1.1.1.

Meaning and Definition of Financial

Derivatives
Financial derivatives financial instruments that
are
specific financial instrument or indicator or commodity,
are linked
and through
to a

which specific financial risks can be traded in financial markets in their

own right.

The financial derivatives were also known as off-balance sheet

instruments because no assets or liability underlying the contract was
put on the balance sheet as such.
In the Indian context the Securities Contracts (Regulation) Act, 1956
defines "derivative" to include:
1) 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.
2) A contract which derives its value from the prices or index of prices,
of underlying securities.

Therefore, derivatives are specialized contracts to facilitate temporarily

for hedging which is protection against losses resulting from unforeseen
price or volatility
changes. Thus, derivatives are a very important tool of
risk management.

1.1.2. Features of Financial Derivatives

The features of derivatives are as follows:
1) 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.
2) The value of a financial derivative derives from the price of an
such as an asset or index.
underlying item,
3) Financial derivatives are used for a number of purposes including
risk management, hedging, arbitrage between markets, and speculation.
 14 MBA Fourth Semester (Financial Derivatives) AU
Financial derivatives contracts are usually settled by net payments
4)
of cash, often before maturity for exchange trded contracts such as
commodity futures.
Financial derivatives allow considerable returns to be made in
5) relation to the outlay. This is known as gearing. For example,

paying the premium is all that is required

to invest in options. The
potential returns can be substantial.
derivatives contract can be traded either
6) The risk embodied in a

itself, such with options, or by

as
by trading the contract
embodies risk characteristics that
creating a new contract which
of the existing contract
match, in a countervailing manner, those
owned.
occurs in forward
This latter activity is termed offsetability, and
be possible to
markets. Offsetability means that it will often
eliminate the risk associated with the derivative by creating
a new,
countervail the
but "reverse", contract that has characteristics that
risk of the first derivative.

1.1.3. Needs of the Financial Derivatives

The needs of the derivatives market are as follows:
1) Management of Risk: Financial derivatives allow for the efficient
management of financial risks and can help to ensure that value
enhancing opportunities will not be ignored.
2) Price Discovery: Derivatives play a crucial role in discovering the
present and future price of any commodity or financial asset. This is
an essential part of an efficient economic system. Prices of stocks
and commodities tend to move in the same direction as the
expectations of market participants.
Hence, the price in the futures market reveals the demand supply
expectation in the future and thus undertakes the process of price
discovery in the spot market. In other words, price discovery means
revealing information about future cash market prices through the
futures market.
3) Price Stabilisation: Derivative helps to keep a stabilising influence
on spot prices by reducing the short-term fluctuations

4) Efficiency in Trading: Financial derivatives allow for free

trading of risk components and that leads to improving market
efficiency.
 15
1.1.4. History of Financial Derivatives
Derivatives are definitely not a modern invention. They were known
and were used from ancient times. The first organised commodity
exchange came into existence in the early 1700s in Japan. The first
formal commodities exchange, the Chicago Board of Trade (CBOTD.
was formed in 1848 in the US to deal with the problem of 'credit risk
and to provide centralised location to negotiate forward contracts. From
forward' trading in commodities emerged the commodity 'futures'. The
first futures type contract was called to arrive at'. Trading in futures
began on the CBOT in the 1860s. In 1865, CBOT listed the first
exchange-traded' derivatives contracts, known as the futures contracts.
Futures trading grew out of the need for hedging the price risk involved
in many commercial operations.
The Chicago Mercantile Exchange (CME), a spin-off of CBOT was
formed in 1919 though it did exist before in 1874 under the names of
The
Chicago Produce Exchange' and 'Chicago Butter and Egg Board'. in the
first financial futures to emerge were the currency futures in 1972
on May 16,
US. The first foreign currency futures contracts were traded
division of the
1972 on the International Monetary Market (IMM), a
were the British pound,
CME. The currency futures traded on the IMM
the Swiss franc, the German
the Canadian dollar, the Japanese yen,
the euro-dollar. Currency futures were
mark, the Australian dollar, and
Interest rate futures contracts
followed soon by interest rate futures.
Stock
were traded for the first
time on the CBOT on October 20, 1975.
in 1982. The first stock index futures
Index futures and options emerged
Kansas City Board of Trade on February 24,
contracts were traded on

1982.
and
options grew at a rapid pace in the 1980s
The market for futures and and
Bretton Woods regime of fixed parities
1990s. The collapse of the in the international
of floating rates for currencies
the introduction number off
for development of a
the way
inancial markets paved risk management tools to
which served as effective
inancial derivatives,
uncertainties.
Cope with market
Derivatives in India
1.1.5. Growth of Financial have shown a
Indian markets
he NSE and BSE are two major volumes and numbers of
traded
in terms of markets
Cmarkable growth both derivatives trading in 2000, in Indian
an
of
racts. Introduction derivative market which has registered
to
was starting of equity s a m e in the years
continue the
expected to Indian
OSive growth and is
in
derivatives trading
a c c o u n t s 99%
of the
. NSE alone
Introduction to Financial Derivatives (Unit1)
21
1.1.7.1. Classification of Derivative Market
The Derivative Market can be classified as Exchange Traded
Derivatives Market and Over the Counter Derivative Market. Swaps,
Options and Forward Contracts are traded in Over the Counter
Derivatives Market or OTC market.

Derivative Market

Exchange-Traded Derivative
Market OTCDerivatives Markets

Exchange-Traded and OTC

Derivatives Markets

1.1.7.2. Exchange-Traded Derivative Market

Exchange-traded derivative market has the following features:
1) An electronic exchange mechanism and emphasises anonymous
trading,
2) Full transparency,
3) Use of computers for order matching,
4) Centralisation of order flow,
5) Price-time priority for order matching,
6) Large investor base,
7) Wide geographical access,
8) Lower costs of intermediation,
9) Settlement guarantee,
10) Better risk management, and
etc.
11) Enhanced regulatory discipline,
OTC Derivatives Markets
1.1.7.3.
witnessed rather sharp growth over
The OTC derivatives markets have
the modernization of
the last few years, which has accompanied
and globalization of financial
commercial and investment banking
in information technology have
activities. The recent developments
extent these developments. While both
to
contributed to a great
offer many benefits, thee
exchange-traded and OTC derivative contracts
structures compared to the
latter.
Tormer have rigid
institutions and
t has been widely discussed that the highly leveraged
main cause of turbulence in
tneir OTC derivative positions were the
of turbulence revealed the
nancial markets in 1998. These episodesin features of OTC derivative
nsks posed to market stability originating
instruments and markets.
22 MBA Fourth Semester (Financial Derivatives) AU
The OTC derivatives markets have the following features comparedd
to exchange traded derivatives:
1) The management of counter-party (credit) risk is decentralized and
located within individual institutions;
2) There are no formal centralized limits on individual positions,
leverage, or margining;
3) There are no formal rules for risk and burden-sharing
4) There are no formal rules or mechanisms for ensuring market
stability and integrity, and for safeguarding the collective interests
of market participants; and
5) The OTC contracts are generally not regulated by a regulatory
authority and the exchange's self-regulatory organization, although
they are affected indirectly by national legal systems, banking
supervision, and market surveillance.
Some of the features of OTC derivatives markets embody risks to
financial market stability. The following features of OTC derivatives
markets can give rise to instability in institutions, markets, and the
international financial system:
1) The dynamic nature of gross credit exposures;
2) Information asymmetries;
3) The effects of OTC derivative activities on available aggregate credit;
4) The high concentration of OTC derivative activities in major
institutions; and
5) The central role of OTC derivatives markets in the global financia
system.

Instability arises when shocks, such as counter-party credit events and

sharp movements in asset prices that underlie derivative contracts occur.
which significantly alter the perceptions of current and
credit exposures. When asset
potential future
prices change rapidly, the size and
configuration of counter-party exposures can become unsustainably
large and provoke a rapid unwinding of positions. There has been some
progress in addressing these risks and
perceptions. However, the
progress has been limited in implementing reforms in risk
including counter-party, liquidity and operational risks,managemen"
and O1
derivatives markets continue to pose a threat to
international financia
stability. The problem is more acute as
derivatives creates the possibility of heavy reliance on OTC
fall outside the more formal systemic financial events, whici
who provide OTC derivative
clearing house structures. Moreover, thoss
products, hedge their risks through the us
of exchange traded derivatives. In view of the
inherent risks associate
with OTC derivatives, and their dependence on
exchange traded
derivatives, Indian law considers them illegal.
Introduction to Financial Derivatives (Unit 1)
23
1.1.7.4. Exchange-Traded and OTC Derivatives Markets
As the word suggests, derivatives that trade on an exchange are called
exchange traded derivatives, whereas privately negotiated derivative
contracts are called 0TC contracts.

The main participants of OTC market are the Investment Banks,

Commercial Banks, Govt. Sponsored Enterprises and Hedge Funds. The
investment banks markets the derivatives through traders to the clients
like hedge funds and the rest.

In the Exchange Traded Derivatives Market or Future Market, exchange

acts as the main party and by trading of derivatives actually risk is traded
between two parties. One party who purchases future contract is said to go
"long" and the person who sells the future contract is said to go "short.

Difference between ETM and OTC Markets

Basis of Difference ETM OTCMarket
1) Counterparty In an exchange traded market,Counterparty risk is more in
Risk the exchange or the regulatory OTC markets, because OTC
becomes the counterpart to derivatives are not traded on
every transaction and delivery an exchange, there 15 no
of securities/funds is central counterparty.
guaranteed. Thus there is no Therefore, they are subject|
counterparty risk is in ETM. to counterparty risk, Hke an
ordinary contract, since each
counterparty relies on the
other to perform.
Price Best price discovery is in |In OTC markets price
2)
exchange traded markets as| discovery depends on the
Discovery
there are number of traders number of dealers (market-
who trade on a single and makers) who trade in a
centralized system. So there | particular security. So there
will be less chances of | will be more chances of
manipulation by operators. manipulation by operators.
traded market Less liquidity is in OTC
3) Liquidity In exchange
there will be buyers and market as there are less
sellers in almost all counters. number of clients and
So there will be more participants.
liquidity in ETM.
All firms that offer exchange |
There is absence of proper
4) Proper be regulatory body in OTC
Regulatory traded products must
Because here
Body members and register with the | markets. raded (and
contracts are
there is greater
exchange,
regulatory oversight which privately negotiated) directly
between two parties, without
can make exchange traded an exchange or
markets a much safer place going through
for individuals to trade. other intermediary.
24

1.1.8. Participants in Derivatives Market

Derivatives are used by businesses, individuals and governments to
be broadly
accomplish a wide variety of objectives. These may
classified into following categories:
eliminate price risk
1) Hedgers: Hedgers are those traders who wish to The objective
with the underlying security being traded.
associated
of these kinds of traders is to safeguard their existing positions by
derivatives market to make
reducing the risk. They are not in the
is comnmon in the
profits. Apart from equity markets, hedging
foreign exchange markets where fluctuations in the exchange rate
transactions or could
have to be taken care of in the foreign currency
have to be
be in the commodities market where spiraling oil prices
controlled using the security in derivative instruments. For example,
an investor holding shares of ITC and fearing that the share price will
decrease in future takes an opposite position (sell futures contracts) to
minimize the extent of loss if the share will to fal1.

2) Speculators: While hedgers might be adept at managing the risks of

exporting and producing petroleum products around the world, there
are parties who are adept at managing and even making money out
of such exogenous risks. Using their own capital and that of clients,
some individuals and organizations will accept such risks in the
expectation of a return. But unlike investing in business along with
its risks, speculators have no clear interest in the underlying activity
itself. For the possibility of a reward, they are willing to accept
certain risks. They are traders with a view and objective of making
profits. These are people who take positions (either long or short
positions) and assume risks to profit from fluctuations in prices
They are willing to take risks and they bet upon whether the markets
would go up or come down.

Speculators may be either day traders or position traders. The

former speculate on the
price movements during one trading day
while the latter attempt to
gain keep their
period to gain from price fluctuations. Inposition
for longer time
the previous examp
(ITC), it is also possible to short futures
shares in spot market. The without actually owning
speculator does so because he
ITC to fall and by entering into short expec
The speculator is not futures, he if
gains price rai
required to pay the entire
of futures contracts x shares under value, i.e., (Numo
each contract x delivery
Only margin money which accounts for 5-10% of total Pi
value is paid upfront by transact
speculator.Thus, futures are highly levere
instruments. For example, if margin money
required is 10%,
speculator can take 10 contracts by paying the price of 1 contract.
 25
Difference between Hedger and Speculator
Basis of Difference
Hedger Speculator
1) Meaning Hedgers are those traders Speculator are parties who are
who wish to eliminate price
risk
adept at managing and even
associated with the making money out of such
underlying security being|exogenous risks. Using their
traded |own capital and that of
clients, some individuals and
organizations will accept such
risks in the expectation of a
return.
2) Risk |They do not accept any kind |They are willing to accept
of risk. certain risks.
3) Arbitrageurs: The third players known as arbitrageurs. From
are
the French for arbitrage or judge, these market participants look for
mis-pricing and market mistakes, and by taking advantage of themn;
they disappear and never become too large. If you have even
purchased a product of a green grocer only to discover the same
product somewhat cheaper at the next grocer, you have an arbitrage
situation. Arbitrage is the process of simultaneous purchase of
securities or derivatives in one market at a lower price and sale
thereof in another market at a relatively higher price. For example,
on maturity if the pepper futures contracts is 7650 per kg and the
spot price is T642, then the arbitragers will buy pepper in spot and
short sell futures, thereby gaining riskless profit of 650-642, i.e., 8
per kg. Here, the two markets are spot and futures market. Thus,
riskless profit making is the prime goal of arbitrageurs.
4) Scalpers: A scalper is a person trading in the equities or options
and futures market who holds a position for a very short period
of time in an attempt to profit from the bid-ask spread. Scalpers
buy large quantities of in-demand items, at regular price, hoping
that the items will sell out and then resell the itenms at a higher
price. They try to exploit the constant fluctuations in
commodities of securities prices during the trading hours. They
do not expect to make large profits on each trade, but they
generate large number of transactions throughout the trading
point. The rapid trading that occurs in legitimate scalping usually
results in small gains, but several small gains can add up to large
returns at the end of the day.
5) Other Traders in Derivative Market: All resident Indians, NRIs,
Flls and Mutual Funds can trade in derivatives markets. In order to
ensure that the derivative market functions efficiently, it is
important to maximise the number of participants in the market to
 NBFCs, mutual
encompass individuals, banks, financial institutions,
funds, insurance companies and corporate.
i) Individuals: Individuals are the most important players in the
market who buy or sell the contracts. They are clients of trading
their yield, or
members. They use derivatives to enhance
A derivative provides
perhaps to take out speculative positions. assets without
them an alternative to investing directly in
buying and holding the asset itself. of credit
and sellers
i) Banks: Banks would typically be both buyers
There
risk in the market. be cases where a bank believes that
may
such case,
it is overexposed to particular credit or industry. In
a
be
the bank will wish to buy protection. Conversely, there may
to
sectors or highly rated companies or fast growing companies
which abank has little or no exposure. Entering the consortium
the bank will
may be a time consuming exercise. In such case,
in the
wish to sell protection. Buying and selling of participation
priority sector is one example where derivatives, albeit in a
different form, has been practiced for several years.
ii) Financial Institutions and NBFCs: Financial Institutions and
NBFCs may also find themselves in a similar position to the banks
and are thus likely to be both buyers and sellers in the market.
iv) Mutual funds and Insuránce Companies: Mutual funds and
insurance companies that have an investment where they
anticipate spread widening would typically be buyers of
protection. Similarly, mutual funds and insurance
companies
that are looking for yield enhancement and
believe that spreads
of a given company are
expected to narrow would typically be
sellers of protection. Mutual funds
and insurance
may also sell protection as a means to companies
and broaden their asset base. diversify their portfolio
v) Corporates: Companies may participate in the derivatives
market to either buy or sell
company would wish to protection.
One instance where a
buy protection is when it is
overexposed to one or more
buyers. Conversely, parent
companies sometimes provide guarantees to banks on behalf of
subsidiaries and these could
vi) Trading Member: A easily be structured as derivatives.
member of the
and on behalf exchange
trades on his own behalf and one who
they are called as Limited of his clients. On BSE,
vii) Clearing Member: Trading Members.
One who
trades as wellthe trades of theundertakes to settle his own
as
known as other non-clearing
Trading
trades through them. Members, 'who have members,
agreed
to settle the
Introduction to Financial Derivatives (Unit 1)
27
1.1.9. Functions of Derivatives Market
Tnspite of the fear and criticism with which the derivative markets
are
commonly looked at, these markets perform a number of economic
functions:
Functions of Derivatives Market

Help in Discovery of Price

H Helps to Transfer Risks
Higher Trading Volumes
Control Market Activities

Acts as Catalyst

1) Help in Discovery of Price: Prices in an organized derivatives

market reflect the perception of market participants about the future
and lead the prices of underlying to the perceived funure level. The
prices of derivatives converge with the prices of the underlying at
the expiration of the derivative contract. Thus, derivatives help in
discovery of future as well as current prices.
2) Helps to Transfer Risks: The derivatives market helps to transfer
risks from those who have them but may not like them to those who
have an appetite for them.
3) Higher Trading Volumes: Derivatives, due to their inherent nature,
are linked to the underlying cash markets. With the introduction of
derivatives, the underlying market witnesses higher trading volumes
because of participation by more players who would not otherwise
participate for lack of an arangement to transfer risk.
4) Control Market Activities: Speculative trades shift to a more
controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying
cash markets. Managing, monitoring and surveillance of the
activities of various participants become extremely difficult in these
kinds of mixed markets.
5) Acts as Catalyst: An important incidental benefit that flows from
derivatives trading is that it acts as a catalyst for new entrepreneurial
activity. The derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial attitude. They
often energize others to create new businesses, new products and
new employment opportunities, the benefit of which are immense.

and
na nutshell, derivatives markets help to increase savings
vestment in the long-run. Transfer of risk enables market participants
to
expand their volume of activity.
 MBA FOurth Semester (Financlal
Derivatives) AU
1.1.10. Types of Derivatives
Broadly, derivatives can be classified into below categories:
Types of Derivatives

On the Basis of On the Basis of On the Basis of On the Basis of

Underlying Assets Financial Derivative Market Complexity
Equity Derivative Forwards Exchange Traded
Hybrid/Exotic/
Interest Rate Futures Derivative Market
Sophisticated
Derivatives OTC Derivatives Derivatives
Options Markets
Foreign Exchange Swaps Weather
Derivative Derivatives
Commodity Repo
Derivatives
Credit Derivative

1) On the Basis of Underlying Assets: Underlying asset is a term used

in derivatives trading, such as with options. A derivative is a financial
instrument whose price is based (derived) from a different asset. The
underlying asset is the financial instrument (eg., stock, futures,
commodity, currency, index) on which a derivative's price is based.
i) Equity Derivative: An equity derivative is a derivative
instrument with underlying assets based on equity securities. An
equity derivative's value will fluctuate with changes in its
underlying asset's equity, which is usually measured by share
price. Options are the most common equity derivatives because
they directly grant the holder the right to buy or sell equity at a
predetermined value. More complex equity derivatives include
equity index swaps, convertible bonds or stock index futures.
ii) Interest Rate Derivatives: An interest rate future
financial derivative with an (IRF is a
interest-bearing instrument as the
underlying asset. Interest rate futures means a standardized interest
rate derivative contract traded on a
recognized stock to exchange
buy or sell a notional security or any other interest
instrument or an index of such instruments
bearing
or interest rates at a
specified future date, at a price determined at the time of contract.
Interest rate futures are
relatively new financial statement.
ii) Foreign Exchange Derivative:
locks
Any financial instrument that
in a future foreign
exchange rate. These can be used by
currency or forex traders, as well as large multinational
corporations. The latter often uses these products when they
expect to receive large amounts of money in the future but want
to hedge their exposure to
currency exchange risk.
Introduction to Financial Derivatives (Unit 1)
29
iv) Commodity Derivatives: In case of commodity
underlying asset can be commodities like wheat, derivatives,
gold, silver
etc., whereas in case of financial derivatives
underlying assets
are stocks, currencies, bonds and other interest
securities
rates bearing
etc. Thus, futures, option
swaps or on gold, sugar,
jute, pepper etc are commodity derivatives.
vCredit Derivative: Are structured based on credit instruments
or loans where the pay off is decided based on a credit event.
These contracts are linked to a third party reference asset.
Credit default swaps, credit default options, collateralized bond
obligations etc. are examples of credit derivatives.
2) On the Basis of Financial Derivative: It includes:
i) Forwards: Forward contract is a cash market transaction in
which delivery of the instrument is deferred until the contract
has been made.
ii) Futures: A futures contract is an agreement between two parties to
an asset at a price.
certain time in the future at a certain
buy or sell
not the obligation)
iii) Options: An option represents the right (but
asset during a given time for a
to buy or sell a security or other
specified price (the "strike" price).
in which the
A is a contract between two parties
iv) Swaps: swap
to the second and the
promises to make a payment
first party Both
a payment to the first.
second party promises to make
Different formulas are
on specified dates.
payments take place be.
two sets of payments will
used to determine what the

Basis of Market in which they Trade: It includes:

3) On the
Derivative Market: As the word suggests,
Traded
i) Exchange traded
derivatives that trade exchange are called exchange
on an
Traded Derivatives Market
derivatives. In the Exchange derivatives
and by trading of
acts as the main party
exchange One party who
traded between two parties.
actually risk is said to go "long"
and the person
future contract is
purchases said to go "short".
contract is
who sells the future context
traded in some
Derivatives Markets:
A security
ii) OTC the NYSE, TSX,
a formal exchange such as
to refer
other than on
"over-the-counter" can be used
AMEX, The phrase
etc. to on a
dealer network as opposed
trade via a and other
to stocks that to debt securities
It also refers
centralised exchange. are traded
derivatives, which
such as
to bring
financial instruments
dealer act to bring the
network. The
through a dealer transaction itself.
have no part in the
counterparties together but
 MBA Fourth Semester

30
It includes:
4) On the Basis of Complexity: Derivatives:
Exotic derivatives
Hybrid/Exotic/Sophisticated derivatives
i) asset. These are
of financial that
are a specific type underlying asset)
on another
(assets whose value
depends for a regular call
pay-off, as is the case
standard which is not a
do not have a derivative security
option. It réfers
to any
call or
o r put
put onon aa single
single
American vanilla
European or are m o r e
complex than
These options
underlying security. generally trade over the
and
on an exchange,
options that trade
counter Derivatives are
are financial
financial
Derivatives: Weather
ii) Weather financial risk
organization of offset the
products that enable
an
allow companies to control the
variable. They
due to a weather This hedging
demand for their products.
effects of weather on predictable
reduces the volatility, of
future revenue to a more
cash flow. A degree-day is
the deviation of a day's average
reference temperature.
This was found to
temperature form the
could use to hedge
be a useful measure
that the energy suppliers
conditions. The c o m m o n
their supply in adverse temperature
are call options, put options, caps,
forms of weather derivatives
floors, collars and swaps.
agreement. Those who deal
ii) Repo: Repo is short for repurchase as a form of overnight
in govenment securities use repos
securities
borrowing. A dealer or other holder of government
and agrees to
(usually T-bills) sells the securities to a lender
repurchasethem at an agreed future date at an agreed price.
They are usually very short-term, from overnight to 30 days or
more. This short-term maturity and government backing means
repos provide lenders with extremely low risk.
Repos are popular because they can virtually eliminate credit
problems. Unfortunately, a number of significant losses over
the years from fraudulent dealers suggest that lenders in this
market have not always checked their collateralisation closely
enough.

1.1.11. Forward
A forward contract is a customised contract between the buyer and the
seller where settlement takes place on a specific date in future at a price
agreed today. In case of a forward contract the price which is
paid/received by the parties is decided at the time of entering into
contract. It is simplest form of derivative contract mostly entered by
individual in day to day life.
 Introduction to Financial Derivatives (Unit 1)
31
For example, Indian car manufacturer
an
buys auto parts from a
Japanese car maker with payment of one million due in 60
The importers in India are short of yen and supposeyen days.
present price yen
of
is 768. Over the next 60 days, yen may rise to R70. The
importer with
hedge this exchange risk by negotiating a 60 days forward contract
can

a bank at a price of
K70. According to forward contract, in 60
bank will give the importer one million yen and importer will days
the
give the
banksR70 million to bank.

1.1.12. Futures
A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts
are special types of forward contracts in the sense that the former are
standardised exchange-traded contracts. A speculator expects an
increase in price of gold from current future prices of 79,000 per 10gm.
The market lot is lkg and he buys one lot of future gold (9,000 x 100)
F9,00,000. Assuming that there is 10% margin money requirement and
10% increase occur in price of gold the value of transaction will also
increase, i.e., 79,900 per 10gm and total value will be 9,90,000. In
other words, the speculator earns 90,000.

1.1.13. Options
Options are derivative contract that give the right, but not the obligation
to either buy or sell a specific underlying security for a specified price
(called as strike/exercise price) on or before a specific date. In theory,
option can be written on almost any type of underlying security. Equity
(stock) is the most common, but there are also several types of non-
equity options, based on securities such as bonds, foreign currency,
indices or commodities such as gold or oil. The person who buys an
option is normally called the buyer or holder. Conversely, the seller is
known as the seller or writer.

For example, suppose the current price to CIPLA share is R750 per
share. X owns 1000 shares of CIPLA Ltd. and apprehends in the decline
in price of share. The option (put) contract available at BSE is of 7800,
in next two-month delivery. Premium cost is R10 per share. X will buy a

put option at 10 per share at a strike price of 7800. In this way. X has
eged his risk of price fall of stock. X will exercise the put option if the

price of stock goes down below 790 and will not exercise the option if
Pnce 1smore than 80q, on the exercise date, In case of options, buyer
asa imited loss and unlimited profit potential unlike in çase of
Torward and futures.
 1.1.14. Swaps or more
two or more people or
A swaps is
an agreement
between

o v e r a period
future. Swaps arePies
in future. are tparties to
exchange sets
of cashflows are innovative ve finaneineraljy
financing generally
customised
transactions.
The swaps
to i n c r e a s e control
over interest
interest which
rate risk
costs, and f s
reduces borrowing includes both spot
spot and
and forex exposure.
The swap
are at the centre of the
forward
transactions in a single agreement. Swaps
are useful in avoiding the problemoof
financial revolution. Swaps
unfavourable fluctuation
in forex market.

that agree to the swap

are known ascounterparties
The parties capital through debt market
to raise some
For example, a firm wants
The firm finds that it can
raise the desired amount based on floatine
baSis points, however, it is interested
interest rate, i.e., MIBOR plus 100
fixed interest rate loan for whatsoever
in getting it exchanged for a
reason (many be the firm is new and does not want to take this risk).

At the same time, there is another firm that could raise the debt amount
at the fixed rate of interest, say at 8% p.a., but was willing to exchange
it for floating rate of interest. Both such firms can explore the possibility
of swapping their respective interest liability through the financial
intermediary dealing in swap agreements for a suitable time period and,
therefore, can have access to desired loan scheme, .e., fixed/floating
interest rate.

Once the deal is finalised for a stipulated time period, the interest
liabilities are routed through the financial intermediary and the
intermediary charges its commission from both the parties for the
services provided. In this regard, it is important to note that only interest
liabilities are exchanged and principal amounts remain with the original
parties.

1.1.15. Advantages of Derivatives

The advantagesof
derivatives are as follows:
1) Reflect Perception of Market
derivatives market reflect the
Participants: Prices in an organizcu
about the perception of market participan
future and lead the prices of
future level. The prices of underlying to the perceive
derivatives of
the converge with the pr
underlying at the
expiration hus,
derivatives help in discovery of of the derivative contract.
future as well as current prices:
2) Helps to Transfer Risks: The
derivatives market helps uho
them but may not like them-to to
risks from those who have
have an appetite for thoso
them.
Tntroduction to Financial Derivatives (Unit 1) 33

3) Higher Trading Volumes: Derivatives, due to their inherent

nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher
trading volumes because of participation by more players who
would not otherwise participate for lack of an arrangement to
transfer risk.
4) Controlled Environment: Speculative trades shift to a more
controlled environment of derivatives market. In the absence of an
organized derivatives market, speculators trade in the underlying
cash markets. Margining, monitoring and surveillance of the
activities of various participants become extremely difficult in these
kinds of mixed markets.
5) Attract Entrepreneurial: An important incidental benefit that
flows from derivatives trading is that it acts as a catalyst for new
entrepreneurial activity. The derivatives have a history of attracting
many bright, creative, well-educated people with an entrepreneurial
attitude. They often energize others to create new businesses, new
productsand new employment opportunities, the benefit of which
are immense.

In a nutshell, derivatives markets help increase savings and investment

in the long-run. Transfer of risk enables market participants to expand
their volume of activity.

1.1.16. Disadvantages of Derivatives

The disadvantages of derivatives are as follows:
) Speculative and Gambling Motives: Since derivatives offer
extremely leveraged position, a large number of participants are
attracted towards the market with nominal capital available with
them. It gives rise to gambling and speculative tendencies. As such
existence
speculation has become the primary purpose of the birth,
and growth of derivatives. Sometimes, these speculative buying and
Selling by professionals and amateurs adversely affect the genuine
producers and distributors.
2)ncreased Bankruptcies: Inherent leverage in derivatives may very
easily cause bankruptcies when one assumesfinancial a position inin

derivatives that is totally out of sync with the position.

Since positions in the tinancial market are taken sequentially
in one

efault may trigger a chain and can cause market failure.

supposed to be efficient tool

ncrease in Risk: The derivatives are

O.risk management in the market. In fact this is also one-sided

 MBA Fourth Semester (Financial Derivatives) Alt
34
observed that the derivatives market
argument. It has been
customized, privately
especially OTC markets, as particularlyare highly risky. Derivatives
managed and negotiated and thus, they in the reduction in risk and
used bythe banks have not resulted are
of risk. They powerful
rather these have risen of new types
leveraged mechanism used to create risk.
derivatives have
of Financial System: It is argued that
4) Instability users but also
for the whole
increased risk not only for their
financial system. The fears of
micro and macro financial crisis
of derivatives which have
have causedto the unchecked growth
losers. The malpractices
turned many market players into big
the users of derivatives have
desperate behavior and fraud by financial
financial markets and the
threatened the stability of the
system.
in derivatives
favor of the
5) Price Instability: Some experts argue and price
that their major contribution is toward price stability
others have doubt about this
discovery in the market whereas some
Rather they argue that derivatives have caused
wild fluctuations in
asset prices and moreover, they have widened
the range of such
fluctuations in the prices. The derivatives may be helpful in price
stabilization only if there existed a properly organized, competitive
and well-regulated market. Further, the traders behave and function
in professional manner and follow standard code of conduct.
Unfortunately, all these are not so frequently practiced in the market
and hence, the derivatives sometimes cause to price instability rather
than stability.
6) Displacement Effect: There is another doubt about the growth
of
the derivatives that they will reduce the volume of the business in
the primary or new issue market specifically for the new and smal
corporate units. It is apprehension that most of investors will diver
to the derivatives markets, raising fresh capital by such units will be
difficult and hence, this will create displacement effect in tne
financial market. However, it is not so
strong argument because
there is no such rigid segmentation of
investors and investo
behave rationally in the market.

7) Burden of Increased Regulatory: Since allow

derivatives allo
accumulation of large position with little capital, the disclosure o
identities and positions taken is imperative. Also derivatives creat
instability' in the financial system as a. result; there. will be more
burdens-on the government or regulatory authorities'to control tne
activities of the traders in financial derivatives..
.
1.1.17. Regulatory Framework of Derivative
Trading in India
Derivatives
Derivatives markets in India can be broadly categorized into two
markets namely:
Derivatives Market

Financial Derivatives Commodities Futures

Markets Market

Regulated Regulated
by by

Forward Market
Commission

SEBI Reserve Bank of lndia

Stock Exchanges Over-the-Counter (OTC)

Figure 1.1: Structure of Derivatives Markets in India