What are derivatives?

• A derivative is a financial instrument whose

value depends on – is derived from – the value
of some other financial instrument, called the
underlying asset

• Common examples of underlying assets are

stocks, bonds, exchange rate, oil price, corn,
pork, wheat, rainfall etc.
 How does it work?
• Just pay an upfront margin, which is
decided by the stock exchanges and
which varies periodically, and take a
“leveraged” position for one, two or three
months. In case the stock moves up, you
get the profit margin. In case the stock
goes down, you might loose the entire
margin money or even more in case the
net loss exceeds the margin money.
 Basic purpose of derivatives
• The main purpose of derivatives is to transfer risk
from one person or firm to another, that is, to
provide insurance
• In derivatives transactions, one party’s loss is
always another party’s gain
• If a farmer before planting can guarantee a certain
price he will receive, he is more likely to plant
• Derivatives improve overall performance of the
economy
 FACTORS DRIVING THE GROWTH OF
DERIVATIVES
• Increased volatility in asset prices in financial
markets
• Increased integration of national financial
markets with the international markets,
• Marked improvement in communication
facilities and sharp decline in their costs
 The need for a derivatives market
 
• They help in transferring risks from risk averse people to
risk oriented people

• They catalyze entrepreneurial activity

• They increase the volume traded in markets because of

participation of risk averse people in greater numbers

• They increase savings and investment in the long run

 
 DERIVATIVE PRODUCTS
Forwards

Futures

Options

Swaps
 PARTICIPANTS IN THE DERIVATIVES
MARKETS

HEDGERS

SPECULATORS

ARBITRAGEURS
 Forward Contract

A forward contract is a simple derivative that involves an

agreement to buy/sell an asset on a certain date at an
agreed price. This is a contract between two parties:
Buyers and sellers

Money
Buyer Seller
Seller
Buyer
Security
Who takes a Who takes a
long position short position
 Future Contracts
A future contract is a standardized forward contract
between two parties where one of the parties
commits to sell and the other to buy a stipulated
quantity of a security or an index at an agreed price on
or before a given date in the future.

Seller Buyer
A B

(Buyer)
Clearing
ClearingHouse
House (Seller)
 Futures v/s Forwards
• Exchange traded & transparent v/s Private
contracts
• Standardised v/s Customised
• Settlement through Clearing House v/s Settlement
between Buyers and Sellers
• Require margin payment v/s no margins
• Mark - to - Market margins v/s no margins
• Counter - party risk is absent in Futures
(settlement of trades is guaranteed)
• Most settled by offset and very few by delivery v/s
most settled by actual delivery.
 OPTION

An option is a contract which gives the right, but not the obligation, to buy
or sell the underlying at a stated date and at a stated price.

Underlying assets

Individual Stock Indices

Introduced on 2.7.2001 S & P CNX Nifty (introduced

on 4.6.2001 in NSE)
 Option

Call option Put option

Option Type Buyer of option Seller of option

(option holder) (option writer)
(a) Call Right to buy obligation to sell
(b) Put Right to sell obligation to buy
 SWAP

A SWAP transaction is one where two or more parties exchange (SWAP) one set of
predetermined payments for another.

Interest Rate SWAP.

Company Fixed (%) Floating (%)

A 7.5 M IBOR + 0.5%

B 9 M IBOR + 3.5%
A borrows Rs. 10,000 from a bank at Floating rate
B borrows Rs. 10,000 from a bank at Fixed rate
As a separate transaction A and B agree as follows:

(i) A will pay B a fixed rate of 7%

(ii) B will pay A a floating rate of MIBOR + 0.5%
 SWAP
A
loan rom bank (%)
(7%) (MIBOR + 0.5%)

B
To understand the benefits from the swap consider the net cash flows of A and B
Party Swap Swap Outflows on Bank Loan Total
Outflow (%) Inflow(%)
A -7 (MIBOR + 0.5%) -(MIBOR + 0.5%) - 7
B - (MIBOR + 0.5%) + 7% - 9% - (MIBOR+2.5)
It may be seen that the net result is
(a) For A, a fixed rate obligation at 7% (this is better than the 7.5% which A
would have paid if it had directly taken a fixed rate loan).
(A gains 0.5%)

(b) For B, a floating rate obligation at MIBOR + 2.5% (this is better then
MIBOR + 3.5%)
(B gains 1%)
• Hedgers use futures or options markets to reduce or eliminate
the risk associated with price of an asset.

• Speculators use futures and options contracts to get extra

leverage in betting on future movements in the price of an
asset. They can increase both the potential gains and potential
losses by usage of derivatives in a speculative venture.

• Arbitrageurs are in business to take advantage of a

discrepancy between prices in two different markets.