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FAQs
Frequently Asked Questions on Equities & Derivatives
What are Derivative Instruments?
A derivative is an instrument whose value is derived from the value of one or more
underlying, which can be commodities, precious metals, currency, bonds, stocks,
stocks indices, etc. Four most common examples of derivative instruments are Forwards,
Futures, Options and Swaps.
Why Derivatives?
There are several risks inherent in financial transactions. Derivatives allow you
to manage these risks more efficiently by unbundling the risks and allowing either
hedging or taking only one (or more if desired) risk at a time (please see risk
management for more details).
For instance, if we buy a share of TISCO from our broker, we take following risks
- Price risk that TISCO may go up or down due to company specific reasons (unsystematic
risk).
- Price risk that TISCO may go up or down due to reasons affecting the sentiments
of the whole market (systematic risk).
- Liquidity risk, if our position is very large, that we may not be able to cover
our position at the prevailing price (called impact cost).
- Counterparty (credit) risk on the broker in case he takes money from us but before
giving delivery of shares goes bankrupt.
- Counterparty (credit) risk on the exchange - in case of default of the broker, we
may get partial or full compensation from the exchange.
- Cash out-flow risk that we may not able to arrange the full settlement value at
the time of delivery, resulting in default, auction and subsequent losses.
- Operating risks like errors, omissions, loss of important documents, frauds, forgeries,
delays in settlement, loss of dividends & other corporate actions etc.
Once we are long on TISCO we can hedge the systematic risk by going short on index
futures. On the other hand, if we do not want to take unsystematic risk on any one
share, but wish to take only systematic risk – we can go long on index futures,
without buying any individual share. The credit risk, cash outflow risk and operating
risks are much easier to manage in this case.
What are Forward Contracts?
A forward contract is a customized contract between two parties, where settlement
takes place on a specific date in future at a price agreed today.
The main features of forward contracts are
- They are bilateral contracts and hence exposed to counter-party risk.
- Each contract is custom designed, and hence is unique in terms of contract size,
expiration date and the asset type and quality.
- The contract price is generally not available in public domain.
- The contract has to be settled by delivery of the asset on expiration date.
- In case, the party wishes to reverse the contract, it has to compulsorily go to
the same counter party, which being in a monopoly situation can command the price
it wants.
What are Futures?
Futures are exchange traded contracts to sell or buy financial instruments or physical
commodities for Future delivery at an agreed price. There is an agreement to buy
or sell a specified quantity of financial instrument/ commodity in a designated
Future month at a price agreed upon by the buyer and seller. The contracts have
certain standardized specifications.
What are the Standardized Terms
in Futures?
The standardized items in any Futures contract are
- 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)
- Location of Settlement
What
is the Difference between Forward Contracts and Futures Contracts?
Futures is a type of forward contract.
- Standardized Vs Customized Contract - Forward contract is customized while the future
is standardized. To be more specific, the terms of a Forward Contracts are individually
agreed between two counter-parties, while Futures being traded on exchanges have
terms standardized by the exchange.
- Counter party risk - In case of Futures, after a trade is confirmed by two members
of exchange, the exchange / clearing house itself becomes the counter-party (or
guarantees) to every trade. The credit risk, which in case of forward contracts
was on the counter-party, gets transferred to exchange / clearing house, reducing
the risk to almost nil.
- Liquidity - Futures contracts are much more liquid and their price is much more
transparent due to standardization and market reporting of volumes and price.
- Squaring off - A forward contract can be reversed only with the same counter-party
with whom it was entered into. A Futures contract can be reversed with any member
of the exchange.
Can there be Futures on Individual
Stocks?
Such instruments exist in some countries (example Sydney Futures Exchange) but in
general are not very popular. Price volatility in individual stocks is much higher
than Index. This results in higher risk of clearing corporation and margin requirements.
In addition, such instruments suffer from lack of depth and liquidity in trading.
In most cases, Futures based on individual stocks often have a physical settlement,
resulting in more complex regulatory requirements. It is much more difficult to
manipulate an Index than individual stock, resulting in price manipulations. In
India, Dr. L.C.Gupta committee has not mentioned Futures on Individual Stocks as
a possible derivative contract.
What is the
Difference between Commodity and Financial Futures?
The basic difference between commodity and financial Futures is the nature of the
underlying instrument. In a commodity Futures, the underlying is a commodity which
may be Wheat, Cotton, Pepper, Turmeric, corn, oats, soybeans, orange juice, crude
oil, natural gas, gold, silver, pork-bellies etc. In a financial instrument, the
underlying can be Treasuries, Bonds, Stocks, Stock-Index, Foreign Exchange, Euro-dollar
deposits etc.
As is evident, a financial Future is fairly standard and there are no quality issues
while a commodity instrument, quality of the underlying matters.
What do you mean by Closing Out
Contracts?
A long position in futures, can be closed out by selling futures while a short position
in futures can be closed out by buying futures on the exchange. Once position is
closed out, only the net difference needs to be settled in cash, without any delivery
of underlying. Most contracts are not held to expiry but closed out before that.
If held until expiry, some are settled for cash and others for physical delivery.
Is the
Settlement Mechanism different for Cash and Physical Delivery?
In case it is impossible, or impractical, to effect physical delivery, open positions
(open long positions always being equal to open short positions) are closed out
on the last day of trading at a price determined by the spot "cash" market price
of the underlying asset. This price is called "Exchange Delivery Settlement Price"
or EDSP.
In case of physical settlement short side delivers to the specified location while
long side takes delivery from the specified location of the specified quantity /
quality of underlying asset. The long side pays the EDSP to clearing house/ corporation
which is received by the short side.
Is there a Theoretical
way of Pricing Index Futures?
The theoretical way of pricing any Future is to factor in the current price and
holding costs or cost of carry.
In general, the Futures Price = Spot Price + Cost of Carry
Cost of carry is the sum of all costs incurred if a similar position is
taken in cash market and carried to maturity of the futures contract less any revenue
which may result in this period. The costs typically include interest in case of
financial futures (also insurance and storage costs in case of commodity futures).
The revenue may be dividends in case of index futures.
Apart from the theoretical value, the actual value may vary depending on demand
and supply of the underlying at present and expectations about the future. These
factors play a much more important role in commodities, specially perishable commodities
than in financial futures.
In general, the Futures price is greater than the spot price. In special cases,
when cost of carry is negative, the Futures price may be lower than Spot prices.
What is the Concept of Basis?
The difference between spot price and Futures price is known as basis. Although
the spot price and Futures prices generally move in line with each other, the basis
is not constant. Generally basis will decrease with time. And on expiry, the basis
is zero and Futures price equals spot price.
What is Contango?
Under normal market conditions Futures contracts are priced above the spot price.
This is known as the Contango Market
What is Backwardation?
It is possible for the Futures price to prevail below the spot price. Such a situation
is known as backwardation. This may happen when the cost of carry is negative, or
when the underlying asset is in short supply in the cash market but there is an
expectation of increased supply in future – example agricultural products.
What are Index Futures?
Index Futures are Future contracts where the underlying asset is the Index. This
is of great help when one wants to take a position on market movements. Suppose
you feel that the markets are bullish and the Sensex would cross 5,000 points. Instead
of buying shares that constitute the Index you can buy the market by taking a position
on the Index Future.
What are Uses of Index Futures?
Index futures can be used for hedging, speculating, arbitrage, cash flow management
and asset allocation.
When did the Index Futures Start
in India?
Both the Bombay Stock exchange (BSE) and the National Stock Exchange (NSE) have
launched index futures in June 2000.
What is Margin Money?
The aim of margin money is to minimize the risk of default by either counter-party.
The payment of margin ensures that the risk is limited to the previous day’s price
movement on each outstanding position. However, even this exposure is offset by
the initial margin holdings.
Margin money is like a security deposit or insurance against a possible Future loss
of value.
Are there different types of Margin?
Yes, there can be different types of margin like Initial Margin, Variation margin,
Maintenance margin and Additional margin.
What is the Objective of Initial
Margin?
The basic aim of Initial margin is to cover the largest potential loss in one day.
Both buyer and seller have to deposit margins. The initial margin is deposited before
the opening of the day of the Futures transaction. Normally this margin is calculated
on the basis of variance observed in daily price of the underlying (say the index)
over a specified historical period (say immediately preceding 1 year). The margin
is kept in a way that it covers price movements more than 99% of the time. Usually
three sigma (standard deviation) is used for this measurement. This technique is
also called value at risk (or VAR).
Based on the volatility of market indices in India, the initial margin is expected
to be around 8-10%.
What is Variation or Mark-to-Market
Margin?
All daily losses must be met by depositing of further collateral - known as variation
margin, which is required by the close of business, the following day. Any profits
on the contract are credited to the client’s variation margin account.
What is the concept of Maintenance
Margin?
Some exchanges work on the system of maintenance margin, which is set at a level
slightly less than initial margin. The margin is required to be replenished to the
level of initial margin, only if the margin level drops below the maintenance margin
limit. For e.g.. If Initial Margin is fixed at 100 and Maintenance margin is at
80, then the broker is permitted to trade till such time that the balance in this
initial margin account is 80 or more. If it drops below 80, say it drops to 70,
then a margin of 30 (and not 10) is to be paid to replenish the levels of initial
margin. This concept is not expected to be used in India.
What is the concept of Additional
Margin?
In case of sudden higher than expected volatility, additional margin may be called
for by the exchange. This is generally imposed when the exchange fears that the
markets have become too volatile and may result in some crisis, like payments crisis,
etc. This is a preemptive move by exchange to prevent breakdown.
What is the Concept of Cross Margining?
This is a method of calculating margin after taking into account combined positions
in Futures, options, cash market etc. Hence, the total margin requirement reduces
due to cross-Hedges. This is unlikely to be introduced in India immediately.
What are Long/ Short Positions?
In simple terms, long and short positions indicate whether you have a net over-bought
position (long) or over-sold position (short).
Who is a Market Maker?
A dealer is said to make a market when he quotes both bid and offer prices at which
he stands ready to buy and sell the security. Thus, he is a person that brings buyers
and sellers together. He lends liquidity in the system by making trading feasible.
What is Marked-to-Market?
This is an arrangement whereby the profits or losses on the position are settled
each day. This enables the exchange to keep appropriate margin so that it is not
so low that it increases chances of defaults to an unacceptable level (by collecting
MTM losses) and is not so high that it increases the cost of transactions to an
unreasonable level ( by giving MTM profits).
What is Gearing?
Gearing (or leveraging) measures the value of your position as a ratio of the value
of the risk capital actually invested. In case of index futures, if the margin requirement
is 5%, the gearing possible is 20times as on a given fund availability, an investor
can take a position 20 times in size.
What is the Role of
the Clearing House/ Corporation?
The Clearing House / Corporation matches the transactions, reconciles sales &
purchases and does daily settlements.
It is also responsible for risk management of its members and does inspection and
surveillance, besides collection of margins, capital etc. It also monitors the net-worth
requirements of the members.
The other role of the Clearing House / Corporation is to ensure performance of every
contract. This can be done in two ways. One way is that Clearing house / Corporation
imposes itself between the two counterparties thereby replacing the original contract
(say between A & B) by two new contracts (between A and Clearing House /Corporation
and between B and Clearing House / Corporation) thereby itself becoming counterparty
to every trade. This is called full Novation. The other way is to guarantees performance
of all the contracts done on the exchange.
What is Price Risk?
Price Risk is defined as the standard deviation of returns generated by any asset.
This indicates how much individual outcomes deviate from the mean. For example,
an asset with possible returns of 5%, 10% and 15% is more risky than one with possible
returns of –10%, 1% and 25%.
What are the Different Types of
Price Risk?
Diversifiable risk (also known as non market risk or unsystematic risk) of a security
arises from the security specific factors like strike in factory, legal claims,
non availability of raw material, etc. This component of risk can be reduced by
diversification.
Non-diversifiable risk (also known as systematic risk or market risk) is an outcome
of economy related events like diesel price hike, budget announcements, etc that
affect all the companies. As the name suggests, this risk cannot be diversified
away using diversification or adding stocks in portfolio.
Can Price Risk be Controlled?
Yes, but to an extent. As mentioned earlier, the different types of price risk impacting
any stock or company can be classified into two categories:
- Company specific; and
- Economy or market related.
As discussed earlier, the Company specific risks (also known as diversifiable risk
or non market risk or unsystematic risk) can be reduced by proper diversification.
What is Hedging?
Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives
are widely used for hedging. A Hedge can help lock in existing profits. Its purpose
is to reduce the volatility of a portfolio, by reducing the risk.
Please note that hedging does not mean maximization of return. It only means reduction
in variation of return. It is quite possible that the return is higher in the absence
of the hedge, but so also is the possibility of a much lower return.
What are General Hedging Strategies?
The basic logic is "If long in cash underlying - Short Future and If short in cash
underlying - Long Future". Let us understand this by a simple example. If you have
bought 100 shares of Company A and want to Hedge against market movements, you should
short an appropriate amount of Index Futures. This will reduce your overall exposure
to events affecting the whole market (systematic risk). In case a war breaks out,
the entire market will fall (most likely including Company A). So your loss in Company
A would be offset by the gains in your short position in Index Futures.
Some examples of where hedging strategies are useful include:
- Reducing the equity exposure of a Mutual Fund by selling Index Futures;
- Investing funds raised by new schemes in Index Futures so that market exposure is
immediately taken; and
- Partial liquidation of portfolio by selling the index future instead of the actual
shares where the cost of transaction is higher.
What is the Hedge Ratio?
The Hedge Ratio is defined as the number of Futures contracts required to buy or
sell so as to provide the maximum offset of risk. This depends on the
- Value of a Futures contract;
- Value of the portfolio to be Hedged; and
- Sensitivity of the movement of the portfolio price to that of the Index (Called
Beta).
The Hedge Ratio is closely linked to the correlation between the asset (portfolio
of shares) to be hedged and underlying (index) from which Future is derived.
What will One do if the Period of Hedge is Longer than Available Futures?
In such an event one can Roll forward a Hedge. This implies closing one Future position
and taking the same position on another Future with the same specifications but
having a later delivery date. However, this leaves the basis-risk open for uncovered
period at the initial stage.
Who are Hedgers, Speculators
and Arbitrageurs?
Hedgers wish to eliminate or reduce the price risk to which they are already exposed.
Speculators are those class of investors who willingly take price risks to profit
from price changes in the underlying. Arbitrageurs profit from price differential
existing in two markets by simultaneously operating in two different markets. All
class of investors are required for a healthy functioning of the market.
Hedgers and investors provide the economic substance to any financial market. Without
them the markets would lose their purpose and become mere tools of gambling. Speculators
provide liquidity and depth to the market. Arbitrageurs bring price uniformity and
help price discovery.
What are the General Strategies
for Speculating?
In general, the speculator takes a view on the market and plays accordingly. If
one is bullish on the market, one can buy Futures, and vice versa for a bearish
outlook.
There is another strategy of playing the spreads, in which case the speculator trades
the "basis". When a basis risk is taken, the speculator primarily bets on either
the cost of carry (interest rate in case of index futures) going up (in which case
he would pay the basis) or going down (receive the basis).
Pay the basis implies going short on a future with near month maturity while at
the same time going long on a future with longer term maturity.
Receiving the basis implies going long on a future with near month maturity while
at the same time going short on a future with longer term maturity.
What are Circuit Breakers
or Circuit Filters?
Circuit Breaker means trading is halted for a specified period in stocks or / and
stock index futures, if the market price moves out of a pre-specified band. Circuit
filters do not result in trading halt but no order is permitted if it falls out
of the specified price range.
Advantages
Allows participants to gather new information and to assess the situation - controls
panic.
Brokerages firms can check on customer funding and compliance.
Exchanges/ Clearing houses can monitor their members.
Disadvantages
Only postpones the inevitable.
Limits the flow of market information – no one knows the real value of a stock.
They precipitate the matter during volatile moves as participants rush to execute
their orders before anticipated trading halt.
What are Hedge Funds?
A hedge fund is a term commonly used to describe any fund that isn’t
a conventional investment fund, i.e. it uses strategies other than investing long.
For example
- Short selling
- Using arbitrage
- Trading derivatives
- Leveraging or borrowing
- Investing in out-of-favour or unrecognized undervalued securities
The name hedge fund is a misnomer as the funds may not actually hedge against risk.
The returns can be high, but so can be losses. These investments require expertise
in particular investment strategies. The hedge funds tend to be specialized, operating
within a given niche, specialty or industry that requires the particular expertise.
What
is the difference between a Hedge fund and a Mutual fund?
- Mutual funds are measured on relative performance – compared to a benchmark
index. Hedge funds are expected to deliver absolute returns – under all circumstances,
even if the indices are down. Mutual funds are not able to effectively protect portfolios
against declining markets other than by going into cash or by shorting a limited
amount of stock index futures. Hedge funds, on the other hand, are able to not only
protect against declining markets, but also produce positive results, by using a
variety of hedging and trading strategies.
- Mutual funds are highly regulated, restricting the use of short selling and derivatives.
Hedge funds on the other hand are unregulated and unrestricted. Informal restrictions
are placed on all hedge fund managers by investors who invest in a particular fund
because of the manager’s expertise in a particular investment strategy. These investors
require and expect the hedge funds to stay within its area of specialization and
expertise.
- Mutual funds generally remunerate management based on a percent of assets under
management. Hedge funds always remunerate managers with performance related incentive
fees as well as a fixed fee.
"Invest Your Time before You Invest Your Money"
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