Derivatives & Risk Management

Unit-II
Chapter – 01
Financial Derivatives: Forward Contracts
Forward Contact: Concept
Forward contract is a simple form of financial derivative instruments. It is an agreement to buy or sell the
specified quantity of an asset at a certain future date for a certain price agreed upon now. A forward
contract is a private agreement between two parties giving the buyer an obligation to purchase
an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. These contracts
are not traded on an exchange.
Most of the forward contracts are traded on the Over-The-Counter market or through telephone dealings.
A forward deal is a contract where the buyer and seller agree to buy or sell an asset or currency at a spot
rate for a specified date in the future (usually up to 60 days). Forward contracts are conducted as a way to
cover (hedge) future movements in exchange rates. The party who agrees to buy the underlying asset is
called to have a ‘long position’ and the other party who agrees to sell the same underlying asset is called
to have a ‘short position’.
The assets often traded in forward contracts include commodities like grain, precious metals, electricity,
oil, beef, orange juice, and natural gas, but foreign currencies and financial instruments are also part of
today's forward markets.
How It Works
If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is
when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to
sell 500 bushels of wheat after the harvest for a fixed price. By locking in the price now, you eliminate the
risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract
entitles you to. However, you might end up overpaying or (hopefully) underpaying for the wheat
depending on the market price when you take delivery of the wheat.
Key Features of Forward Contracts
 Highly customized - Counterparties can determine and define the terms and features to fit their
specific needs, including when delivery will take place and the exact identity of the underlying asset.
 All parties are exposed to counterparty default risk - This is the risk that the other party may not make
the required delivery or payment.
 Transactions take place in large, private and largely unregulated markets consisting of banks,
investment banks, government and corporations.

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Derivatives & Risk Management
 Underlying assets can be stocks, bonds, foreign currencies, commodities or some combination thereof.
The underlying asset could even be interest rates.
 They tend to be held to maturity and have little or no market liquidity.
 Any commitment between two parties to trade an asset in the future is a forward contract.
 It is tailor made contract. So, no exchange board involved in the forward contract.
Determination of Forward Prices
Forward contracts are generally easier to analyze than future contracts because in forward contacts there
are no daily settlement and only a single payment is made at maturity. The following are the assumptions
for the determination of forward prices:
 There are no transaction cost,
 Same tax rate for all the trading profits,
 Borrowing and lending of money at the risk free interest rate,
 Traders are ready to take advantage of arbitrage opportunity as and when arise.
Forward Price for Investment Assets
 Investment asset provides no income: This is the easiest forward contract to value because such assets
do not give any additional income to the holder. These are usually non-dividend paying equity shares
and discounted bonds.
 Investment asset provides known cash income: Forward contracts on such assets which provide known
cash income such as coupon bearing bonds, treasury securities, known dividend etc.
 Investment asset provides known income: In this case, invested asset provides known dividend yield to
the investor, which can be expressed in percentage.
Numerical Sums…

Dr. Meghashree Dadhich

Derivatives & Risk Management
Unit-II
Chapter – 02
Financial Derivatives: Futures Contracts
Future Contract: Concept
The first futures contracts were negotiated for agricultural commodities, and later for natural resources
such as oil. Financial futures were introduced in 1972, and in recent decades, currency futures, interest
rate futures and stock market index futures have played an increasingly large role in the overall futures
markets. The original use of futures contracts was to mitigate the risk of price or exchange rate
movements by allowing parties to fix prices or rates in advance for future transactions.
A futures contract is a standardized contract which can be easily traded between parties other than the two
initial parties to the contract. The parties initially agree to buy and sell an asset for a price agreed upon
today (the forward price) with delivery and payment occurring at a future point, the delivery date.
Because it is a function of an underlying asset, a futures contract is a derivative product. Contracts are
negotiated at futures exchanges, which act as a marketplace between buyers and sellers. The buyer of a
contract is said to be long position holder, and the selling party is said to be short position holder. Futures
are considered to be better as compare to forwards because of the following reasons:
 Standard Volume
 Liquidity
 Counterparty Guarantee by Exchange
 Intermediate Cash Flows
The prime objective of future market is to manage price risk and to achieve insurance against adverse
price changes. Futures position protects against the unfavorable price movements before the due date or
expiration. To facilitate liquidity in futures contracts, the exchange defines certain standard specifications
for a particular contract , including a standard underlying instrument, a standard quantity and quality of
that underlying assets ( to be delivered or cash settled), and a standard timing for such a settlement. If you
have taken position in equity futures, whether long or short, you have to close the position by entering in
an equal and opposite transaction anytime prior to expiry of the contract as there is no delivery of the
underlying assets.
Clearing House Mechanism
Clearing is a fundamental benefit in the futures markets. Long before a trade is cleared through a clearing
house, clearing firms check the financial strength of both parties to the trade, whether they’re a big
institution or an individual trader. They also provide access to trading platforms, where the buyer and

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Derivatives & Risk Management
seller agree on the price, quantity and maturity of the contract. Then, when the contract is cleared by
matching these offsetting (one buy, one sell) positions together, the clearing house guarantees that both
buyer and seller get paid. This offsetting or “netting” process takes risk out of the financial system as a
whole. In other words, clearing house can be defined as entity which is different from the exchange,
although it works closely with the exchange so that day to day operations of the exchange can run
smoothly. Clearing house is integral part of the derivatives market. The following are the important
functions performed by the clearing house:
 As clearing house give guarantee for all the transactions and acts as counterparty for all the
transactions it will never have open positions in the market.
 It ensures that all parties adhere to the system and procedures so that various parties in the market can
do trading smoothly which in turn leads to more confidence of the players on the markets and hence it
increases liquidity in the market.
 It ensures a proper risk management system in place by stipulating that margin is maintained which is
of two types – initial and maintenance margin and hence accounting is done for all the gains and losses
on daily basis and hence chances of default are reduced considerably.
 It ensures that delivery of the underlying asset is consistent in terms of quality, quantity, size etc. so
that there is no confusion among parties, in other words all contracts are standardized.
Hence from the above we can say that clearing house is the backbone of the derivatives market and is very
important for smooth running of the derivatives markets.
Types of Orders
The most common types of orders are market orders, limit orders, and stop-loss orders.
 Market Order: It is an order to buy or sell a security at the prevailing price in the market. It
represents the best price one can get at a point of time. A market order generally will execute at or near
the current bid (for a sell order) or ask (for a buy order) price. However, it is important for investors to
remember that the last-traded price is not necessarily the price at which a market order will be
executed.
 Limit Order: It is an order to buy or sell a security at a specific price or a price better than that. A buy
limit order can only be executed at the limit price or lower, and a sell limit order can only be executed
at the limit price or higher. Thus, a limit order is exemplified when a client may give a broker a price
limit above which he should not buy or below which he should not sell. Example: An investor wants to
purchase shares of ABC stock for no more than $10. The investor could submit a limit order for this
amount and this order will only execute if the price of ABC stock is $10 or lower.

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Derivatives & Risk Management
 Stop-loss Order: A stop-loss order is aimed at closing out positions when a particular price level is
traded. It is the kind of an order when, a client orders his broker to sell shares, if market price falls to a
certain level below the current price. Example – One may have bought shares Rs. 320 each. The price
of the share rises to, Rs. 470 and might rise even further. But sudden price started to decline
consistently. Furthermore, he gave his broker a stop-loss order at Rs. 410; so that he does not lose the
entire profit.
 Buy Stop Order: It is entered at a stop price above the current market price. Investors generally use a
buy stop order to limit a loss or protect a profit on a stock that they have sold short. A sell stop order is
entered at a stop price below the current market price. Investors generally use a sell stop order to limit
a loss or protect a profit on a stock they own.
 Stop-Limit order: It is said to be placed when, for example, a client can place a stop limit order at a
particular level with a limit beyond which the market would cease to be chased. Example – sell 3188
limit 82, the broker to look to sell the position once the market declines and trades at 3188, but he
would not sell below 3182.
 All or None (AON): A limit order either to buy or to sell a security in which the broker is directed to
attempt to fill the entire amount of the order or none of it. An all-or-none order differs from a fill-or-
kill order in that, with an all-or-none order, immediate execution is not required.
 Fill-or-Kill: This is an order to a broker to buy or sell a security or derivative immediately. If the
order is not executed once, it is treated as withdrawn or automatically canceled.
 GTC (Good till Canceled): A variant of a limit order either to buy or to sell a security, this order
remains in effect until it is canceled by the customer or executed by the broker.
 Market-If-Touch (MIT): A MIT order is an order to execute a transaction at the best available price,
when the market reaches at price specified by the investor.
 Market-on-Close (MOC): This type of order is an instruction to the broker to execute the order at the
time when market is about to close at best possible price.
 Hot Held Order: This is a type of order where the broker gives a discretion to wait to buy if he feels
that the prices will go further down or wait to sell is he feels that the prices will go further up.
Margins
A margin in the futures market is the amount of cash an investor must put up to open an account to start
trading. This cash amount is the initial margin requirement and it is not a loan. It acts as a down payment
on the underlying asset and helps ensure that both parties fulfill their obligations. Both buyers and sellers
must put up payments. This margin has to be deposited at the time of entering into the contract. The basic

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objective of margin is to provide a financial safeguard for ensuring that the investor will perform their
contract’s obligation at the time of maturity. The following are the types of margin:
 Initial Margin: This is the initial amount of cash that must be deposited in the account to start trading
contracts. It acts as a down payment for the delivery of the contract and ensures that the parties honor
their obligations. This margin will approximately be equal to 5% of the contract value. The initial
margin could be returned to the party after due completion of all obligations associated with trader’s
future position.
 Maintenance / Minimum Margin: This is the balance a trader must maintain in his or her account as
the balance changes due to price fluctuations. It is some fraction - perhaps 75% - of initial margin for a
position. If the balance in the trader's account drops below this margin, the trader is required to deposit
enough funds or securities to bring the account back up to the initial margin requirement. Such a
demand is referred to as a margin call. The trader can close his position in this case but he is still
responsible for the loss incurred. However, if he closes his position, he is no longer at risk of the
position losing additional funds.
 Variation Margin: This is the amount of cash or collateral that brings the account up to the initial
margin amount once it drops below the maintenance margin. If the investor fails to deposit variation
margin, the broker closes out the position by selling the contract.
Mark-to-Market
Margins are adjusted every day depending on the profit made on the days’ long and short position. This
mechanism is called ‘mark-to-market’. Mark-to-market or fair value accounting refers to accounting for
the "fair value" of an asset or liability based on the current market price, or for similar assets and
liabilities, or based on another objectively assessed "fair" value. This concept will be better explained by
using an example to compute the margin balance. Let's start with a future's price of $200. The initial
margin requirement is $10 and the maintenance margin is $6. The trader buy five contracts and deposits
$50 (5 contacts x $10)
Day 0 - The ending balance is $50.
Day 1 - The price moves to $199.50. The adjustment that needs to be made is -$2.50 (200-199.5 x 5
contracts). The ending balance is now $47.50 ($50 - 2.50). Since this is above the maintained margin
($30) no funds need to be added to the account.
Day 2 - The price moves down to $195. The loss, based on five contracts, is $22.50, so the account
balance is $25. This is below the maintenance margin. The trader will receive a margin call and will
need to deposit $25 into the account to bring it back up to the initial margin requirement.
Numerical Sums….

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Derivatives & Risk Management
Index Future Contracts
Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures
Contracts. For example: futures contract on NIFTY Index and BSE-30 Index. These contracts derive their
value from the value of the underlying index. Index futures are the future contracts for which underlying is
the cash market index. For example: BSE may launch a future contract on "BSE Sensitive Index" and NSE
may launch a future contract on ‘S&P CNX NIFTY’.
Popular Indices in India
• BSE-30 Sensex
• BSE-100 Natex
• BSE-200
 BSE-200 Dollex
• S&P CNX Nifty
• S&P CNX Nifty Junior
• S&P CNX Defty
• S&P CNX Midcap
• S&P CNX 500
BSE-30 Sensex: The BSE 30 or simply the SENSEX is a free-float market-weighted stock market
index of 30 well-established and financially sound companies listed on Bombay Stock Exchange. The 30
component companies which are some of the largest and most actively traded stocks are representative of
various industrial sectors of the Indian economy. The purpose of BSE is quantifying the price movements
as also the sensitivity of the market in an effective manner. The sensex is calculated every minute and
displayed continuously during trading hours.
BSE-100 Natex: After the introduction of sensex in January 1986, another index was launched in January
1989 in the form of BSE National Index of Equity Prices with the base year as 1983-84, comprising 100
scrips of financially sound companies listed on the country’s five major stock exchanges at Mumbai,
Kolkata, Delhi, Ahmedabad and Chennai. This index enabled the assessment of stock price movements on
a national level.
BSE-200: BSE-200 Index was launched on May 27, 1994 on full market capitalization method. The equity
shares of 200 selected companies from the specified and non-specified lists of BSE were considered for
inclusion in the sample for `S&P BSE 200'. The selection of companies was primarily been done on the
basis of current market capitalization of the listed scrips. Moreover, the market activity of the companies
as reflected by the volumes of turnover and certain fundamental factors were considered for the final
selection of the 200 companies. The purpose of the index is to quantify price movements and monitor
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Derivatives & Risk Management
sensitivity of the market. The rapid growth in the market created need for a new broad-based index series
reflecting the market trends in a more effective manner and providing a better representation of the
increased equity stocks, market capitalization as also to the new industry groups.
BSE-200 Dollex: All BSE indices reflect the growth in the market value of the constituent stocks over the
base period in Rupee terms. A need was felt to design a yardstick by which these growth values are also
measured in Dollar terms. Such an index would reflect, in one value, the changes in both the stock prices
and the foreign exchange variation. This was facilitated by the introduction of a dollar-linked index in
which the formula for calculation of the index is suitably modified to express the current and the base
market values in dollar terms. The scope for the dollar-linked index emerged from the background of the
Indian equity markets increasingly getting integrated with the global capital markets and the need to assess
the market movements in terms of international benchmarks. The dollar-linked indices are useful to
overseas investors, as it helps them measure their ‘real returns’ after providing for the exchange rate
fluctuations. For construction of this index, equity shares of 200 companies selected on the basis of their
market capitalization. The index is constructed taking the year 1989-90 as the base. The index is
constructed on the weighted aggregative basis, with the number of equity shares outstanding as weights. It
was conceived as the ‘new broad based index series’ reflecting the present market trends in a more
effective manner and providing a better representation of the increased equity stocks, market capitalization
as also the newly emerged industry groups.
S&P CNX Nifty: A stock index endorsed by Standard & Poor's and composed of 50 of the largest and
most liquid stocks found on the National Stock Exchange (NSE) of India. It is commonly used to
represent the market for benchmarking Indian investments. The S&P CNX Nifty tracks the behavior of a
portfolio of blue chip companies, the largest and most liquid Indian securities. It includes 50 of the
approximately 935 companies listed on the NSE, captures approximately 60% of its equity market
capitalization and is a true reflection of the Indian stock market. The S&P CNX Nifty covers 22 sectors of
the Indian economy and offers investment managers exposure to the Indian market in one efficient
portfolio. The index has been trading since April 1996 and is well suited for benchmarking, index funds
and index based derivatives.
S&P CNX Nifty Junior: It represents the next rung of liquid securities after the NIFTY 50. It consists of
50 companies representing approximately 10% of the traded value of all stocks and has a market
capitalization of at least Rs. 2 billion on the National Stock Exchange of India. It was introduced on
January 1, 1997 with a base date as November 4, 1996 and base value as 1000. The S&P CNX Nifty
Junior index is intended to be a representative bench-mark to measure the performance of stocks in the
medium capitalization range.
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Derivatives & Risk Management
S&P CNX Defty: The S&P CNX Defty is a U.S. dollar-denominated index based on the S&P CNX Nifty.
This index has been developed to provide a benchmark to the international investors, providing them with
an instrument for measuring returns on their equity investment in dollar terms. While the underlying S&P
CNX Nifty is calculated in Indian rupees, the S&P CNX Defty is calculated and denominated in U.S.
dollars. This ensures that the risk arising out of currency fluctuation is covered through the S&P CNX
Defty. If the S&P CNX Defty rises by 2%, it means that the Indian stock market rose by 2%, measured in
dollars.
S&P CNX Midcap: The medium capitalized segment of the stock market is being increasingly perceived
as an attractive investment segment with high growth potential. The primary objective of the CNX Midcap
Index is to capture the movement and be a benchmark of the midcap segment of the market. The CNX
Midcap Index represents about 13.86% of the free float market capitalization of the stocks listed on NSE
as on March 31, 2015.
S&P CNX 500: An index consisting of 500 stocks chosen for market size, liquidity and industry group
representation, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities,
and it is meant to reflect the risk/return characteristics of the large-cap universe. It is a market-cap index
representing 500 leading companies in leading industries in U.S. in large cap blue chip stocks
Benefits of Trading in Derivatives
When managed properly, derivative products can be efficient, powerful financial tools that enhance
stability of business operations. They also can allow money managers the opportunity to structure an
institution's balance sheet to help achieve desired objectives in almost any economic environment.
Derivatives are useful for hedging the risks normally associated with commerce and finance. Farmers can
use derivatives to hedge the risk that the price of their crops falls before they are harvested and brought to
market. Banks can use derivatives to reduce the risk that the short-term interest rates they pay to their
depositors will rise against the fixed interest rate they earn on their loans and other assets. Pension funds
and insurance companies can use derivatives to hedge against large drops in the value of their portfolios.
Hedging
Hedging is defined as reducing exposure to risk of loss resulting from fluctuations in exchange rates,
commodity prices, interest rates etc. Hedgers participate in the derivatives market to lock the prices at
which they will be able to do the transaction in the future. Thus they are trying to avoid the price risk.
Hedging is buying and selling futures contracts to offset the risks of changing underlying market prices.
Arbitrage
Arbitrage is possible when one of three conditions is met • The same asset does not trade at same price on
all markets • Two assets with identical cash flows do not trade at the same price • An asset with a known
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Derivatives & Risk Management
price in future does not trade today at its future price discounted at risk free interest rate Arbitrators watch
the spot and futures markets and whenever they spot a mismatch in the prices of the two markets they
enter to get the extra profit in a risk-free transaction.
Speculation
Speculators participate in the futures market to take up the price risk, which is avoided by the hedgers.
Speculation is more commonly used by hedge funds or traders who aim to generate profits with only
marginal investments, essentially placing a bet on the movement of an asset. Leverage the use of various
financial instruments or borrowed capital, such as margin, to increase the potential return of an
investment. Leverage can be created through options, futures, margin and other financial instruments. For
example, say you have Rs. 5,000 to invest. This amount could be invested in 10 shares of ABC Limited,
but to increase leverage, you could invest Rs 5,000 in five options contracts. You would then control 500
shares instead of just 10.

Dr. Meghashree Dadhich