The Hindu Business Line : The long and the short of it

FOR those who have always been afraid of "Options and Futures" here is some help: the third edition of a book on that very subject by D.C. Patwari and A. Bhargava from Jaico (www.jaicobooks.com).

Derivative instruments are of two types, write the authors, beginning from the beginning, to answer the very questions that crop up in the minds of novices.

The first type is what is traded on the floor of an exchange, e.g. futures and options. And the second gets traded over the counter (OTC) in the form of forwards, FRAs or forward rate agreements, and swaps.

The key differences between the two are counterparty risk and liquidity. Compared to exchange-traded instruments, the OTC ones carry counterparty risk and are not so liquid, point out the authors.

What is counterparty risk? The phrase refers "the risk associated with the financial stability of the party entered into contract with" as the site of the Commodity Futures Trading Commission www.cftc.gov explains. Forward contracts impose upon each party the risk that the counterparty will default, it adds.

The value of the book lies in the simple style that the authors adopt for explaining various concepts, and the numerous examples from an Indian perspective. For instance, while discussing the features of futures contracts, one reads that contracts are identified with their delivery/ maturity months. And the authors add, "For example, the Nifty February 2005 futures contract has a maturity date of February 24, 2005 on the NSE (National Stock Exchange)."

Similarly, when pointing out that derivatives contracts adjust for corporate actions such as dividends, the book cites the example of Hindustan Lever Ltd (HLL), which declared, "a 250 per cent interim dividend in August 2003, with an ex-dividend date of August 14, 2003." The face value of each HLL share was Rs 2, and so the dividend worked out to Rs 5, which translated to "only 2.8 per cent of the closing price (Rs 175.70) of the underlying shares on the last cum-dividend date (August 13)," note the authors, to reason why no adjustment was made.

"If one goes through HLL futures prices and HLL share prices, one will see that the futures were trading at a discount to HLL share prices up to the close of August 13, 2003. This shows that the futures market was pricing in the dividend," explain the authors.

Ever heard of `terror futures'? A shaded box in the book recounts reports that agencies with prior knowledge of 9/11 attacks "had gone long on oil futures and shorted stock market futures before the tragedy." It appears they benefited after the attacks. "What's Wrong with Terror-Futures Markets?" is a two-year-old piece by Casey Khan on www.mises.org. Such a market is a monstrosity, says Khan; and calls phoney "the market for US debt securities, EPA emission credits, or power market designs."

The book on hand has convincing reasons supporting hedging. For example, instead of watching the company's share price rise and fall, an employee can "short the stock futures at a price at which he is comfortable selling the ESOP (employees' stock option plan) shares he will receive or sell in the future," suggest the authors.

Another example paints the scenario of a person who sells his real estate in Gangtok, and awaits the receipt of payment by the end of a week. "He wants to invest this money in the stock market. He runs the risk of waiting for seven days only to find that there has been a stock rally of 300 points (on the Sensex)." What is your advice to him? He can buy now some Sensex or Nifty futures to stay with the market rise by paying a nominal margin, suggest the authors.

In the chapter on `stock index futures', you'd read about VIX (volatility index) of CBOE (the Chicago Board of Options Exchange), which is considered by many to be "the world's premier barometer of investor sentiment and market volatility." As for stock index futures closer home, the authors opine that proper controls are necessary to ensure the integrity of the system.

The book devotes attention to trading strategies, currency futures, interest rate derivatives, and accounting/ taxation aspects. Try your hand at the review questions at the end of each chapter. Such as: "A corporate treasurer believes that the yield curve will shift in a parallel manner. He wants to hedge his portfolio of T-bills worth Rs 20 crore." What should be the hedge if the portfolio is of 0.5-year duration?

From the glossary at the end of the book, you'd learn that leg is `one side of a spread position,' and that naked is `a long (short) market position with no offsetting short (long) market position.' The key word `position' means `the sum total of a trader's open contracts in a particular underlying market'.

In short, this is a book you can go long on!

BookValue@TheHindu.co.in