Derivatives : Managing

Financial Risk
 Definition
• A security derived from a debt instrument,
share, secured/unsecured loan, risk
instrument or any other form of security.

• A contract that derives its value from the

prices/index of prices of underlying
securities.
 Variants
• Forwards

• Futures

• Options
 Participants
• Hedgers : Face risk with the price
associated with an asset.

• Speculators : Wish to bet on future

movements in the price of an asset.

• Arbitrageurs : To take advantage of a

discrepancy between prices in two
different markets.
Economic Functions of Derivatives
• Prices in an organised derivative market
reflect the perception of the market
participants about the future and lead the
prices to a perceived future level.
• Helps to transfer risk from those who have
them and may not like them to those who
have an appetite for them.
• Are linked to the underlying cash markets.
• Speculative trades shift to a more
controlled environment of derivatives
market.
• It acts as a catalyst for new
entrepreneurial activity.
• Help increase savings and investment in
the long run. Transfer of risk enables
market participants to expand their volume
of activity.
 Forward Contract
• A agreement to buy or sell an asset on a
specified date of a specified price.

• Normally traded outside stock exchanges.

• They are popular in the Over the Counter

(OTC) market.
• They are bilateral contract and hence
open to counterparty risk.
• Each contract is customer designed and
hence unique.
• The asset is price is not generally
available in public domain.
• On expiry date the contract has to be
settled by delivery of the asset.
• If a party wishes to reverse, it has to go
compulsorily to the same counterparty.
 Limitations of FCs
• Lack of centralisation of trading.

• Counterparty risk (default of any one party

to the transaction)
 Futures/Future Contracts
• Designed to solve problems that exist in the
Forward Markets:
• An agreement between two parties to buy or sell
an asset at a certain time in the future, at a
certain price.
• But, unlike forward contracts, future contracts
are standardised and stock-exchange traded.
• A futures contract may be offset prior to maturity
by entering into an equal and opposite
transaction.
 Distinction between Future and
Forwards
Futures Forwards
1. Traded on an 1. Over the counter in
organised stock nature.
exchange.
2. Standardised 2. Customised contract
contract terms, terms, hence, less
hence more liquid. liquid.
3. Requires margin 3. No margin payment.
payments. 4. Settlement happens
4. Follows daily in the end of the
settlement. period.
 Options/Options Contracts
• Options are fundamentally different from forward
ad future contracts.
• It gives the holder the right to do something.
• The holder need not necessarily exercise this
right.
• In F & F contracts the two parties have
committed themselves to do something.
• It costs nothing (except margin payments) to
enter into a F & F contract; the purchase of an
Option requires an upfront payment.
 Difference between Futures and
Options
Futures Options

1. Exchange traded 1. Same as futures

with novation
2. Exchange defines 2. Same as futures
the product 3. Strike price is fixed,
3. Price is zero, strike price moves.
price moves
4. Price is always
4. Price is zero positive.
5. Linear payoff 5. Non linear payoff
6. Both long and short 6. Only short at risk
at risk
Pay off for Buyer of Futures: Long
Futures
• The pay offs for a person who buys a futures
contract is similar to the pay off for a person who
holds an asset. He has potentially unlimited
upside as well as downside. Take the case of a
speculator who buys a two month Nifty index
futures contract when the Nifty stands ant 1220.
The underlying asset in this case is the Nifty
portfolio. When the index moves up, the long
futures position starts making profits and when
index moves down it starts making losses.
 Pay off for Seller of Futures: Short
Futures
• The pay off for a person who sells a futures
contract is similar to the pa off for a person who
shorts an asset. He has potentially unlimited
upside as well as downside. Take the case of a
speculator who sells a two month Nifty index
futures contract when the Nifty stands at 1220.
The underlying asset in this case is the Nifty
portfolio. When the index moves down, the short
future position starts making profits and when
the index moves up, it starts making losses.
 Illustration 1
• On January 15, X bought a January Nifty
futures contract that cost him Rs.5,38,000.
For this he had to pay an initial margin of
Rs.43,040 to his broker. Each Nifty futures
contract is for the delivery of 200 Nifties.
On January 25, the index closed at 2,720.
How much profit/loss did he make?
 Solution 1
• X bought one futures contract costing
Rs.5,38,000. At a market lot of 200, this
means he paid Rs.2,690 per Nifty future.
On the futures expiration day, the futures
price converges to the spot price. If the
index closed at 2,720 this must be the
futures close price as well. Hence, he
would have made profit (Rs.2,720 –
Rs.2,690)X200 = Rs.6,000.