BASICS OF EQUITY DERIVATIVES
1. Introduction to Derivatives 2. Market Index 3. Futures and Options 4. Trading, Clearing and Settlement 5. Regulatory Framework 6. Annexure I – Sample Questions 7. Annexure II – Options – Arithmetical Problems 8. Annexure III – Margins – Arithmetical Problems 9. Annexure IV – Futures – Arithmetical Problems 10. Annexure V – Answers to Sample Questions 11. Annexure VI – Answers to Options – Arithmetical Problems 12. Annexure VI I– Answers to Margins – Arithmetical Problems 13. Annexure VII – Answers to Futures – Arithmetical Problems 1 - 9 10 - 17 18 - 33 34 - 62 63 - 71 72 - 79 80 - 85 86 - 92 93 - 98 99 - 101 102 - 104 105 - 106 107 - 110
CHAPTER I - INTRODUCTION TO DERIVATIVES
The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by lockingin asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.
1.1 DERIVATIVES DEFINED
Derivative is 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, forex, 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. The price of this derivative is driven by the spot price of wheat which is the "underlying". In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines "derivative" to include1. A security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices, of underlying securities. Derivatives are securities under the SC(R)A and hence the trading of derivatives is governed by the regulatory framework under the SC(R)A. EMERGENCE OF FINANCIAL DERIVATIVE PRODUCTS 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. 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.
1.2 FACTORS DRIVING THE GROWTH OF DERIVATIVES
Over the last three decades, the derivatives market has seen a phenomenal growth. A large variety of derivative contracts have been launched at exchanges across the world. Some of the factors driving the growth of financial derivatives are: 1. Increased volatility in asset prices in financial markets, 2....
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