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7967 results in Economic theory

Page 111 of 399

  • 16 - Exchange Traded Funds and Structured Products

  • from Part–V - Other Derivatives and Derivative-like Instruments
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 241-254

  • Summary

    This chapter examines exchange traded funds (ETFs) and ‘structured products’. Some, but not all, ETFs and structured products are effectively derivatives.

    Exchange traded funds

    ETFs are investment funds that can be bought or sold on an exchange like a share. They may be of two types:

  • • ‘Index mutual funds’ or ‘Cash ETFs’ whose composition and performance matches a specified equity or other price index; such funds may hold the actual underlying asset in the same proportion as the index. For example, an ETF mirroring the Nifty index might hold the shares comprised in the Nifty in exactly those proportions; a gold ETF will hold gold. Cash ETFs may be geared up by borrowing.

  • • Synthetic funds whose performance matches a specified underlying without actual ownership of the underlying.

    • ETFs usually trade close to, but not exactly at, their Net Asset Value (NAV) although depending on demand and supply they can trade at significant premia/ discounts. The NAV is the value of the assets owned by the fund but the shares of the fund may trade at values higher or lower than that underlying value. To the extent the fund actually owns income-earning assets; ETFs may have a yield through dividends.

    Most ETFs have an annualised expense ratio – ranging from 0.1 per cent of the price or NAV to around 2 per cent, depending on the liquidity, quantity of assets under management and strategy. (A strategy requiring more frequent trading or ‘rolling over’ of underlying assets will require higher costs than one involving passive holding of a fixed set of assets.) In this respect, the cost of holding the index fund is different from an actual holding of the underlying.

    As with company shares, unless there is an Initial Public Offering (IPO) or Follow-on Public Offering (FPO), most trading takes place in the secondary market. Only some dealers buy ETF units in large blocks called ‘creation units’ directly from the ETF distributor.

  • 15 - Other Derivatives

  • from Part–V - Other Derivatives and Derivative-like Instruments
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 235-240

  • Summary

    The three main derivative securities (futures, swaps and options) have been discussed at length in preceding chapters. This chapter covers other derivatives, in brief. Analytically, many of these derivatives can also be viewed as being constructed from the basic building blocks of futures and options, an exception being event-based derivatives which are closer conceptually to insurance contracts.

    Forward rate agreements

    A forward rate agreement is a contract, generally entered into between a bank and a customer, which gives the latter a guaranteed future rate of interest to cover a specified sum of money over a specified period of time in the future. A forward rate agreement (FRA) does not involve actual lending or borrowing of sums of money. It is merely an agreement which fixes a rate of interest for a future transaction. At the time when the customer actually requires funds, he has to separately borrow the money in the cash market at the rate of interest prevailing then. If the rate of interest payable in the cash market turns out to be higher than the rate of interest fixed in the FRA (entered into earlier), the bank which signed the FRA will pay to the customer the difference in the interest rate. However, if the rate of interest payable in the cash market turns out to be lower than that fixed in the FRA, the customer has to pay the difference in the rate of interest. This transaction is known as purchase of a FRA from the bank.

    It is worth repeating that no actual lending or borrowing is involved in the FRA. If the customer eventually decides not to borrow the sum of money, no amount is payable from or to the bank. While reference was made to a customer intending to borrow, it is also possible for a customer to enter into an FRA for his deposits. A customer may wish to have a guaranteed rate of interest for a sum of money which he intends to deposit at a future point of time. He can enter into an FRA with a bank. He has to separately make a deposit in the cash market at the appropriate point of time.

  • 18 - Infrastructure for Derivatives Trading

  • from Part–VI - Accounting, Taxation and Regulatory Framework
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 282-292

  • Summary

    Derivatives can be traded on exchanges, or OTC. In principle, not much infrastructure is required for OTC trading – all it requires is for two parties to agree. Exchanges originated as informal below-the-tree marketplaces for hedging and speculating. In earlier days, an exchange was often merely a known marketplace in contrast to isolated one-on-one transactions, and did not afford one the counterparty protections of a modern clearing house. Nonetheless, the public and open nature of the transactions meant that the credibility and reputation of both parties were involved and this offered some protection against default.

    Exchanges are essentially the first layer of regulation for exchange-traded derivatives. Modern exchange trading generally reduces counter-party risks because the two parties are shielded from each other by the exchange's clearing houses, their margin requirements and regulatory safeguards. For example, A and B can decide on a wheat transaction for next year directly with each other (that would be a forward contract) or through an exchange (a ‘futures’ contract). In India, forward contracts in commodities outside an exchange are, unless intended for and closed by delivery, generally illegal. Since the financial crisis of 2008-09 there has been a global push towards promoting exchange-based trading above OTC trading (bringing it closer to the long-standing Indian position). The infrastructure requirements of an exchange and its various stakeholders are acquiring greater significance.

    Yet, non-exchange contracts will always remain, primarily because the standardised terms of exchange traded derivatives may not match the specific needs of certain hedgers. The biggest advantage of OTC markets for participants is that terms can be customised.

    Apart from this ‘genuine’ reason for using OTC contracts, another motivation for treating contracts as OTC (even when customisation is not needed) is regulation. OTC contracts may be legal but exempted from the regulatory requirements applicable to exchange-traded transactions, in many countries. Therefore, large but semi-standardised ‘OTC’ markets have grown in certain countries and for certain instruments. Many of them use a large number of standardised terms agreed upon by industry participants. Such contracts, though nominally are over the counter, have exchange-like characteristics: they are OTCs for the purpose of avoiding government regulation, but in practice an informal ‘exchange’ or association works.

  • 19 - Regulation of Derivatives Trading: An Introduction

  • from Part–VI - Accounting, Taxation and Regulatory Framework
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 293-298

  • Summary

    W. R. Natu, a former Chairman of the Forward Markets Commission and one of the pioneer futures regulators in India summarised the need for regulation in the following words:

    The private interest of an operator can … be at considerable variance with the interest of the trade and public interest. It is because of this divergence that the need for regulation arises.

    While this was in relation to futures markets, it is applicable to derivatives generally. In addition to the need for regulation in order to secure the public interest, there is also another justification, at a more practical and down-to-earth level, for regulating derivatives. This arises in connection with such matters as which varieties of a particular commodity or financial instrument may be delivered against the futures market, where delivery can be given or taken, how price differences are to be fixed between one variety and another, etc. Generally, regulations on such matters are framed by the exchanges which operate futures markets, and the national regulatory authority does not come into the picture except in abnormal circumstances.

    Regulatory instruments

    The main instruments of regulation used by the regulatory authorities and/or governing bodies of individual markets for ensuring orderly trading, are the following:

  • a. Margin variation: As explained earlier in this book, margin is a proportion of the contract value which a buyer or seller in the futures market is required to put up against his transaction. The purpose of margin is to prevent defaults. The higher the margin the greater the amount of capital which is locked up against a particular transaction and, therefore, the higher the cost of the contract. Increase in margins is an inducement to reduce the volume of trading, and vice-versa. Increase in margin is generally resorted to when the regulatory authorities feel that there is an excess of speculative activity. On the other hand, decrease in margins is prescribed when it is felt that there is inadequate trading activity thus impairing liquidity of the market.

  • b. Imposition of special margins: Special margins, which are over and above the ordinary margins referred to in (i) above, are generally imposed on only one side of the market-place. For example, when it is felt that there is an excessive amount of speculative buying in the market, it may be decided to impose a special margin on buyers alone.

Derivatives
  • 2nd edition
  • T. V. Somanathan, V. Anantha Nageswaran, Harsh Gupta
  • Published online:
    02 August 2019
    Print publication:
    06 September 2017
  • This book provides a comprehensive but concise treatment of the subject of derivatives. It focuses on making essential concepts accessible to a wider audience. The book eschews complicated mathematics and high school level mathematics is sufficient to understand it. It describes and explains various derivative instruments, their use and pricing, and the functioning of derivative markets. It uses a large number of examples to elucidate concepts and illustrate their real-life application. A distinguishing feature of the book is that it goes beyond the narrow perspective of derivative traders and investors and takes a broader approach which enhances its appeal to a range of readers. This book will be useful for students in the fields of economics, econometrics, derivatives, and finance and financial professionals, bankers and investors.

  • Preface to the First Edition

  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp xv-xvi

  • Summary

    As recently as 1985, futures trading was so obscure in India that even bankers, financial journalists and some professors of finance and economics would ask what it was. Discussions on the subject, with layman or professional alike, would almost always have to begin with a lengthy introduction.

    Today, awareness has increased. The gradual globalisation of the Indian economy means that Indian professionals and academics simply cannot afford to be unaware of futures and other derivatives, and their applications in India. Yet, there is no work of reference on the subject for the Indian reader to turn to. This book is a modest attempt to fill that gap.

    While covering the whole canvas, the book tries to address the specific needs of diverse groups of readers. For the professional and the student of finance, it provides a detailed study of the manner in which the markets work and how the knowledge can be used to make profits or avoid losses. For the academic and the student of economics, it surveys the theoretical literature, explains methods by which empirical studies can be performed and presents some of the findings of the author's empirical research on Indian futures markets. For the policymaker, regulator and government official, the book examines at length the larger public purpose of derivatives markets, covering the regulatory experience in India, comparing it with experience abroad and suggesting improvements. For the generalist manager, management accountant, internal auditor and board member of a corporate entity, it discusses at length the management of derivative exposures; a job which cannot be left entirely to the specialist (as the spate of expert-led derivative disasters has so painfully shown). For the financial accountant and external auditor, it provides a detailed overview of the accounting treatment of derivative transactions and the issues involved. For the tax practitioner, it examines the taxation of derivatives under the Income Tax Act.

    In a book of this nature, there is always a difficulty in balancing the needs of the practitioner with those of the academic. However, the author is hopeful that just the right balance has been struck. Issues primarily of academic interest have been placed in Appendices. Similarly, there is a difficult judgement to be exercised on the degree of complexity to which the text should go, since an attempt to meet the needs of the derivatives super-specialist would detract from the usefulness of the book to others.

  • 11 - Options – II: Pricing of Options

  • from Part–IV - Options
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 179-193

  • Summary

    As briefly mentioned in chapter 10, the price of an option is the sum of two components: intrinsic value and time value.

    Intrinsic value

    To recapitulate, the intrinsic value of an American option is:

  • • For call options: The difference, if positive, between the current price of the underlying and the strike price of the option.

  • • For put options: The difference, if positive, between the strike price of the option and the current price of the underlying.

    • The intrinsic value of a European option is the difference, if positive, between the current price of the underlying and the discounted present value of the strike price for calls and vice versa for puts.

    As was seen in chapter 10, an option which has intrinsic value is said to be ‘in-the-money’ and one with no intrinsic value is either ‘at-the-money’ or ‘out-of-the-money’. In the case of traded options the premium is usually referred to as the ‘price’ of the option and hence the term pricing refers to how the premium is determined.

    Time value

    As regards the second component, time value, this is due to the fact that even if the price may be unattractive today, future fluctuations may make the option profitable. The time value depends on the interplay of a number of factors:

    Time

    It is obvious that the longer the period of time, the greater are the chances of price fluctuations and vice-versa. Thus, time value generally varies directly with amount of time left to maturity. This leads to the fact that options are wasting assets: as an option's expiration date approaches, its time value diminishes and eventually becomes nil. The only value remaining is the intrinsic worth, if any. Therefore, if an option is not sold or exercised by the expiration date, it becomes worthless. (This is important from an investor's point of view: in contrast to options, underlying assets like shares can be held indefinitely.)

    Extent of the difference between current price and strike price

    An option which is deeply out-of-the-money has a lower time value than an option which is only slightly out-of-the-money. A deep OTM option has a much lower probability of ever becoming profitable than one which is slightly OTM for the same maturity period.

  • 7 - Futures on Equities

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 120-132

  • Summary

    This chapter deals with the special features of futures markets in equity shares, including equity indices (also known as stock futures and stock index futures). The general principles applicable to futures markets are also applicable to futures in equity markets. The raison d'etre of equity futures is to enable the hedging of equity positions.

    A special and rather unusual feature of the equity or ‘stock futures’ market in India is that it is increasingly seen not as a supplement to the cash market but as a substitute. The relatively higher volume of trading on the futures markets in India vis-à-vis the cash stock market appears to be explained by two main factors.

    The first factor is that India's futures market is one of the few that has active futures trading in individual shares (single stock futures) rather than in broad stock market indices. This is partly the legacy of the old Indian badla system that was an indigenous form of forward trading in individual shares that ended in the late 1990s and was replaced by equity futures. Because there are futures markets in individual shares, the Indian equity futures markets allow speculation on specific companies without basis risk. When only index futures are available, an investor in the stock market cannot really use futures to back his view on an individual company. The Indian market allows speculation on individual shares through futures.

    The second factor is margin or leverage. The cost, extent, and ease of leverage is higher through futures:

  • • India's credit markets are not as well developed as in, say, the United States. Getting a loan in order to trade on equities is not easy or quick. The ‘automatic borrowing’ in the futures market (through the fractional margin system) makes things much easier; there is no formal credit agreement nor the attendant transaction costs and time.

  • • When a speculator borrows from a broker to buy stock and takes a long position with, say, a ‘2x’ (two times) leverage, the broker lends money for half the position to the investor and charges him interest.

  • 4 - Futures Trading: Pricing and Hedging

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 51-87

  • Summary

    This chapter covers more advanced aspects of the economics of futures trading. It has two sections. The first deals with the relationship between spot and futures prices while the second discusses the relationship between the ‘basis’ or price spread and hedging effectiveness. The discussion will be based primarily on futures in commodities, but the discussion is also applicable to futures in financial instruments etc., with minor modifications which will be discussed in subsequent chapters.

    The relationship between spot and futures prices

    Intuitively, it is not difficult to see that spot and futures prices must be inter-related. After all they are prices of the same asset, albeit at different points in time, which means that the basic factors affecting supply and demand are the same. Also, the option of delivery (meaning that a futures contract can be closed by means of actually giving or taking delivery of the physical commodity or financial instrument) means that on the maturity date spot and futures prices must be in close proximity. This implies that the difference between the two prices must narrow over time and eventually be whittled down to nil or thereabouts. This leaves the question of how the difference is determined. There are several theories which attempt to explain the relationship between spot and futures prices. The essence of these is set out below. In the following discussion, readers should note that:

  • • when the futures price is higher than the spot price, the futures price is said to be at a ‘contango’; and

  • • when the futures price is lower than the spot price it is said to be at a ‘backwardation’.

    • The expectations approach

    This school of thought, owing its origins to such luminaries as J. M. Keynes, J. R. Hicks and N. Kaldor, sees the futures price as the market expectation of the price at the future date. Thus, the October gold futures price in June is what the market in June expects or forecasts will be the gold price in October. Any major deviation of the futures price from the expected price is likely to be corrected by speculative activity.

  • 8 - Swaps – Part I: Interest Rate and Currency Swaps

  • from Part–III - Swaps
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 135-142

  • Summary

    Swaps are contracts in which two separate streams of cash flow are exchanged or ‘swapped’. The streams could be two different kinds of interest amounts, two currencies or indeed any two differing streams of cash.

    This chapter introduces the conceptual basis of swap contracts and then explains interest rate swaps and currency swaps. The next chapter deals with other types of swaps and some general issues relating to the swaps market.

    Definition

    A swap transaction is a contract by which two or more parties exchange (swap) one set of pre-determined payments for another.

    Some important types of swap are the following:

  • An interest rate swap is an agreement between two parties to exchange interest obligations or receipts in the same currency on an agreed amount of notional principal for an agreed period.

  • A currency swap is an agreement between two parties to exchange payments or receipts in one currency for payments or receipts in another.

  • An equity swap is an agreement between two parties to exchange dividends and/or capital returns on an underlying share with another equity flow or interest flow, in the same or different currencies.

    • Currency swaps slightly predated interest rate swaps, but the latter now predominate in volume. Equity swaps are more recent but growing fast. Swaps can also combine some of the features of interest rate and, say, currency swaps. Thus, a fixed rate payment in dollars might be swapped for a floating rate payment in yen. Such transactions are more complex.

    A key feature of swaps is that they deal with a set of cash flows involving multiple periods, not a one-time cash flow. This is an important distinction between swaps and futures or options, both of which deal with a single expected cash flow at one specified time in the future. In a swap, invariably there are multiple dates involved where one or more income streams would need to exchange hands. Sometimes the two cash flows are paid gross to each other, while in some cases, the amount due is ‘netted’ and the net amount due from one party to another is transferred.

  • 6 - Currency Futures

  • from Part–II - Forwards and Futures
  • T. V. Somanathan, V. Anantha Nageswaran, Singapore Management University, Harsh Gupta
  • Book:
    Derivatives
    Published online:
    02 August 2019
    Print publication:
    06 September 2017, pp 113-119

  • Summary

    Any company or individual with dealings in foreign exchange, whether through imports or exports or through inward or outward investments, lending or borrowing, faces some degree of exchange rate risk. Currency forwards or futures are forward or futures contracts with a foreign currency as the underlying. Thus, a contract for the purchase of US dollars denominated in Indian rupees is effectively a contract on the Indian rupee – US dollar exchange rate (referred to as INR: USD). Currency forwards or futures can therefore also be referred to as exchange rate forwards or futures. The basic pricing and trading structure of currency futures and forwards is not different from examples of equity or commodity futures that were seen in previous chapters, but this chapter will explore some of the special features of currency forwards and futures in greater detail. In the foreign exchange markets, a three letter convention is commonly used to refer to currencies – INR for Indian Rupees, USD for US Dollars, GBP for Great Britain Pounds, JPY for Japanese Yen etc.

    Typically, hedging needs of smaller firms and for short durations are served better by standardised exchange-traded futures, whereas larger firms with specialised needs and more long-term hedging requirements often go to the forward (OTC) market. Forward contracts are typically entered into through banks, either directly or through a foreign subsidiary. Many India-based multi-nationals, for example, access INR-USD OTC forwards of various kinds in the Singapore market.

    Example 6.1

    In March, P Ltd., an importer of paper and pulp machinery has a contractual requirement to pay USD 100 million in September, and any pre- or post-payment is not advantageous from an interest rate or liquidity point of view. The rupee revenue from selling these imported machines in the domestic (Indian) market is more or less predictable but P Ltd. still bears the currency risk due to the amount payable being denominated in a foreign currency. The current exchange rate is INR 60 per USD and the forward rate for September is also INR 60 per USD. (Interest rate on rupees and dollars is assumed to be zero in this example – thus there is neither a carrying cost nor a yield.)

Page 111 of 399