FD – Unit – 1

1. Introduction to financial derivatives

Financial derivatives are financial instruments that are linked to a specific financial instrument or
indicator or commodity, and through which specific financial risks can be traded in financial
markets in their own right. Transactions in financial derivatives should be treated as separate
transactions rather than as integral parts of the value of underlying transactions to which they may
be linked.

The value of a financial derivative derives from the price of an underlying item, such as an asset
or index. Unlike debt instruments, no principal amount is advanced to be repaid and no investment
income accrues. Financial derivatives are used for a number of purposes including risk
management, hedging, arbitrage between markets, and speculation.

Financial derivatives enable parties to trade specific financial risks -- such as interest rate risk,
currency, equity and commodity price risk, and credit risk, etc -- to other entities who are more
willing, or better suited, to take or manage these risks, typically, but not always, without trading
in a primary asset or commodity.

The value of the financial derivative derives from the price of the underlying item: the reference
price. Because the future reference price is not known with certainty, the value of the financial
derivative at maturity can only be anticipated, or estimated. The reference price may relate to a
commodity, a financial instrument, an interest rate, an exchange rate, another derivative, a spread
between two prices, an index or basket of prices. An observable market price or index for the
underlying item is essential for calculating the value of any financial derivative -- if there is no
observable prevailing market price for the underlying item, it cannot be regarded as a financial
asset.

Despite the clear benefits that the use of derivatives can offer, too often the public and shareholder
perception of these instruments has been coloured by the intense media coverage of financial
disasters where the use of derivatives has been blamed. The impression is usually given that these
losses arose from extreme complex and difficult to understand financial strategies. The reality is
quite different. When the facts behind the well-reported disasters are analysed almost invariably it
is found that the true source of losses was a basic organizational weakness or a failure to observe
some simple business controls.

2. Meaning of financial derivatives

 Derivatives are financial contracts, set between two or more parties, that derive their value
from an underlying asset, group of assets, or benchmark.
 A derivative can trade on an exchange or over-the-counter.
 Prices for derivatives derive from fluctuations in the underlying asset.
 Derivatives are usually leveraged instruments, which increases their potential risks and
rewards.
 Common derivatives include futures contracts, forwards, options, and swaps.

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 The basic principle behind entering into derivative contracts is to earn profits by speculating
on the value of the underlying asset in future.

• Why do investors enter derivative contracts?

 Arbitrage advantage: Arbitrage trading involves buying a commodity or security at a low price
in one market and selling it at a high price in the other market. In this way, you are benefited
by the differences in prices of the commodity in the two different markets.

 Protection against market volatility: A price fluctuation of an asset may increase your
probability of losses. You can look for products in the derivatives market which will help you
to shield yourself against a reduction in the price of stocks that you own. Additionally, you
may buy products to safeguard against a price rise in the case of stocks that you are planning
to buy.

 Park surplus funds: Some individuals use derivatives as a means of transferring risk. However,
others use it for speculation and making profits. Here, you can take advantage of the price
fluctuations without actually selling the underlying shares.

3. Features of financial derivatives

 Financial Derivative is a contract.

 It derives value from underlying assets.
 It has specified obligation as per the contract which means there are parties involved with
specified conditions.
 Financial Derivatives are carried off-balance sheets.
 Trading of underlying assets is not involved.
 Financial Derivatives are mostly secondary market instruments.
 Financial Derivatives are exposed to risks such as operational, counter party and legal.
 Derivatives have a maturity or expiry date post which they terminate automatically
 All the transactions in derivatives take place in future specified date
 There are no specified limits on the number of units that can be transacted as there are no
physical assets for transactions

4. Uses of derivative markets

• Financial Derivatives are used as Risk Aversion tools. Derivatives manage to averse risks
through various strategies like hedging, arbitraging, spreading etc. Derivatives are used in
highly volatile financial market conditions.
• Financial Derivatives for prediction of future prices. Derivatives serve as a barometer of future
trends in prices for the security and hence help in discovery of new prices in the spot and future
market.
• Financial derivatives enhance liquidity. Derivatives trading is basically based on margin
trading hence a large number of traders, speculators, arbitrageurs are operating in the derivative
market. Such trading’s enhance liquidity and reduce transaction cost for underlying assets.

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• Derivative is an investing instrument hence assisting investors while making investment
decisions. Derivatives provide alternatives for the investors, traders and fund managers for
asset allocation.
• Financial derivatives assist in financial market growth. Derivative market allows investing
grounds to different market operators such as speculators, hedgers, traders and arbitrageurs
based on the preferred risks. This leads to an increase in trading volume in the country.

5. Types of financial derivatives

• Forward
Forward are simply an agreement between two parties for buying or selling an underlying asset at
a specified price at some future date. It is a non-standardized type of contract which is traded over
the counter. These contracts are flexible and can be customized according to the needs of buyers
and sellers. Forward contracts involve large amounts of counterparty risk as these are unregulated
contracts without the involvement of any intermediary.

• Futures
Future are the standardized type of contracts enter into by parties for buying and selling of
underlying securities at an agreed price at some future date. These are traded over an exchange via
intermediary and are completely regulated. Future contracts cannot be customized as per the party
needs and carry lower counterparty risk. The value of these contracts is decided as per the market
movement on a daily basis till the expiration date.

• Options
Options are derivative contracts that provide the buyer a right but not an obligation to buy or sell
an underlying asset. The buyer of an option contract pays a premium to the seller for buying such
right, whereas the seller is under an obligation to discharge his duty in return for the premium he
received. Options are of 2 types: – Call option and Put option. Call option provides the buyer a
right but not an obligation to buy an asset at the pre-decided price at some future date. On the other
hand, the put option provides the buyer a right but is not under any obligation to sell an asset at
some future date at the agreed price.

• Swaps
Swaps are the most complicated type of derivative contracts which are entered into for exchanging
cash flows in the future between 2 parties. These are the private agreements which are done over
the counter. Interest rate swaps and currency swaps are the two most common types of swap
contracts. These contracts carry a high amount of risk as the interest rate and currency are
underlying assets in these contracts which are highly volatile.

6. Functions of Derivatives

• Transfer Of Risk
Derivatives are used for transferring the risk from one party to another that is a buyer of a
derivative product to the seller. It is an effective risk management tool that transfers the risk
from those having a low-risk appetite to those having a high-risk appetite.

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• Hedging Risk
It helps in hedging risk against unfavourable price movements of an underlying asset. By
entering into a forward contract, the buyer and seller agrees to complete the deal at a pre-
decided price at some specific date in the future. Any unexpected price hikes or drop will not
influence the contract value, thereby providing protection against these types of risks.

• Lower Transaction Cost

The cost of trading in derivative instruments is quite low as compared to other segments in
financial markets. They act as a risk management tool and thereby lower the transaction costs
of the market.

• Provide Access to Unavailable Assets and Markets

Derivative enables business in reaching out to hard to trade assets and markets. Organizations
with the application of interest rate swaps can obtain better interest rates than available in the
current market.

• Higher Leverage
Derivatives instruments provide higher leverage than any other instrument available in the
financial market. Capital required to take positions in derivative instruments is very low as
compared to the stock market. In the case of a future contract, only 20-40% of the contract
value is needed whereas, in case of options, only the amount of premium is required for trading.

• Price Discovery
Derivatives assist in defining prices of underlying assets and future spot rates for the
commodity.

• Check on Speculation
Derivative helps in hedging the risk against unfavourable price movements of assets with the
help of future and forward contracts.

• Encourage young investors and entrepreneurs.

• Motivates and increases savings and investments.

7. Advantages and disadvantages of Derivatives

• Hedging Risk
Derivative contracts are used for hedging risk arising out of fluctuations in price movements.
Value of these contracts is dependent upon the value of underlying assets. Investor will
purchase those derivative contracts whose value moves opposite to the value of security the
investor owns. Therefore, losses in underlying commodities may be offset by profit in contracts
of derivatives.

• Determine Underlying Asset Price

Derivatives contracts helps in ascertaining the price of underlying assets. An approximation of
commodity prices is known through the spot prices of future contracts.

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• Provide Access to Unavailable Market or Asset
Another important advantage of derivative is that it provides access to unavailable market and
assets to peoples. Individuals can acquire funds at lower or favourable rate of interest as
compared to direct borrowings with the help of interest rate swaps.

• Enhance Market Efficiency

Derivatives plays an efficient role in improving the financial market’s efficiency. These
contracts are used for replicating the assets payoff. It enables in getting fair and correct
economic value of underlying commodity as these contracts brings price corrections via
arbitrage. This way market becomes price efficient and an equilibrium is attained.

• Low Transaction Cost

Trading of these instruments involves low transaction cost which is beneficial for investors.
This acts as a risk management tool and a protection against price fluctuations. Cost of trading
in derivatives is lower as compared to other securities like shares or debentures.

• High Risk
Derivatives contracts are exposed to high degree of risk due to high volatile price of underlying
securities. Prices of these underlying securities like shares or metals keeps on changing rapidly
as derivatives are mostly traded in open market. This involves a high degree of risk.

• Counter Party Risk

There is a possibility of default on the part of counter-party in case of derivatives traded over
the counter due to lack of due diligence process. OTC derivatives as compared to exchange
derivatives lacks a benchmark for due diligence.

• Speculative Features
Derivatives are instrument which are used for speculation purpose for earning profits.
Sometimes huge losses may occur due to unreasonable speculation as derivatives are of
unpredictable and high risky nature.

• Requires Expertise
This is one of the major drawbacks in trading of derivative instruments. Investor’s requires
high knowledge and expertise for trading in these instruments as compared to other securities
likes stocks and metals.

8. Critiques of derivatives

• Speculation and gambling

For hedging to work, there must be speculators on the other side of the trade. The more speculators
the market attracts, the cheaper it becomes to hedge. Unfortunately, the perception of speculators
is not a good one. They are thought to be short-term traders who seek to make a short-term profit
and engage in price manipulation and trade at extreme prices. The profit from short-term trading
is taxed more heavily than profit from long-term trading – a way of “punishing” these activities.
Many view derivatives trading as a form of legalized gambling; however, there are notable
differences. For example, gambling benefits only a limited number of participants. Generally, it

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does not help society as a whole, while the derivatives market brings extensive benefits to the
financial services industry.

• Destabilization and systematic risk

Opponents of the derivatives market claim the operational benefits result in an excessive amount
of speculative trading, bringing instability to the financial markets. They argue that as speculators
use large amounts of leverage, they are subjecting themselves and their creditors to high risk if the
market moves against them. Defaults by speculators can lead to defaults by their creditors, and
these chain-reaction events can be systemic. Instability can, therefore, be spread through the
market.

• Complexity
Some investors criticize derivatives for being too complex and based on models that are far from
reality.

9. Need for financial derivatives