued shares.
The capital of a company is divided into a number of equal parts known as shares. According to Farewell .j, a share is, “the interest of a shareholder in the company, measured by a sum of money, for the purpose of liability in the first place, and if interest in the second, but also consisting a series of mutual covenants entered into by all the shareholders interest’. Section 2(46) of the companies act, 1956 defines it as “ a share in the share capital of a company, and includes stock except where a distinction between stock and shares expressed or implied.
Share market is of two types. They are cash market and derivative market.
Cash markets are the secondary markets where trading in existing securities is done. Listing of new issues for investment and disinvestments by savers/investors takes place. It imparts liquidity or encash ability to stocks and shares. Stock exchange is a market in which securities are bought and sold and it is an essential component of a developed capital markets.
The securities contracts (Regulation) Act, 1956, defines Stock Exchange as follows: “It is an association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling of business in buying, selling and dealing in securities”.
A stock exchange, thus imparts marketability and liquidity to securities, encourage investments in securities and assists corporate growth. Stock exchanges are organized and regulated markets for various securities issued by corporate sector and other institutions.
Derivatives are a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate,) in a contractual manner. The underlying asset can be equity, fore ex. Commodity or any other asset. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. Such a transaction is an example of a derivative.
In the last 20 years derivatives have become notably important in the world of finance. Futures and options are now globally traded on many exchanges. Forward contracts, Swaps and many different types of options are regularly conducted by outside exchanges by financial institutions, fund managers and corporate treasurers in what is termed the over the counter market. Derivatives are also sometimes added to a bond or stock issue. Further, the very nature of volatility in the financial markets, the use of derivative products, it is possible to partially or fully transfer price risks by locking in asset prices. But these instruments of risk management are generally do not influence the fluctuations in the underlying asset prices. However, by locking asset prices, the derivative products minimize the fluctuations in the asset prices on the profitability and cash flow situations on risk to the investor.
The derivatives are becoming increasingly important in world of markets as a tool for risk management. Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is cheaper and more convenient than what could be obtained by using cash instruments. It is so because, when we use derivatives for hedging, actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative market.
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. The following three broad categories of participants – hedgers, speculators, and arbitrageurs trade in the derivatives market. Hedgers face risk associated with the price of an asset. They use futures or options markets to reduce or eliminate this risk. Speculators wish to bet on future movements in the price of an asset. Futures and options contracts can give them an extra leverage; that is, they can increase both the potential gains and potential losses in a speculative venture. Arbitrageurs and in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
Derivative products initially emerged as hedging devices against fluctuations in commodity prices, and commodity-linked derivatives remained the sole form for such products for almost three hundred years. Financial derivatives came into spotlight in the post-1970 period due to 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. In recent years, the market for financial derivatives has grown tremendously in terms of variety of instruments available, their complexity and also turnover.
In the class of equity derivatives the world over, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indexes with various portfolios and ease of use. The lower costs associated with various portfolios and ease of use. The lower costs associated with index derivatives vis-à-vis derivative products based on individual securities is another reason for their growing use.
The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on option in securities.
The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta. on November 18,1996 to develop appropriate regulatory framework for derivatives trading in India.
The committee submitted its report on March 17,1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as ‘securities’ so that regulatory framework applicable to trading of ‘securities’ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma., to recommend measures for risk containment in derivatives market in India. These instruments can be used to speculate or to manage risk in the equity markets.
Derivatives are products whose values are derived from one of more basic variables called bases. These bases can be underlying assets such as foreign currency, stock or commodity, bases or reference rates such as LIBOR or US Treasury Rate etc. For example, an Indian exporter in anticipation of the receipt of dollar-denominated export proceeds may wish to sell dollars at a future date to eliminate the risk of exchange rate volatility by the date. Such transactions are called derivatives, with the spot price of dollar being the underlying asset.
Derivatives thus have no value of their own but derive it from the asset that is being dealt with under the derivative contract. For instance, look at an ashtray. It has no value of its own but gains its importance only when one smokes and gain if one wants to collect that ash at one place instead of dirtying the whole room with cigarette ash and its stubs. A smoker can hedge against the risk of stewing the cigarette stubs and ash all around the room.
Similarly a financial manager can hedge himself from the risk of a loss in the price of a commodity or stock by buying a derivative contract. Thus derivative contracts acquire their value from the spot prices of the assets that are concerned by the contract.
The primary purpose of a derivative contract is to transfer “risk” from one party to another i.e. risk in a financial sense in transferred from a party that wants to get rid of it to another party that is willing to take it on. Here, the risk that is being dealt with is that of price risk. The transfer of such a risk can therefore be speculative in nature or act as a hedge against price movement in a current or anticipate physical position.
A derivative is an instrument whose value is derived from the value of one or more underlying which can either in the form of commodities, precious meat, currencies, bonds, stock and stock indices”. As the price of the wheat derivatives would be determined or based on the prices of wheat itself.
Given the fast change and growth in the scenario of the economic and financial sector have brought a much broader impact on derivatives instrument. As the name signifies, the value of this product is derived of based on the prices of currencies, interest rate (i.e. bonds), share and share indices, commodities, etc. Not going into very back, financial derivatives just came into existence in the early 1980’s. Here the principal instruments, clubbed under the general term derivatives, include
1. Futures & Forwards
2. Options,
3. Swaps
4. Warrants
5. Exotic and are the modern tools of financial risk management.
All pricing of derivatives is done by arbitrage, and by arbitrage alone. Here, there is a relationship between the price of the spot and the price in the futures. If this relationship is violate, then an arbitrage opportunity is available, and we people exploit this opportunity, the price reverts back to its economic value. Therefore, arbitrage is the basic requirement for pricing. The role of liquidity i.e. the low transaction costs is in making arbitrage check up and convenient. Derivative markets in Brazil are some of the largest markets in the world even first derivative dealing were started in USA. We can even know that as the prices of the forward contacts are based on future therefore it can even be termed as derivative instrument.
Derivative contracts have several variants. The most common variants are forwards, futures, options and swaps. A brief note on the various derivative that are used are as follows:
Forwards. A forward contract is a customized contract between tow entities, where settlement takes place on a specific date in future at today’ pre agreed price.
Futures. A future contract is an agreement between two parties to buy
Or sell an asset at a certain time in the future at a certain price. Future contracts are
Special types of forward contracts means that the former are standardized exchange
Traded contracts.
Options. Options are of two types,
Calls 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.
Puts Option. Puts Option give the buyer the right, but not obligation to sell a
Given quantity of the underlying asset at a given price on or before a given date.
Warrants. Longer dated options are called warrants and are generally
Traded over the counter.
Swaps. Swaps are private agreements between two parties to exchange cash flows in the future according to a pre- arranged formula. They can be regarded as portfolios of forward contracts.
Need for Study:
Although financial derivatives have existed for a considerable period of time they have become major forces in financial market only since the early 1970s. The 1970s constituted a watershed in financial history, partly because the fixed exchange rate regime (the Bretton Woods Systems) that had operated since the 1940s, broke down.
These developments established the context in which financial derivatives could develop, flourish and became a major force in world financial markets. When the Breton Wood Systems collapsed in the early 1970s, a regime of fixed exchange rates gave way to financial environment in which exchange rates were constantly changing in response to pressure of demand and supply. The fact that currency prices move constantly and often substantially, in the new situation meant that businesses face new risks.
Currency derivatives developed in response to the need to manage these risks. In other words the new system of variable exchange rates generated a need to find techniques to reduce the risks arising and simultaneously created opportunities for speculations. Thus financial derivatives develop as a vehicle for these two forms of economic activities. When an investor feels the market will fall, he can hedge this position by selling. Say, Nifty futures against his portfolio.