2.

1 Derivative

Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more
basic underlying asset (often simply known as underlying).These contracts are legally binding agreements,
made on trading screen of stock exchange, to buy or sell an asset in future. The asset can be share, index,
interest rate, bond ,rupee dollar exchange rate ,sugar , crude oil, soya been, coffee etc.

Everybody wants to know about them, everybody wants to talk about them. Derivatives however remain a type
of financial instrument that few of us understand and fewer still fully appreciate, although many of us have
invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose
underlying assets include derivative products

A simple example of derivative is curd, which is derivative of milk. The price of curd depends upon price of
milk which in turn depends upon the demand and supply of milk.

Section 2(aa) of Securities Contract (Regulation) Act 1956 defines Derivative as:

"Derivative" includes -

“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;

a contract which derives its value from the prices, or index or prices, of underlying securities ”.

A working definition of derivative which will help to lay foundation.

“A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of
other, more basic underlying variables.”

---John C. Hull

What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself
is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying
asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and
market indexes. Most derivatives are characterized by high leverage.

Investopedia explains Derivative

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives
are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as
the amount of rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For
example, a European investor purchasing shares of an American company off of an American exchange (using
U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the
investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and
currency conversion back into Euros.

Derivatives are compared to insurance. Just as you pay an insurance company a premium in order to obtain
some protection against a specific event, there are derivative products that have a payoff contingent upon the
occurrence of some event for which you must pay a premium in advance.
Example

Suppose you have a home of Rs. 50,00,000. You insure this house for premium of Rs 15000 (It is a very risky
house!) Now you think about policy (ignoring the house) as an investment.

Suppose the house is fine after 1 year. You have lost the premium of Rs 15000.

Suppose your house is fully damaged and broken in one year . You receive Rs 50,00,0000 on just paying
premium of Rs 15,000.If you have bought insurance of any sort you have bought an option. Option is one type
of a derivative.

Difference in share and Derivative

The difference is that while shares are assets, derivatives are usually contracts (the major exception to this are
warrants and convertible bonds, which are similar to shares in that they are assets).

We can define financial assets (e.g. shares, bonds) as: claims on another person or corporation; they will usually
be fairly standardised and governed by the property or securities laws in an appropriate country.

On the other hand, a contract is merely: an agreement between two parties, where the contract details may not
be standardised.

Due to their great flexibility, many different types of investors use derivatives. A good toolbox of derivatives
allows the modern investor the full range of investment strategy: speculation, hedging, arbitrage and all
combinations thereof.

DERIVATIVE INSTRUMENTS

Forward Contract

There are no sure things in global markets. Deals that looked good six months ago can quickly turn sour if
unforeseen economic and political developments trigger fluctuations in exchange rates or commodity prices

Over the years traders have developed tools to cope with these uncertainties. One of this tool is the forward
agreements

“A contract that commits one party to buy and other to sell a given quantity of an asset for fixed price on
specified future date”.

In Forward Contracts one of the parties assumes a long position and agrees to buy the underlying asset at a
certain future date for a certain price. The specified price is called the delivery price. The contract terms like
delivery price, quantity are mutually agreed upon by the parties to contract. No margins are generally payable
by any of the parties to the other.

Features of Forward Contract

It is negotiated contract between two parties i.e. Forward contract being a bilateral contracts, hence exposed to
counterparty risk.

Each Contract is custom designed and hence unique in terms of contract size, expiration date, asset quality,
asset type etc.

A contract has to be settled in delivery or cash on expiration date

In case one of two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter
party being in a monopoly situation can command at the price he wants.
Example

“A” Ltd requires $500000 on May 2006 for repayment of loan installment and interest .As on December 2005 it
appears to the company that the dollar may become dearer as compared to the exchange rate, prevailing on that
date say.

Accordingly A Ltd may enter into forward contract with banker for $500000.The Forward rate may be higher or
lower than spot rate prevailing on the date of the forward contract. Let us assume forward rate as on December
2005 was 1$=Rs 44 as against spot rate of Rs 43.50. As on future i.e. May 2006 the banker will pay A Ltd
$500000 at Rs 44 irrespective of the spot rate as on that date.

B) FUTURES

A Future contract is an agreement between two parties to buy or sell an asset at a certain time in future at a
certain price. Future contracts are special type of forward contracts in the sense that the former are standardized
exchange-traded contracts.

In other words

A future contract is one in which one party agrees to buy from/ sell to the other party a specified asset at price
agreed at the time of contract and payable on future date. The agreed price is known as strike price. The
underlying asset can be commodity, currency debt, or equity. The Futures are usually performed by payment of
difference between strike price and market price on fixed future date and not by the physical delivery and
payment in full on that date.

Features Of Future Contract

An organized exchange.

Unlike the Forwards, the Future contracts are standardized contracts and are traded on stock exchange

It is standardized contract with standard underlying instruments, a standard quantity and quality of the
underlying instrument that can be delivered and standard time for such settlement transactions.

Existence of a regulatory authority.

Margin requirements and daily settlement to act as a safeguard.

Leveraged positions--only margin required.

Trading in either direction--short/long

Index trading.

Hedging/Arbitrage opportunity.

Example 1

When you are dealing in March 2006 Futures Infosys the minimum market lot i.e. minimum quantity that you
can buy and sell is 1000 shares of Infosys The contract would expire on 28th March 2006 The price is quoted
per share the tick size is 50 paisa per share 1500*.05=Rs 75 per contract/per market lot. The contract would be
settle in cash and closing price in cash market on the expiry date would be the settlement price.
Example2

On 1st September Mr. A enters into Futures contract to purchase 100 equity shares of X Ltd at an agreed price
of Rs 100 in December. If on maturity date the price of equity stock rises to Rs120 Mr. A will receive Rs 20 per
share and if the price of share falls to Rs 90 Mr. A will pay Rs 10 per share. As compared to forward contract
the futures are settled only by the difference between the strike price and market price as on maturity date.

Distinction between forwards and futures:

The basic nature of a forward and future, in a strict legal sense, is the same, with the difference that futures are
market-driven organized transactions. As they are exchange-traded, the counterparty in a futures transaction is
the exchange. On the other hand, a forward is mostly an over-the-counter transaction and the counterparty is the
contracting party. To maintain the stability of organized markets, market-based futures transactions are subject
to margin requirements, not applicable to OTC forwards. Futures markets are normally marked to market on a
settlement day, which could even be daily, whereas forward contracts are settled only at the end of the contract.
So the element of credit risk is far higher in case of forward contracts

C) Options

Option As the name implies, trading in options involves choice Someone who invest in option is purchasing
right but not the obligation, to buy or sell a specified underlying item at an agreed upon price, known as
exercise price or strike price.

In other words

Options are contracts that give the buyers the right (but not the obligation) to buy or sell a specified quantity of
certain underlying assets at a specified price on or before a specified date. On the other hand, the seller is under
obligation to perform the contract (buy or sell). The underlying asset can be a share, index, interest rate, bond,
rupee-dollar exchange rate, sugar, crude oil, Soya bean, cotton, coffee etc.

An option contract is a unilateral agreement in which one party, the option writer, is obligated to perform under
the contract if the option holder exercises his or her option. (The option holder pays a fee or "premium" to the
writer for this option.) The option holder, however, is not under any obligation and will require performance
only when the exercise price is favorable relative to current market prices. If, on the one hand, prices move
unfavorably to the option holder, the holder loses only the premium. If, on the other hand, prices move
favorably for the option holder, the holder has theoretically unlimited gain at the expense of the option writer.
In an option contract the exercise price (strike price), delivery date (maturity date or expiry), and quantity and
quality of the commodity are fixed.

There are two basic types of options-call and put.

A call option gives an investor right to buy underlying item during specified period of time at an agreed upon
price while put option confers the right to sell it.

Before going into Call and Put Options it is necessary to understand

American options can be exercised at any time between the date of purchase and the expiration date.
Most exchange-traded options are of this type.

European options are different from American options in that they can only be exercised at the end of their
lives.

The options on the Nifty and Sensex are European style options--meaning that the buyer of these options can
exercise his options only on the expiry day. He cannot exercise them before the expiry of the contracts as in
case with options on stocks. As such the buyer of index options needs to square up his positions to get out of the
market.

In India all stock options are American style options and index options are European style options.

The significant difference between a future and an option is that the option provides the contracting parties only
an option, not an obligation, to buy or sell a financial instrument or security at a pre-fixed price, called the strike
price. Obviously, the option buyer will exercise the option only when he is in the money, that is, he gains by
exercising the option.

For example, suppose X holding a security of Rs 1000 buys an option to put the security at its current price with
Y. Now if the price of the security goes down to Rs. 900. X may exercise the option of selling the security to Y
at the agreed price of Rs. 1000 and protect against the loss on account of decline in the market value. If, on the
other hand, the price of the security goes upto Rs. 1100, X is out of the money and does not gain by exercising
the option to sell the security at a price of Rs. 1000 as agreed. Hence, X will not exercise the option. In other
words, the option buyer can only get paid and does not stand to a position of loss.

Had this been a futures contract or forward contract, Y could have compelled X to sell the security for the
agreed price of Rs. 1000 in either case. That is to say, while a future contract can result into both a loss and a
profit, an option can only result into a profit, and not a loss.

Call Option

The option that gives the buyer the right to buy is called a call option.

A call option grants the holders of the contract the right, but not the obligation, to purchase a good from the
writer of the option in consideration for the payment of cash (the option premium).

Example: Suppose you have bought a call option of 2,000 shares of Hindustan Lever Ltd (HLL) at a strike price
of Rs250 per share. This option gives you the right to buy 2,000 shares of HLL at Rs250 per share on or before
March 28, 2006. The seller of this call option who has given you the right to buy from him is under the
obligation to sell 2,000 shares of HLL at Rs250 per share on or before specified date say March 28, 2004
whenever asked.

Put Option

The option that gives the buyer the right to sell is called a put option.

A put option grants the holder the right, but not the obligation, to sell the underlying good to the option writer.

Suppose you bought a put option of 2,000 shares of HLL at a strike price of Rs250 per share. This option gives
its buyer the right to sell 2,000 shares of HLL at Rs250 per share on or before specified date say March 28,
2006. The seller of this put option who has given you the right to sell to him is under obligation to buy 2,000
shares of HLL at Rs250 per share on or before March 28, 2006 whenever asked.

American options can be exercised at any time between the date of purchase and the expiration date.
Most exchange-traded options are of this type.

European options are different from American options in that they can only be exercised at the end of their
lives.

The options on the Nifty and Sensex are European style options--meaning that the buyer of these options can
exercise his options only on the expiry day. He cannot exercise them before the expiry of the contracts as in
case with options on stocks. As such the buyer of index options needs to square up his positions to get out of the
market.
D) SWAP

A swap can be defined as barter or an exchange. A swap is contract whereby parties agree to exchange
obligations that each of them have under their respective underlying contracts or we can say a swap is an
agreement between two or more parties to exchange sequence of cash flows over a period in future . The parties
that agree to swap are known as counterparties.

Swap is an agreement between two counterparties to exchange two streams of cash flows—the parties "swap"
the cash flow streams. Those cash flow streams can be defined in almost any manner.

In other words: In a swap, two counterparties agree to a contractual arrangement wherein they agree to
exchange cash flows at periodic intervals

Interest Rate Swap

In interest rate swap one party agrees to make fixed rate interest payment in return for floating –rate interest
payments from counterparty, with interest rate payment based on a hypothetical amount of principal called
notional amount. Notional amount typically do not change hands and is simply used to calculate payments.
Firm A is a AAA-rated Indian company. It needs Rs. 10,000,000 to finance an investment with a five-year
economic life. Firm A is considering issuing 5-year fixed-rate bonds at 10% percent. Alternatively, Firm A can
raise the money by issuing 5-year floating-rate notes at Bank Rate +.3 percent. Firm A would prefer to borrow
at a floating rate.

Firm B has lower rate and can borrow at 11% fixed rate while it has an alternative to borrow at Bank Rate+.5%.
Firm B prefers to borrow at a fixed rate

FIRM A FIRM B

FIXED RATE 10% 11%

FLOATING RATE Bank Rate +.3% Bank Rate+.5%

Preference Floating Rate Fixed Rate

So they enter into a swap agreement .Firm A borrows at fixed rate 10% Firm B borrows at Bank Rate +.5%.
The parties agree a rate for swapping their interest commitments. Firm B pays a fixed rate of 10.1% to Firm A.

For Firm A

Borrows 10%

Receives from Firm B 10.1%

Pays To Firm B Bank Rate

Net Interest Cost i.e. savings Bank Rate - .1%

For Firm B

Borrows Bank Rate + .5%

Receives from Firm A (Bank Rate)

Pays To Firm A 10.1%

Net Interest Cost i.e. savings 10.6%

Thus both the Firms benefits from Interest Rate Swap.

In short the investors need to be sure they understand what they are getting into. They need to determine how
much risk they are willing to tolerate, and they need to think about what they will do if things go wrong be
Investors who plan to sell derivative before maturity needs to consider at least two major points 1) how easy or
difficult will it be to sell before maturity and 2) how much will it cost? Are there any penalties for selling before
maturity? What if the derivative is trading at a much lower price?

TYPES OF RISKS IN DERIVATIVES

Systemic risk: manifests itself when there is a large and complex organization of financial positions in the
economy. Systemic risk is said to arise when the failure of one big player or of one clearing corporation
somehow puts all other clearing corporations in the economy at risk.

Credit Risk is the possibility of loss from the failure of counterparty to fully perform on its contractual
obligations is a significant element of the galaxy of risks facing the derivatives dealer and the derivatives end-
user. There are different grades of credit risk. The most obvious one is the risk of default. Default means that
the counterparty to which one is exposed will cease to make payments on obligations into which it has entered
because it is unable to make such payments.

Market Risk is the possibility that the value of on-or off-balance-sheet positions will adversely change before
the positions can be liquidated or offset with other positions. For banks, the value of these positions may change
because of changes in domestic interest rates (interest rate risk) or foreign exchange rates (foreign exchange rate
risk).

Operational Risk is the possibility that losses may occur because of inadequate systems and controls, human
error, or mismanagement..

Legal Risk is the possibility of loss that arises when a contract cannot be enforced - for example, because of
poor documentation, insufficient capacity or authority of the counterparty, or enforceability of the contract in a
bankruptcy or insolvency proceeding.

Liquidity Risk has two board types: 1) market liquidity risk and 2) funding risk.

Market liquidity risk arises from the possibility that a position cannot be eliminated quickly either by
liquidating it or by establishing offsetting positions.

Funding risk arise from the possibility that a firm will be unable to meet the cash requirements of its contracts.
An underlying asset is the asset on which the price of a derivative depends. Most traded derivatives (i.e. those traded on
exchanges) are settled for cash, not by actual delivery of the underlying.

Derivative

What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a
contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are
characterized by high leverage.

Investopedia explains Derivative

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are
contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of
rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a
European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so)
would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency
futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros.

What are some types of derivatives?

A future or forward contact is an agreement to enter into a financial transaction at a given price on a
given date or dates in the future. Such a contract is called a "future" when traded on an exchange or a
"forward" when traded OTC.

Swap contracts are agreements to exchange one asset or liability for another. The asset or liability is
usually a future payment or stream of payments. If it is a foreign currency swap this may entail buying
a currency on the spot market and simultaneously selling it forward. If it is an interest rate swap this
may involve exchanging income flows; for example, exchanging a stream of fixed rate payments (such
as those received from a fixed rate bond) for a variable rate payment stream.

Options are the right but importantly not the obligation to enter into a pre-arranged financial
agreement at a pre-defined price on a future date or dates. As with futures and forwards, options may
be traced either on exchanges or OTC. There may be conditions that must be fulfilled before the right
to enter in to the agreement is conferred. Credit default swaps (which are typically traded OTC) are a
good example of this.

In general, futures, forwards and swaps have payoff profiles that are approximately linear functions of
the performance of the underlying. In derivatives-speak they are said to have approximately constant
delta, delta being the change in value of the derivative contract for the change in the price of the
underlying instrument. Options, however, will have a payoff profile that is a non-linear function of the
value of the underlying instrument. This can make option trading much more complex than trading
approximately linear derivatives.

For what types of underlying markets are derivatives traded?

A wide variety of derivatives exist. The "underlying" may include the following.

• Spot foreign exchange. This is the buying and selling of foreign currency at the exchange rates
that you see quoted on the news. As these rates change relative to your "home currency"
(dollars if you are in the US) you make or lose money.
• Commodities, like grain discussed in the example above. Others include pork bellies, coffee
beans, orange juice, gold, silver, and crude oil.
• Equities (termed stocks in the US).
• Government bonds. Bonds are medium to long-term negotiable debt securities issued by
national governments. They may generally be freely traded without reference to the issuer of
the security, unlike loans.
• Short term ("money market") negotiable debt securities such as Treasury Bills (issued by
governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are
much like bonds, differing mainly in their maturity - always less than one year, and typically
less than 90 days.
• OTC money market indexes - typically LIBOR (the London Interbank Offered Rate) or some
other similar index of the rates at which banks are willing to enter OTC lending transactions
with each other.
• Credit risk - a credit default swap (CDS), despite its name, is actually more like an option or
insurance contract. In exchange for a stream of premium payments the buyer of a vanilla (or
"single issuer") CDS obtains the right to require the CDS seller to purchase bonds of the issuer
named in the agreement at a given price (usually the face value) but only if the named issuer
triggers a default or other similar "credit event". The market price of these bonds is typically
much less than face value when a default occurs so the CDS buyer will profit and the CDS
seller will lose. If the named issuer does not default during the agreed period of the CDS the
contract expires worthless, just as an option would if it was not worth exercising.
• Indexes - many index varieties are used as the underlying for derivative contracts. They may
be constructed with reference to financial assets (such as stock market indexes like the Dow
Jones Industrial Average) or even to temperature or rainfall (in the case of weather
derivatives).
 Introduction to the basic concept of derivatives
Derivatives in general refer to contracts that derive from another - whose value depends on
another contract or asset. Derivatives are essentially devised as a hedging device to insulate
a business from risks over which a business has no or little control, but in practice, they are
also used as yield-kickers.

Where there are risks, there are derivatives to strip the risk and transfer it. As derivatives
are essentially devices of transferring risks, their types and applications differ based on the
type of risk facing a business. Take, for instance, the following sources of risk and the
derivatives to protect a business against such risks:

Interest rate risk:

Banks and financial institutions face the risk of changes in interest rates. If a bank has
liabilities carrying floating costs and assets having fixed rates, it faces the risk of an
adverse movement, that is, a decline in interest rates. This risk can be sheltered by writing
an interest rate swap - that is, swapping the floating rate for fixed rates.
Associated with interest rate movements is the basis risk that is risk of unpredicted changes
in the basis on which interest rates float. Let us say, a business has loans which are floating
with reference to the LIBOR or EURIBOR, whereas the assets of the business are floating
with reference to US treasuries. To cushion against this risk, the business may like to swap
the basis by entering into a basis swap.

Foreign exchange risk:

If a business has assets or liabilities denominated in foreign currency, there is a risk of

adverse changes in exchange rates. This risk is sheltered by foreign exchange futures or
forward covers.

Commodity risks:

A business having any position on commodities faces risk of changes in commodity prices.
Such risks are also sheltered by futures and forwards in commodities.

Risk on capital market instruments:

If someone holds equity shares, there is a risk that prices of equity shares will move up or
down. To manage this risk, there are various futures and options available.

Credit risk:

Yet another risk in all financial transactions is credit risk. Credit derivatives are used to
hedge against credit risk.

Weather risk:

Even something like risk of changes in weather is hedged and transferred. There is a
variety of weather derivatives, that is, instruments that pay off based on weather changes.

Definition of a derivative:

Accounting standard SFAS 133 defines a derivative thus:

A derivative instrument is a financial instrument or other contract with all

three of the following characteristics:

a . It has (1) one or more underlyings, and (2) one or more notional amounts
or payment provisions or both. Those terms determine the amount of the
settlement or settlements... and in some cases, whether or not a settlement is
required.

b. It requires no initial net investment or an initial net investment that is

smaller than would be required for other types of contracts that would be
expected to have a similar response to changes in market factors.
 c . Its terms require or permit net settlement, it can readily be settled net by a
means outside the contract, or it provides for delivery of an asset that puts the
recipient in a position not substantially different from net settlement

Types of derivatives:

The following are the basic types of derivatives:

Forwards:

A forward is a contract to buy a thing or security at a prefixed future date. The typical
usage of a forward would be something like this: a business having its assets in a local
currency has taken a loan repayable in a foreign currency 6 months hence. There is an
exchange rate risk here: if the local currency suffers against the foreign currency, the
business has to write a loss. To cover against this risk, the business enters into a forward
contract - that is, it agrees today to buy the foreign currency 6 months hence at prices
prevailing today, against a pre-fixed premium. Obviously, if the perceptions of the seller
and the buyer as to future prices of the foreign currency differ, both will strike what they
perceive is a win-win deal.

Forwards are also quite common in commodities, and can be used either for speculation or
for hedging. Say, XYZ has an order to ship 10000 tons of steel 6 months hence at a
prefixed price of say USD 1000 per ton (by the way, I have no idea of steel prices, this is
just an example!). And XYZ expects the price of steel to go up. So, to hedge against the
price risk, XYZ enters into a forward purchase agreement, for 10000 tons 6 months hence.
XYZ's position is now fully hedged: if the price of steel goes up as expected, XYZ will
either claim a delivery from the forward seller, or a net settlement. If the price comes
down, XYZ will be obliged to settle by making a payment for the price difference to the
forward seller, but will be fully offset by the pre-fixed price it gets from its own forward
sale contract.

Futures:

Futures are more standardised forms of forward contracts and mostly operate in organised
markets. While it is possible to have a forward contract for any commercial transaction,
futures are normally exchange-traded. Futures contracts are highly uniform contracts that
specify the quantity and quality of the good that can be delivered, the delivery date(s), the
method for closing the contract, and the permissible minimum and maximum price
fluctuations permitted in a trading day.

Distinction between forwards and futures:

The basic nature of a forward and future, in a strict legal sense, is the same, with the
difference that futures are market-driven organised transactions. As they are exchange-
traded, the counterparty in a futures transaction is the exchange. On the other hand, a
forward is mostly an over-the-counter transaction and the counterparty is the contracting
party. To maintain the stability of organised markets, market-based futures transactions are
subject to margin requirements, not applicable to OTC forwards. Futures market are
normally marked to market on a settlement day, which could even be daily, whereas
forward contracts are settled only at the end of the contract. So the element of credit risk is
far higher in case of forward contracts.

Options:

The significant difference between a future and an option is that the option provides the
contracting parties only an option, not an obligation, to buy or sell a financial instrument or
security at a pre-fixed price, called the strike price. Obviously, the option buyer will
exercise the option only when he is in the money, that is, he gains by exercising the
option.

For example, suppose X holding a security of USD 1000 buys an option to put the security
at its current price with Y. Now if the price of the security goes down to USD 900. X may
exercise the option of selling the security to Y at the agreed price of USD 1000 and protect
against the loss on account of decline in the market value. If, on the other hand, the price of
the security goes upto USD 1100, X is out of the money and does not gain by exercising
the option to sell the security at a price of USD 1000 as agreed. Hence, X will not exercise
the option. In other words, the option buyer can only get paid and does not stand to a
position of loss.

Had this been a futures contract or forward contract, Y could have compelled X to sell the
security for the agreed price of USD 1000 in either case. That is to say, while a future
contract can result into both a loss and a profit, an option can only result into a profit, and
not a loss.

Two basic types of options are: call options and put options. A call option is an option to
call, that is, acquire a particular quantity and/or at particular strike price. A put option is
just the reverse- the option to put or sell a particular quantity and/or at a particular strike
price.

Swaps:

In a swap, both the parties exchange recurring payments with the idea of exchanging one
stream of payments for another. A typical usage is a swap of fixed interest rates with
floating rates, or rates floating with reference to one basis to another basis. In credit
derivatives market, there are swaps based on the total return from a particular credit asset
against total return on a reference asset.

Caps, floor and collars

Caps, floors and collars are essentially options designed to shift the risk of an upward
and/or downward movement in variables such as interest rates. These are normally linked
to a notional amount and a reference rate.
For example, if some one wants to transfer the risk of interest rates going up, one will enter
into a cap on a notional amount of say, USD 100 million, with the interest rate of 5.5%.
Now if the interest rate increases to 6%, the cap holder will be able to claim a settlement
from the cap seller, for the differential rate of 0.5% on the notional amount. If the interest
does not go up, or rather declines, the option holder would have paid the premium, and
there is no settlement.

On the other hand, if some one expects the interest rate to go down which spells a risk to
him, he would enter into a floor, which would allow him to claim a settlement if the
interest rate falls below a particular strike rate.

Interest rate collar is the fixation of both a cap and floor, so that the payment will be
triggered if the rate goes above the collar and below the floor.

Swaption:

A swaption is an option on a swap. The option provides the holder with the right to enter
into a swap at a specified future date at specified terms. This derivative has characteristics
of an option and a swap.

Symmetric and asymmetric returns:

A return from a contract or investment is said to be symmetric when it can either give a
profit or incur a loss.

Returns from forwards and futures are symmetrical: if you enter into a forward at a
particular price, the price might either go up or come down, and so, you might either make
a profit or a loss.

However, options have an asymmetric return profile: an option is an option with one party.
The option will be exercised only when the purchaser of the option is in-the-money.
Therefore, the only loss in an option is the cost of writing and carrying the option. Hence,
options have an asymmetric return profile.

On the other hand, the option-seller only makes returns by way of fees or premium for
selling the option, against which he takes the risk of being out-of-money. If the option is
not exercised, he makes his fees, but if the option is exercised, he might lose substantially.

When people think of stocks, bonds or Treasury bills, they can usually come up with a clear picture in their minds, and
probably some examples as well. When the word is "derivatives", most people are lucky if they can conjure up anything
but an indistinct fog.
Derivatives are generally placed in the realm of advanced or technical investing, but there is no reason why they should
remain a mystery to common investors. This article will use a simple story of a fictional farm to explore the mechanics of
derivatives.

The Definition
Derivatives are financial products with value that stems from an underlying asset or set of assets. These can be stocks, debt
issues, or almost anything. A derivative's value is based on an asset, but ownership of a derivative doesn't mean ownership
of the asset.

We will look at some examples.

The Future of Healthy Hen Farms

Gail, the owner of Healthy Hen Farms, is worried about the volatility of the chicken market with all the sporadic reports of
bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with
an investor who enters into a futures contract with her.

The investor agrees to pay $30 per bird when the birds are ready for slaughter, say, in six months time, regardless of the
market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the
birds for less than market cost and sell them onto the market at a higher price for a gain.

If the price goes below $30, then Gail will be receiving the benefit because she will be able to sell her birds for more than
the current market price, or what she would have gotten for the birds in the open market.

By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30
per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price
falls to $10 on news of a bird flu outbreak.

By hedging with a futures contract, Gail is able to focus on her business and limit her worry about price fluctuations. (For
related reading, see A Beginner's Guide To Hedging.)

Swapping
Gail has decided that it's time to take Healthy Hen Farms to the next level. She has already acquired all the smaller farms
near her and is looking at opening her own processing plant. She tries to get more financing, but the lender, Lenny, rejects
her.

The reason is that Gail financed her takeovers of the other farms through a massive variable-rate loan and the lender is
worried that, if interest rates rise, Gail won't be able to pay her debts. He tells Gail that he will only lend to her if she can
convert the loan to a fixed-rate. Unfortunately, her other lenders refuse to change her current loan terms because they are
hoping interest rates will increase too.

Gail gets a lucky break when she meets Sam, the owner of a chain of restaurants. Sam has a fixed-rate loan about the same
size as Gail's and he wants to convert it to a variable-rate loan because he hopes interest rates will decline in the future.

For similar reasons, Sam's lenders won't change the terms of the loan. Gail and Sam decide to swap loans. They work out a
deal by which Gail's payments go toward Sam's loan and his go toward Gail's loan. Although the names on the loans
haven't changed, their contract allows them both to get the type of loan they want. (To learn more, read An Introduction To
Swaps.)

This is a bit risky for both of them because if one of them defaults or goes bankrupt, the other will be snapped back into his
or her old loan, which may require a payment for which either Gail of Sam may be unprepared. But it allows for them to
modify their loans to meet their individual needs.

Buying Debt
Lenny, Gail's financier, ponies up the additional capital at a favorable interest rate and Gail goes away happy. Lenny is
pleased as well because his money is out there getting a return, but he is also a little worried that Sam or Gail may fail in
their business.
To make matters worse, Lenny's friend Dale comes to him asking for money to start his own film company. Lenny knows
Dale has a lot of collateral and that the loan would be at a higher interest rate because of the more volatile nature of the
movie industry, so he's kicking himself for loaning all his capital to Gail.

Fortunately for Lenny, derivatives offer another solution. Lenny spins Gail's loan into a credit derivative and sells it to
a speculator at a discount to the true value. Although Lenny doesn't see the full return on the loan, he gets his capital back
and can issue it out again to his friend Dale.

Lenny likes this system so much that he continues to spin out his loans as credit derivatives, taking modest returns in
exchange for less risk of default and more liquidity.

Options
Years later, Healthy Hen Farms is a publicly traded corporation (the ticker symbol is (obviously) HEN) and is America's
largest poultry producer. Gail and Sam are both looking forward to retirement.

Over the years, Sam bought quite a few shares of HEN. In fact, he has more than $100,000 invested in the company. Sam
is getting nervous because he is worried that some shock, another case of bird flu for example, might wipe out a huge
chunk of his retirement money. Sam starts looking for someone to take the risk off his shoulders. Lenny, financier
extraordinaire and an active writer of options, agrees to give him a hand.

Lenny outlines a deal in which Sam pays Lenny a fee to for the right (but not the obligation) to sell Lenny the HEN shares
in a year's time at their current price of $25 per share. If the share prices plummet, Lenny protects Sam from the loss of his
retirement savings.

Lenny is OK because he has been collecting the fees and can handle the risk. This is called a put option, but it can be done
in reverse by someone agreeing to buy a stock in the future at a fixed price (called a call option). (For more insight, read
the Options Basics tutorial.)

The Happy Ending

Healthy Hen Farms remains stable until Sam and Gail have both pulled their money out for retirement. Lenny profits from
the fees and his booming trade as a financier.

In this ideal tale, you can see how derivatives can move risk (and the accompanying rewards) from the risk averse to
the risk seekers. Although Warren Buffett once called derivatives, "financial weapons of mass destruction", derivatives can
be very useful tools, provided they are used properly. Like all other financial instruments, derivatives have their own set of
pros and cons, but they also hold unique potential to enhance the functionality of the the overall financial system.
An Introduction To Swaps

by Michael McCaffrey (Contact Author | Biography)

Derivatives contracts can be divided into two general families:

1. Contingent claims, i.e., options

2. Forward claims, which include exchange-traded futures, forward contracts and swaps
A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the
time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such
as an interest rate, foreign exchange rate, equity price or commodity price. Conceptually, one may view a swap as either a
portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article
will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps.

The Swaps Market

Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are
customized contracts that are traded in the over-the-counter(OTC) market between private parties. Firms and financial
institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC
market, there is always the risk of a counterparty defaulting on the swap. (For background reading, see Futures
Fundamentals and Options Basics.)

The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth,
swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps
market had a total notional value of $865.6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank
for International Settlements. That's more than 15 times the size of the U.S. public equities market.

Plain Vanilla Interest Rate Swap

The most common and simplest swap is a "plain vanilla" interest rate swap. In this swap, Party A agrees to pay Party B a
predetermined, fixed rate of interest on a notional principalon specific dates for a specified period of time. Concurrently,
Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same
specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same
currency. The specified payment dates are called settlement dates, and the time between are called settlement periods.
Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other
interval determined by the parties. (For related reading, see How do companies benefit from interest rate and currency
swaps?)

For example, on December 31, 2006, Company A and Company B enter into a five-year swap with the following terms:

• Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million.
• Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of
$20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in
the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the
floating rate. For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007
and concluding in 2011.

At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000. On December 31, 2006, one-year
LIBOR was 5.33%; therefore, Company B will pay Company A $20,000,000 * (5.33% + 1%) = $1,266,000. In a plain
vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap
contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays
$66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a
"notional" amount. Figure 1 shows the cash flows between the parties, which occur annually (in this example). (To learn
more, read Corporate Use Of Derivatives For Hedging.)

Figure 1: Cash flows for a plain vanilla interest rate swap

Plain Vanilla Foreign Currency Swap
The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for
principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a
currency swap will exchange principal amounts at the beginning and end of the swap. The two specified principal amounts
are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated.

For example, Company C, a U.S. firm, and Company D, a European firm, enter into a five-year currency swap for $50
million. Let's assume the exchange rate at the time is $1.25 per euro (i.e., the dollar is worth $0.80 euro). First, the firms
will exchange principals. So, Company C pays $50 million, and Company D pays ¬40 million. This satisfies each
company's need for funds denominated in another currency (which is the reason for the swap).

Figure 2: Cash flows for a plain vanilla currency swap, Step 1.

Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal
amounts. To keep things simple, let's say they make these payments annually, beginning one year from the exchange of
principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise,
Company B, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let's say
the agreed-upon dollar-denominated interest rate is 8.25%, and the euro-denominated interest rate is 3.5%. Thus, each year,
Company C pays ¬40,000,000 * 3.50% = ¬1,400,000 to Company D. Company D will pay Company C $50,000,000 *
8.25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-
prevailing exchange rate. If, at the one-year mark, the exchange rate is $1.40 per euro, then Company D's payment equals
$1,960,000, and Company C would pay the difference ($4,125,000 - $1,960,000 = $2,165,000).

Figure 3: Cash flows for a plain vanilla currency swap, Step 2

Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original
principal amounts. These principal payments are unaffected by exchange rates at the time.

Figure 4: Cash flows for a plain vanilla currency swap, Step 3

Who would use a swap?

The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The
normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can
alleviate. For example, consider a bank, which pays a floating rate of interest on deposits (i.e., liabilities) and earns a fixed
rate of interest on loans (i.e., assets). This mismatch between assets and liabilities can cause tremendous difficulties. The
bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-
rate assets, which would match up well with its floating-rate liabilities.

Some companies have a comparative advantage in acquiring certain types of financing. However, this comparative
advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it
has a comparative advantage, then use a swap to convert it to the desired type of financing.

For example, consider a well-known U.S. firm that wants to expand its operations intoEurope, where it is less well known.
It will likely receive more favorable financing terms in theUS. By then using a currency swap, the firm ends with the euros
it needs to fund its expansion.

Exiting a Swap Agreement

Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an
investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this.
1. Buy Out the Counterparty
Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the
contract by paying the other this market value. However, this is not an automatic feature, so either it must be
specified in the swaps contract in advance, or the party who wants out must secure the counterparty's consent.

2. Enter an Offsetting Swap

For example, Company A from the interest rate swap example above could enter into a second swap, this time
receiving a fixed rate and paying a floating rate.

3. Sell the Swap to Someone Else

Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this
requires the permission of the counterparty.

4. Use a Swaption
A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a
potentially offsetting swap at the time they execute the original swap. This would reduce some of the market risks
associated with Strategy 2..
Conclusion
Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method
of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla
swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of
this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are
looking for.
Derivatives are financial contracts whose value/price is dependent on the behavior of the price of one or more
basic underlying asset (often simply known as underlying).These contracts are legally binding agreements,
made on trading screen of stock exchange, to buy or sell an asset in future. The asset can be share, index,
interest rate, bond ,rupee dollar exchange rate ,sugar , crude oil, soya been, coffee etc.
Everybody wants to know about them, everybody wants to talk about them. Derivatives however
remain a type of financial instrument that few of us understand and fewer still fully appreciate,
although many of us have invested indirectly in derivatives by purchasing mutual funds or
participating in a pension plan whose underlying assets include derivative products

A simple example of derivative is curd, which is derivative of milk. The price of curd depends upon
price of milk which in turn depends upon the demand and supply of milk.
Section 2(aa) of Securities Contract (Regulation) Act 1956 defines Derivative as:
"Derivative" includes -
• “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;
• a contract which derives its value from the prices, or index or prices, of underlying securities ”.
A working definition of derivative which will help to lay foundation.
“A derivative can be defined as a financial instrument whose value depends on (or derives from) the values of
other, more basic underlying variables.”
---John C. Hull
What Does Derivative Mean?

A security whose price is dependent upon or derived from one or more underlying assets. The
derivative itself is merely a contract between two or more parties. Its value is determined by
fluctuations in the underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized
by high leverage.

Investopedia explains Derivative

Futures contracts, forward contracts, options and swaps are the most common types of derivatives.
Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on
weather data, such as the amount of rain or the number of sunny days in a particular region.

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative
purposes. For example, a European investor purchasing shares of an American company off of an
American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while
holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a
specified exchange rate for the future stock sale and currency conversion back into Euros.

Types of derivatives:

The following are the basic types of derivatives:

Forwards:
A forward is a contract to buy a thing or security at a prefixed future date. The typical usage of a
forward would be something like this: a business having its assets in a local currency has taken a loan
repayable in a foreign currency 6 months hence. There is an exchange rate risk here: if the local
currency suffers against the foreign currency, the business has to write a loss. To cover against this
risk, the business enters into a forward contract - that is, it agrees today to buy the foreign currency 6
months hence at prices prevailing today, against a pre-fixed premium. Obviously, if the perceptions of
the seller and the buyer as to future prices of the foreign currency differ, both will strike what they
perceive is a win-win deal.

Forwards are also quite common in commodities, and can be used either for speculation or for
hedging. Say, XYZ has an order to ship 10000 tons of steel 6 months hence at a prefixed price of say
USD 1000 per ton (by the way, I have no idea of steel prices, this is just an example!). And XYZ
expects the price of steel to go up. So, to hedge against the price risk, XYZ enters into a forward
purchase agreement, for 10000 tons 6 months hence. XYZ's position is now fully hedged: if the price
of steel goes up as expected, XYZ will either claim a delivery from the forward seller, or a net
settlement. If the price comes down, XYZ will be obliged to settle by making a payment for the price
difference to the forward seller, but will be fully offset by the pre-fixed price it gets from its own
forward sale contract.

Futures:

Futures are more standardised forms of forward contracts and mostly operate in organised markets.
While it is possible to have a forward contract for any commercial transaction, futures are normally
exchange-traded. Futures contracts are highly uniform contracts that specify the quantity and quality
of the good that can be delivered, the delivery date(s), the method for closing the contract, and the
permissible minimum and maximum price fluctuations permitted in a trading day.

Distinction between forwards and futures:

The basic nature of a forward and future, in a strict legal sense, is the same, with the difference that
futures are market-driven organised transactions. As they are exchange-traded, the counterparty in a
futures transaction is the exchange. On the other hand, a forward is mostly an over-the-counter
transaction and the counterparty is the contracting party. To maintain the stability of organised
markets, market-based futures transactions are subject to margin requirements, not applicable to OTC
forwards. Futures market are normally marked to market on a settlement day, which could even be
daily, whereas forward contracts are settled only at the end of the contract. So the element of credit
risk is far higher in case of forward contracts.

Options:

The significant difference between a future and an option is that the option provides the contracting
parties only an option, not an obligation, to buy or sell a financial instrument or security at a pre-fixed
price, called the strike price. Obviously, the option buyer will exercise the option only when he is in
the money, that is, he gains by exercising the option.

For example, suppose X holding a security of USD 1000 buys an option to put the security at its
current price with Y. Now if the price of the security goes down to USD 900. X may exercise the
option of selling the security to Y at the agreed price of USD 1000 and protect against the loss on
account of decline in the market value. If, on the other hand, the price of the security goes upto USD
1100, X is out of the money and does not gain by exercising the option to sell the security at a price
of USD 1000 as agreed. Hence, X will not exercise the option. In other words, the option buyer can
only get paid and does not stand to a position of loss.
Had this been a futures contract or forward contract, Y could have compelled X to sell the security for
the agreed price of USD 1000 in either case. That is to say, while a future contract can result into both
a loss and a profit, an option can only result into a profit, and not a loss.

Two basic types of options are: call options and put options. A call option is an option to call, that is,
acquire a particular quantity and/or at particular strike price. A put option is just the reverse- the
option to put or sell a particular quantity and/or at a particular strike price.

Swaps:

In a swap, both the parties exchange recurring payments with the idea of exchanging one stream of
payments for another. A typical usage is a swap of fixed interest rates with floating rates, or rates
floating with reference to one basis to another basis. In credit derivatives market, there are swaps
based on the total return from a particular credit asset against total return on a reference asset.