FINANCIAL

DERIVATIVES
AN INTRODUCTION
 What is a Derivative
• A derivative is a financial security with a value that
is reliant upon, or derived from, an underlying asset
or group of assets. The derivative itself is a contract
between two or more parties, and its price is
determined by fluctuations in the underlying asset.
The most common underlying assets
include stocks, bonds, commodities,currencies, 
interest rates and market indexes.
• The term ‘derivative’ indicates that it has no
independent value,ie , its entire value is derived
from the value of the underlying asset.
• In the RBI Act, 1934 (amended in 2006), derivatives have been defined in
Section 45 (U)(a)16 as “ 'derivative' means an instrument, to be settled at
a future date, whose value is derived from change in interest rate, foreign
exchange rate, credit rating or credit index, price of securities (also called
'underlying'), or a combination of more than one of them and includes
interest rate swaps, forward rate agreements, foreign currency swaps,
foreign currency-rupee swaps, foreign currency options, foreign currency-
rupee options or such other instruments as may be specified by the Bank
from time to time.”
• AS per The Securities contracts (regulation) [Act SC(R) A], 1956,
“derivative” includes— (A) 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; (B) a contract which derives
its value from the prices, or index of prices, of underlying securities;
• Let us take the example of a commodity, such as cotton which is the
raw material for the textile industry. It may so happen that the price
of cotton rises before and after the harvest but falls at the time of
harvest. The farmer, who is exposed to such risk of price fluctuations,
can eliminate the risk by selling his harvest at a future date by
entering into a forward, or futures contract. This contract takes place
in the ‘derivatives’ market.
• Derivatives have a similar nature like that of insurance as they protect
against market risks- volatility in interest rates, currency rates,
commodity prices, share prices.
• They offer a range of mechanisms to improve redistribution of risk
which can be extended to every product existing from coffee to
cotton and live cattle to debt instruments.
 WHY DERIVATIVES?
• Increased volatility in global markets.
• Technological changes enabling cheaper communications and computer
power.
• Breakthrough in modern financial theory, providing economic agents a
wider choice of risk management strategies and instruments that optimally
combine the risk and returns over a large number of financial assets.
• Political developments, wherein the role of the government in the
economic arena has become more of a facilitator and less of a prime
mover. The move towards market-oriented policies and the deregulation in
financial markets has led to an increase in financial risk at the individual
participants’ level.
• Increased integration of domestic financial markets with international
markets.
 NEED FOR DERIVATIVES
• They shift risk from ‘those who have it but
may not want to’ to ‘those who have the
appetite and are willing to take it’.
• Price risks can be:
1- market risk
2- Interest rate risk
3-Exchange rate risk
 TRADERS IN DERIVATIVES MARKET
• Hedger: A hedge is a position taken in order to offset the risk associated
with some other position. A hedger is someone who faces risk associated
with price movement of an asset and who uses derivatives as a means of
the means of reducing that risk.
• Speculator: These buy and sell derivatives to make profits and not to
reduce risk. They keep the market going as they bear risks that no one is
willing to take.
• Arbitrageur: A person who simultaneously enters into transactions in two
or more markets to take advantage of the discrepancy between prices in
the market. An arbitrageur would, for example, seek out price
discrepancies between stocks listed on more than one exchange by buying
the undervalued shares on one exchange while short selling the same
number of overvalued shares on another exchange, thus capturing risk-free
profits as the prices on the two exchanges converge.
 ETD vs OTC
•Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated)
directly between two parties, without going through an exchange or other intermediary. Products
such as swaps, forward rate agreements, exotic options – and other exotic derivatives – are
almost always traded in this way. The OTC derivative market is the largest market for derivatives,
and is largely unregulated with respect to disclosure of information between the parties, since
the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds.
Reporting of OTC amounts is difficult because trades can occur in private, without activity being
visible on any exchange.
•Exchange-traded derivatives (ETD) are those derivatives instruments that are traded via
specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where
individuals trade standardized contracts that have been defined by the exchange. A derivatives
exchange acts as an intermediary to all related transactions, and takes initial margin from both
sides of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of
transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which
lists a wide range of European products such as interest rate & index products), and CME
Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board
of Trade and the 2008 acquisition of the New York Mercantile Exchange).
DERIVATIVES- CLASSIFICATION
 FORWARDS
• A forward contract is a customized contract between two
parties where settlemant takes place on a specific date in
future at a price agreed today. They are OTC contracts.
• FEATURES:
-Bilateral contracts where all details such as delivery date,
price, quantity are negotiated bilaterally by parties to the
contract. Hence, they are exposed to party risk.
-Custom designed terms.
-Contract price is not available in public domain.
-Contract has to be settled by delivery of the asset on the
expiry date.
• Forward markets of some goods are highly
developed and have staandardized market
features. Forward contracts are of special use
in case of hedging of foreign exchange
exposures. They have their limitations, but
their dominance in hedging foreign exchange
rate fluctuations make them a popular mode
of payment.
 FUTURES
• It is similar to forwards. They are recognized as the most effective way of risk
hedging. They are OTC contracts.
• A futures contract is a legal agreement to buy or sell a particular commodity or
asset at a predetermined price at a specified time in the future. Futures contracts
are standardized for quality and quantity to facilitate trading on a futures exchange.
The buyer of a futures contract is taking on the obligation to buy the underlying
asset when the futures contract expires. The seller of the futures contract is taking
on the obligation to provide the underlying asset at the expiration date. 
• An oil producer needs to sell their oil. They may use futures contracts do it. This
way they can lock in a price they will sell at, and then deliver the oil to the buyer
when the futures contract expires. Similarly, a manufacturing company may need
oil for making widgets. Since they like to plan ahead and always have oil coming in
each month, they too may use futures contracts. This way they know in advance
the price they will pay for oil (the futures contract price) and they know they will be
taking delivery of the oil once the contract expires.
 OPTIONS
• Options are another common form of derivative. An
option is similar to a futures contract in that it is an
agreement between two parties to buy or sell an asset at
a predetermined future date for a specific price. The key
difference between options and futures is that, with an
option, the buyer is not obligated to "exercise" the
option, while the option seller is obligated to either buy
or sell the underlying asset if the buyer chooses to
exercise the contract. As with futures, options may be
used to hedge or speculate on the price of the
underlying asset.
• Imagine an investor owns 100 shares of a stock worth $50 per share that she believes will rise in
value in the future. However, this investor is concerned about potential risks and decides to
hedge her position with an option. The investor could buy a put option that gives her the right to
sell 100 shares of stock for $50 per share (strike price) until a specific day in the future (expiration
date).
• Assume that the stock falls in value to $40 per share by expiration and the put option buyer
decides to exercise her option and sell the stock for the original strike price of $50 per share. If
the put option cost the investor $200 to purchase, then she has only lost the cost of the option
($200) because the strike price was equal to the price of the stock when she originally bought
the put option. A strategy like this is called a "protective put" because it hedges the stock's
downside risk.
• Alternatively, assume an investor does not own the stock that is currently worth $50 per share;
however, he believes that the stock will rise in value over the next month. This investor could buy
a call option that gives him the right to buy the stock for $50 before or at expiration. Assume that
this call option cost $200 and the stock rose to $60 before expiration. The call buyer can now
exercise his option and buy a stock worth $60 per share for the $50 strike price, which is an initial
profit of $10 per share. A call option represents 100 shares, so the real profit is $1,000 less the
cost of the option for a net profit of $800.
 SWAPS
• These are generally customized arrangements
between counterparts to exchange one set of
financial obligations for another as per tterms
of agreement. Major types of swaps are
currency swaps, interest rate swaps, bond
swaps, coupon swaps, debt-equity swaps.
 WARRANTS AND CONVERTIBLES
• Warrants are a derivative that give the right, but not the
obligation, to buy or sell a security—most commonly an equity—at
a certain price before expiration. The price at which the underlying
security can be bought or sold is referred to as the exercise price
or strike price. Warrants are in many ways similar to options, but a
few key differences distinguish them. Warrants are generally
issued by the company itself, not a third party, and they are traded
over-the-counter more often than on an exchange. Unlike options,
warrants are dilutive. When an investor exercises their warrant,
they receive newly issued stock, rather than already-outstanding
stock. Warrants tend to have much longer periods between issue
and expiration than options, of years rather than months
 OTHER DERIVATIVES
• Through banks and financial institutions,
various new types of derivatives have
emerged to meet the specific needs of their
clients.
• Credit derivatives
• Weather derivatives
• Commodity derivatives
• Idea futures
 BENEFITS OF DERIVATIVES
• Enable hedging and hence reduce risk, which is the prime concern
for financial markets.
• Enhance the liquidity of the underlying asset market. Trading
volume increases.
• They lower transaction costs as compared to actual instruments.
• The prices in the derivative market reflect the perception of market
participants about the future, and lead the prices of the underlying
to the perceived level.
• Provide wide variety of hedging structures and help investors to
adjust the risk and return characteristics of their stock portfolio.
• Provide information on the magnitude and the direction in which
various market indices are expected to move.
 CRITIQUE OF DERIVATIVES
• Promote speculation and gambling motives.
• Increase in risk, as in OTC.
• Instability of financial system.
• Price instability.
• Displacement effect.
• Increased regulatory burden.
DERIVATIVE MARKET IN INDIA- SOME FACTS
• Commodity futures dates back to 1875. Futures trading was banned in 1960s and
70s. It was referred as tezi mandi.
• On march 1,2000, government rescinded the three decade old prohibition on
forward trading.
• You can do derivatives trading in India through National stocks Exchange (the NSE),
Bombay Stocks Exchange (the BSE) in stocks. Similarly, if your interest is to trade in
commodities, MCX and NCDEX are there. The MCX  stands for the Multi Commodity
Exchange. While NCDEX stands for the National Commodity and Derivatives
Exchange.
• Futures trading is permitted in 41 commodities. There are 18 commodity exchanges
in India.
• NSE is the leading stock exchange for equity and derivatives trading.
• Mutual funds can also trade in derivatives for hedging and portfolio balancing ONLY.
• SEBI and RBI are chief regulatory bodies.
THANK YOU!