Is derivative market beneficial for

all? How it can be beneficial for

import - export trading?
 Contents
• Introduction- What is derivatives??
• Type of Derivatives
    (i) forwards
    (ii) futures
    (iii) options
     (iv) swaps
• Purpose of derivative market
• Benefits of Derivative markets
• Derivatives markets in india
• Criticism to Derivative market
• Benefits to import-export trading
• Conclusion
 Introduction
 The liberalized policy being followed by the Government of India and the
gradual withdrawal of the procurement and distribution channel necessitated
setting in place a market mechanism to perform the economic functions of price
discovery and risk management.
 To reduce this risk, the concept of derivatives comes into the picture.
Derivatives are products whose values are derived from one or more basic
variables called bases .
 India is traditionally an agriculture country with strong government
intervention. Government arbitrates to maintain buffer stocks, fix prices, impose
import-export restrictions, etc. This paper focuses on the basic understanding
about derivatives market and its development in India.
 What is Derivatives ?

 Derivatives are financial contracts whose values are derived from the
value of an underlying primary financial instrument, commodity or index, such
as: interest rates, exchange rates, commodities, and equities.
 Derivatives include a wide assortment of financial contracts, including
forwards, futures, swaps, and options.
 The International Monetary Fund defines Derivatives as "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. The value of financial derivatives derives from the
price of an underlying item, such as asset or index. Unlike debt securities, no
principal is advanced to be repaid and no investment income accrues."
 Types of Derivatives
(1) Forward Contracts: -

A forward contract is an agreement between two parties – a buyer and a seller

to purchase or sell something at a later date at a price agreed upon today and without
the right of cancellation

(2) Future Contracts: -

A futures contract is an agreement between two parties – a buyer and a seller –

to buy or sell something at a future date. The contact trades on a futures exchange
and is subject to a daily settlement procedure.

(3) Options Contracts: -

It is of two types: -

(i) Calls: -

. Calls give the buyer the right but not the obligation to buy a given quantity of
the underlying asset, at a given price on or before a given future date.
 Types of Derivatives contd..
(ii) Puts give the buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.

(4) Swaps: -

Swaps are private agreements between two parties to exchange cash flows in the future
according to a prearranged formula. They can be regarded as portfolios of forward contracts.

The two commonly used swaps are interest rate swaps and currency swaps.
(i) Interest rate swaps involves swapping only the interest related cash flows between the
parties in the same currency.

(ii) Currency swaps entail swapping both principal and interest between the parties, with the
cash flows in one direction being in a different currency than those in the opposite direction.
 The need for a derivatives market

• Changes in interest rates and equity markets around the world

• Currency exchange rate shifts
• Changes in global supply and demand for commodities such as agricultural products,
precious and industrial metals, and energy products such as oil and natural gas .
• Help in transferring risks from risk adverse people to risk oriented people
• Help in the discovery of future as well as current prices They increase the volume
traded in markets because of participation of risk adverse people in greater
numbers.
• They increase savings and investment in the long run
 Benefits of Derivative market
• The two most widely recognized benefits attributed to derivative instruments
are price discovery and risk management. 

1. Price Discovery: -
• Futures market prices depend on a continuous flow of information from around
the world and require a high degree of transparency
• A broad range of factors (climatic conditions, political situations, debt default,
refugee displacement, land reclamation and environmental health, for example) impact
supply and demand of assets (commodities in particular) – and thus the current and
future prices of the underlying asset on which the derivative contract is based.
 1.Price Discovery
• With some futures markets, the underlying assets can be geographically
dispersed, having many spot (or current) prices in existence. The price of the
contract with the shortest time to expiration often serves as a proxy for the
underlying asset.
• Second, the price of all future contracts serve as prices that can be
accepted by those who trade the contracts in lieu of facing the risk of
uncertain future prices.
•   Options also aid in price discovery, not in absolute price terms, but in the
way the market participants view the volatility of the markets. This is because
options are a different form of hedging in that they protect investors against
losses while allowing them to participate in the asset's gains. 
2. Risk Management
Risk management is the process of identifying the desired level of risk, identifying
the actual level of risk and altering the latter to equal the former. This process can fall into
the categories of hedging and speculation. 

Hedging has traditionally been defined as a strategy for reducing the risk in holding a
market position

Speculation referred to taking a position in the way the markets will move. Today,
hedging and speculation strategies, along with derivatives, are useful tools or techniques that
enable companies to more effectively manage risk. 
 Other benefits
3. They Improve Market Efficiency for the Underlying Asset
• If the cost of implementing these two strategies is the same, investors
will be neutral as to which they choose.
• If there is a discrepancy between the prices, investors will sell the
richer asset and buy the cheaper one until prices reach equilibrium. In this
context, derivatives create market efficiency. 

4. Derivatives Also Help Reduce Market Transaction Costs

• Derivatives are a form of insurance or risk management, the cost of
trading in them has to be low or investors will not find it economically sound to
purchase such "insurance" for their positions
 Derivatives Market in India

• Derivatives markets have had a slow start in India. The first step
towards introduction of derivatives trading in India was the promulgation of
the Securities Laws (Amendments) Ordinance, 1995, which withdrew the
prohibition on options in securities.
• SEBI set up a 24-member committee under the Chairmanship of Dr. L.C.
Gupta on 18th November 1996 to develop appropriate regulatory framework
for derivatives trading in India.
• SEBI was given more powers and it starts regulating the stock
exchanges in a professional manner by gradually introducing reforms in trading.
• Derivatives trading commenced in India in June 2000 after SEBI
granted the final approval in May 2000.
 Derivatives Market in India

• SEBI permitted the derivative segments of two stock exchanges, viz

NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivative contracts.
• Index futures on CNX Nifty and BSE Sensex were introduced during
2000. The trading in index options commenced in June 2001 and trading in
options on individual securities commenced in July 2001.
• Futures contracts on individual stock were launched in November 2001.
• June 2003, SEBI/RBI approved the trading in interest rate derivatives
instruments and NSE introduced trading in futures contract on June 24, 2003
on 91 day Notional T-bills.

• . Derivatives contracts are traded and settled in accordance with the

rules, bylaws, and regulations of the respective exchanges and their clearing
house/corporation duly approved by SEBI and notified in the official gazette.
 Criticisms of Derivatives
• Options offer the potential for huge gains and huge losses. While
the potential for gain is alluring, their complexity makes them
appropriate for only sophisticated investors with a high tolerance for
risk.  

(1) When a derivative fails to help investors achieve their objectives, the
derivative itself is blamed for the ensuing losses when, in fact, it's
often the investor who did not fully understand how it should be used,
its inherent risk, etc. 

(2) Some view derivatives as a form of legalized gambling enabling users

to make bets on the market.
 Criticisms of Derivatives
• Lifespan - Derivatives are "time-wasting" assets. As each day passes and the
expiration date approaches, you lose more and more "time" premium and the
option's value decreases.
• Direction and Market Timing - In order to make money with many derivatives,
investors must accurately predict the direction in which the market or index will
move (up or down) and the minimum magnitude of the move during a set period of
time. A mistake here almost guarantees a substantial investment loss. 
• Costs - The bid/ask spreads of more common derivatives such as options can be
daunting. An option with a bid of 5.25 and an ask of 5.875 means an investor could
buy a round lot (100 units) for Rs. 587.50 but could only sell them for Rs 525,
resulting in an immediate loss of Rs 61.50 before factoring in commissions. 
•
Interest Rate Exposure
Interest Rate Derivatives – instruments used to manage
interest rate risk
– Interest Rate Swaps
– Interest Rate Futures
– Interest Rate Options
• Interest Rate Cap - ensures a floating rate loan receives a
ceiling if interest rates rise
• Interest Rate Floor - a hedge against rates dropping below a
certain level
• Interest Rate Collar - combo of Cap and Floor that effectively
locks in a range for its borrowing costs
– Forward Rate Agreement (FRA)
 FX Rate Exposure
• Types of FX Exposure
– Economic Exposure - long term effect of exchange
rate changes on present value of future cash flows
– Transaction Exposure- balance sheet exposed to
foreign exchange rates
– Translation Exposure - foreign subsidiaries or
operations exposed when converting currency to
parent’s home currency
• Currency derivatives used to manage FX rate risk
 FX Rate Exposure
• FX Derivatives:
– Currency or FX Forwards - commitment to buy foreign
currency at a future date.
– Currency Futures - Similar to forwards but traded on
the exchange and standard contract.
– Currency Swaps - exchange of floating rate cash flow
in one currency for fixed in another currency.
– Currency Options - right to buy or sell fixed amount of
foreign currency at a fixed exchange rate, on or
before specified date.
 Commodity Price Exposure
• Price Exposure- potential for changes in price
of commodity
• Delivery Exposure- regular supply of
commodity is crucial
• Exposure hedged by forwards, futures, swaps
and options
 Derivative Instruments
• Forwards
– Contracts between two parties that require specific
action at a later date at a price agreed upon today
– Future Date = Maturity Date
– Contract Price = Delivery price
– Not traded on an organized exchange
– The buyer is in a long position, the seller is in a short
position
– Long position gains value when the price rises and
loses when the price falls
• Futures
Derivative Instruments
– Same as Forward, but traded on organized exchanges
• Chicago Board of Trade (grains, metals, financials)
• Chicago Mercantile Exchange (livestock, wood,
meat)
• International Money Market (foreign currency
futures)
• New York Mercantile Exchange (metals,
petroleum, fiber)
– Requires a margin account
 Derivative Instruments
• Swaps - Agreement to exchange a set of cash
flows at a future point in time
– Interest rate swap most common type of swap. One
party swaps its floating interest rate for a fixed rate
and vice versa
– Allows Companies with weaker credit ratings to get
better rates
– Other types include currency and commodity swaps
 Derivative Instruments
• Options - Contract between two parties where the buyer has the right to buy
or sell a fixed amount of underlying asset at a fixed price on or before a
specified date
– Call Option: the contract allows the owner to buy the asset at a fixed price
– Put Option: the owner has the right to sell the asset at a fixed price
– Fixed price is the strike/exercise price of contract
– Possible relationships between premium and strike price:
 At-the-money→ asset price = strike price
 Call Out-of-the-Money →asset price less than strike price
 Put Out-of –the-Money → asset price greater than strike price
 Call In-the-Money → asset price greater than strike price
 Put In-the-Money → asset price less than strike price