DERIVATIVES

MARKETS
 AGENDA
 Introduction
 Concept of derivatives,
 History of Derivatives Trading
 Types of Derivatives
 Forward, Futures , Option , Swaps
 Difference between futures, options, forwards & Badla
contracts.
 Uses of Derivatives
 Benefits of Derivatives Trading
 Global Derivatives Market
 Indian Derivatives Market
 Case 1
 Suppose You require Gold in January 2009
 The Current Price (Dec.2008)of Gold is Rs
12500 per 10 gram.
 You are of the fear that by the January the
price of Gold will reach Rs 12800.
 You approach to Goldsmith who offer you to
buy Gold in January @Rs 12600 from him.
 Case 1 contd..
 Here the Price is determined today i. e (for
December Future Delivery in January).
 So from the Current price of Gold we have
derived the price of January. It is called
Derivative.
 Here Derivative is Gold January Contact.
Case -2
 Suppose there are two Companies A & B
 A is Indian Importer and B is USA based Exporter.
 A import some goods worth US $ 1 Million from B on
Credit.
 Payment will be made after 90 days.
 Since Payments are to be made after a period of time
i. e after 3 months, Currency price might fluctuate by
that time.
 Due to these fluctuation in Exchange Rate( US $/Rs)
Importer might have to pay more in terms of Rupees.
Case -2 contd….
 Current (Spot) exchange Rate between US $ and
rupee is Rs 42/$.
 After 90 days chances of exchange rate is Rs 45/$.
 This rise means now cost of deal to importer will be
Rs 45 million.
 A approach to Citi Bank that promise to give 1
million US $ @ Rs 43.50 after 90 days
 This Rs 43.50 is derived from the Current( Spot)
price of the US $ v/s Rs.
 Introduction

Risk is a characteristics feature of all

commodity and capital markets. Prices of all
commodities – be they agricultural like wheat,
cotton, rice, coffee or tea or non-agricultural like
silver, gold etc. are subject to fluctuations over
the time in keeping with prevailing demand and
supply conditions.
The last two decades has witnessed the multiple
growths in volume of international trade and
business due to the wave of globalization and
liberalization all over the world.
 In this respect, changes in interest rates, exchange
rates, stock market prices at different financial
markets increased the financial risk to the corporate
world.
 So management of such risk is very much
important in the world of uncertainty. Derivatives are
the solution to the problem of uncertainty and
volatility.
Derivative- Concept
 To derive something from something.
 A product whose price depends upon the
underlying Assets.
 A Contact which does not have any
Independent value, its value is derived from
the other( underlying Asset)
 The Underlying assets can be Commodity,
Financial Assets, Currency, Interest Rate
bearing Security, Index etc.
Derivatives Defined….
 Derivative is a security or contract designed in
such a way that its price is derived from the price
of an underlying assets.
 For example, the price of Gold to delivered in
December will depend or derived from the price of
Gold that is prevailing today in the market.
 Derivatives indicates that it has no independent
value, i. e its value is entirely derived from the
value of the underlying assets.
 Financial Derivatives
 Financial derivative is financial instruments
whose value is derived from the value of an
underlying financial asset or instrument.
 The financial assets or instrument can be
Stock, currency, Debt security, Index etc.
 SCRA Definition
 SCRA ( Securities Contract Regulation Act
1956) defines derivatives as..
 Derivatives includes:-
1. Security derived from a debt instrument, shares,
loan whether secured or non-secured, risk
instrument or any other form of security
2. A contact which derives its value from the prices,
or Index of prices of underlying securities.
 Underlying Assets of
Derivatives Contract
 Commodities including grain, coffee beans, orange
juice
 Precious metals like gold and silver
 Foreign exchange rate
 Bonds of different types, including medium to long
term negotiable debt securities issued by
governments, companies, etc.
 Short term securities such as T-bills ,: and
 Over- the Counter (OTC) money market products
such as loans or deposits.
History of Derivatives
 The 1970 constituted a watershed in
financial history, because of the fixed
exchange rate regime (the Bretton
woods system) that had operated
since the 1940’s broke down
 When Bretton Wood system collapsed in the
early 1970s, a regime of fixed exchange rates
gave way to a financial environment in which
exchange rates were constantly changing in
response to the pressures of demand and
supply. Currency derivatives developed in
response to the need to manage those risks.
They also provide a motivation those willing to
take risk and earn profit from such situation.
 The new found instability was not limited to
currency markets. Short term interest rates also
become prone to fluctuations. So, from the
1970s short term interest rates become more
volatile than they had previously been. This
increased instability of short term interest rates
had implications for long term interest rates and
hence bond prices fluctuates. This in turn
involves greater risk for both the issuer and
investors.
 Types of Derivatives
A) Commodity Derivatives
B) Financial Derivatives
Types of Financial Derivatives

Financial Derivatives

Options
Forward Futures Swaps

Equity Futures Index Futures Currency Futures Interest Rate Futures

 Other Categorization of
Derivatives Products
 Exchange traded derivatives: Derivatives traded on the regulated
exchanges are highly standardized, (example - exchange traded
futures & options).
 Options & Futures contracts are standardized. In other words, the
parties to the contracts do not decide the terms of futures/option
contracts; but they merely accept terms of contracts standardized by
the Exchange.
 Exchange traded derivatives offer the maximum protection to the
investor as they are regulated by SEBI, FMC and respective stock
exchanges.
 Over-the-counter derivatives: It includes tailored financial
derivatives, such as Forward, swaps, swaptions, that are traded in
the offices of the world's leading financial institutions. These
contracts are customized. In other words, the terms of OTC
contracts are individually agreed between two counter-parties.
 Forward Contact
 Forward Contract is a agreement to buy or
sell a specified quantity of an asset at a
certain future date for a price agreed upon
now.
 It is private contract between the parties to
trade underlying financial assets at some
future date at a stated price and Quantity.
 Features of a Forward contract
 Tailor Made Contract
 Price is decided at the time of entering into
contact, which is negotiated between the
parties
 No Initial Investment
 Flexible delivery dates
 Flexible Contract size.
 Limitations of Forward Contact
 Counter Party Risk
 Less liquidity
Futures Contract
 A standardized forward contact to buy( Long) or
Sell( Short) the underlying asset at a specified price
at a specified future date through a specified
Exchange.
 Futures Contract are traded on Exchanges that
work as a buyer or seller for the counterparty.
 Exchange Sets the Standardized terms in term of
Quality, quantity, Price quotation , Date and
Delivery place( in case of commodity) .
Positions in Futures Market
 Long Position
 Which commits the buyer to purchase an
item at the contracted price on maturity
 Short Position
 Which commits the seller to deliver an item at the
contracted price on maturity
Features of Futures Contract
 Traded on Exchanges like CBOT, IMM, LIFFE,
SIMEX, CME etc.
 Standardization of the Contract
 Clearing House
 Mark – to – Market Mechanism
 Margins Requirements
 No Counter party Risk
 High Liquidity
 Daily Profit/ Loss Settlement.
Types of Futures Contact

 Commodity Futures
 Financial Futures
 FINANCIAL FUTURES
1. Stock futures or Equity Futures
2. Index futures or stock Index Futures
3. Interest Rate Futures
4. Currency Futures or Foreign Currency
Futures
5. Bond index futures
Equity or Stock Futures
 Equity futures is a contact to buy (long) or
Sell (Short) the Equity/ Stock of a particular
company at a organized stock/ derivative
exchange.
 Example:-
 RIL, ABB, Dabur, ACC etc. Futures contact
traded at NSE F&O segment for three month
category i.e. 1 month, 2 month, 3 months
Index futures or stock Index
Futures
 In case of index futures the underlying
assets is not a single stock but a Market
Index that consists of group of stocks. These
contracts are based on the stock market
indices.
 Example: S& P 500 futures traded at
NYSE, Nifty Futures at NSE ( India), Nikki
225 at Tokyo Stock Exchange, Bank Nifty at
NSE, CNX at NSE, CNX 100 at NSE.
 Product Specifications BSE-30
Sensex Futures
 Contract Size - Rs. 50 times the Index
 Tick Size - 0.1 points or Rs. 5
 Expiry day - last Thursday of the month
 Settlement basis - cash settled
 Contract cycle - 3 months
 Active contracts - 3 nearest months
Product Specifications S&P CNX
Nifty Futures
 Contract Size - Rs. 200 times the Index
 Tick Size - 0.05 points or Rs. 10
 Expiry day - last Thursday of the month
 Settlement basis - cash settled
 Contract cycle - 3 months
 Active contracts - 3 nearest months
Interest Rate Futures

 In case of Interest rate futures, the

underlying asset is Interest rate bearing
security such as T-Bills, T- Bonds, G- Bonds,
Corporate Bonds etc.
 More Popular in USA
 Helps to company in reducing Interest Rate
Risk
 Started in 1975 at CBOT.
Bond index futures
 These are futures contracts that are based
on particular bond indices i. e Index of Bond
prices.
 Example of Bond index futures is US
Municipal bond traded on Chicago Board of
Trade (CBOT)
 Major user are Corporate, Financial
Institutions , Mutual funds, Pension Fund
Managers.
 Currency Futures or Foreign
Exchange Futures

 These Financial futures as the name indicates ,

trade in the foreign currencies. These are also
known as exchange rate futures.
 These contract are very much popular in USA
and UK.
 Available on selected currencies of the World
like US $, Euro € and UK £ and some other
currencies.
 Traded on LIFEX, PHX,CBOE, IMM etc.
 Marking -to -Market System

 The Daily settlement in the futures market is called

marking- to- market .
 The traders realize their gains on the daily basis and
amount is debited or credited to their respective Margin
account.
 Both buyer and seller have to deposit margins with the
broker who in turn deposit it to exchange or clearing
house. Broker also maintain the account of each of the
party.
 Margins are of three type:-
1. Initial Margin
2. Variation Margin
3. Maintenance Margin
 OPTIONS

 An option is the right, but not the obligation, to buy

or sell something at a stated date at a stated price.
A “call option” gives one the right to buy, a “put
option” gives one the right to sell.

 Options are the standardized financial contracts that

allows the buyer (holder) of the options, i.e. the right
at the cost of option premium, not the obligation, to
buy (call options) or sell (put options) a specified
asset at a set price on or before a specified date
through exchanges.
Important Terminology in
Option Contract
 Option Buyer: The person or the Party who buy the option
contract.
 Option Writer: Also known as option seller, the person or party
who gives right to other party to buy or sell the underlying asset.
 Call Option: Right to buy the Underlying asset .
 Put option: Right to sell the underlying asset.
 Exercise price or Strike Price: the Price at which option will be
exercised is known as Strike Price
 Option Price: Also known as Option Premium, it is the amount
which the option Buyer pay to the Option Seller for buying the
option contract. It is paid at the time of entering into contract.
 Spot Price: Current price prevailing at a particular time in the
Market is known as Spot price.
 Specified date: The date on which option
can be exercised is called Specified date or
maturity date or expiration date.
 European Style option: The option that
can be exercised only at the expiration date
is called European Option.
 American Style Option: The option that
can be exercised at any time up to and
including expiration date is called American
Option.
Call Options

 A call option gives the holder (buyer/ one who is long

call), the right to buy specified quantity of the
underlying asset at the strike price on or before
expiration date.
 The seller (one who is short call) however, has the
obligation to sell the underlying asset if the buyer of
the call option decides to exercise his option to buy.
 Example: An investor buys One European call option
on Infosys at the strike price of Rs. 3500 at a premium
of Rs. 100. If the market price of Infosys on the day of
expiry is more than Rs. 3500, the option will be
exercised.
Put Options
 A Put option gives the holder (buyer/ one who
is long Put), the right to sell specified quantity
of the underlying asset at the strike price on
or before an expiry date.
 The seller of the put option (one who is short
Put) however, has the obligation to buy the
underlying asset at the strike price if the
buyer decides to exercise his option to sell.
 Right to sell is called a Put Option.
For Call Option
 In- the –Money Option : A option is said to
be In- the –money, when the underlying stock
price is greater than the strike price. (S>k).
 At-the –Money: A option is said to be In- the
–money, when the underlying stock price is
equal to the Strike price. (S=k).
 Out-of –Money:- A option is said to be In-
the –money, when the underlying stock price
is less than the strike price. (S<k).
For Put Option
 In- the –Money Option : A option is said to
be In- the –money, when the underlying stock
price is less than the strike price. (S<k).
 At-the –Money: A option is said to be In- the
–money, when the underlying stock price is
equal to the Strike price. (S=k).
 Out-of –Money:- A option is said to be In-
the –money, when the underlying stock price
is greater than the strike price. (S>k).
Categories of Options
 Exchange Traded
 Over-The- Counter
 SWAPS

Swap is defined as the agreed exchange of future

cash flows between two parties according to
terms and conditions defined at the time of
entering into the contract.

An exchange of streams of payments over time

according to specified terms. The most common
type is an interest rate swap, in which one party
agrees to pay a fixed interest rate in return for
receiving a adjustable rate from another party.
 Types of Swaps

 Interest
Rate Swap
 Currency Swap

 Debt- Equity Swap

 Warrants
 Warrant is like an option contact where the
holder has the right to buy the shares of
specified company at a certain price during
the given time period.
 Warrants are attached with primary security
as a sweeteners. The primary security can be
shares, bonds or debentures. Warrants can
be detached and traded separately.
 Badla Trading
 Badla trading involved buying stocks with
borrowed money with the stock exchange acting
as an intermediary at an interest rate determined
by the demand for the underlying stock and a
maturity not greater than 70 days.
 Badla transaction refers to the facility of
carrying forward a transaction in a share from
one settlement period to another.
 A person entering into a contract in
specified shares in a settlement cycle of
seven days has the option of carrying
forward his transaction to the next
settlement cycle besides the options of
giving/taking delivery or offsetting the
transaction by an opposite transaction in
the same settlement.
Example of Badla Trading
 Suppose you buy 1,000 shares of Infosys at Rs 3,500, your
cash outflow is Rs 35 lakh. Instead of paying cash, you can
ask your broker to find a borrower to finance your trade. This
process of buying stocks with borrowed money is Badla
trading.
 The stock exchange acts as an intermediary between you
and the actual lender. You will be charged an interest rate
for borrowing, which will be determined by the demand for
that stock under badla trading.
 Thus, higher the demand for Infosys under badla trading
higher will be the interest rate. You can keep your borrowing
unpaid for a maximum of 70 days, after which you will have
to repay the badla financier through the exchange
Badla and Derivatives Trading
 Futures and Option provide the facility to the trader
to buy or sell the underlying asset with making a
very low investment initially at the time of entering
into contract. In Futures contract by depositing
Margins, party can trade with a large number of
stock.
 In Badla, parties can carry forward their transaction
by entering into lending and borrowing activities.
 In essence, however, both futures and badla system
allow investors to buy stocks without huge cash
outflow. In other words, both help in leveraged
trades.
 Badla v/s Futures
BADLA
Expiration date unclear
Spot market and different
expiration dates are mixed up
Identity of counterparty often
known
Counterparty risk present
Badla financing is additional
source of risk
Position can breakdown if
borrowing/lending proves
infeasible
FUTURES
Expiration date known
Spot market and different
expiration dates all trade distinct
from each other
Clearing corpn. is counterpart
No counterparty risk
No additional risk
You can hold till expiration date
for sure, if you want to
Forward v/s Futures Contract
FORWARD FUTURES
Over the Counter Products Traded on organized Exchanges

Customized Contract Standardized Contract

No Involvement of Clearing House Clearing House Guarantee

No Margins Margins are Must

Less Liquidity High Liquidity

Self Regulated Regulated by agencies like SEC, SEBI etc.

Counter Party Risk No Counterparty Risk

Settled by actual delivery Cash Settled

Settled on the Maturity Daily Settlement
Futures v/s Options Contract
Futures Options
Traded only on organized Exchange Traded and OTC products
Exchanges
Both the Parties are under Only writer ( seller ) is Obligatory to
Obligation perform
No Premium is Paid Premium is Paid by the Buyer to the
Seller (writer)
Profit or Loss of the Parties are Maximum profit of Seller and
not Certain and Unknown. Maximum Loss of Buyer is Certain
Only Standardized Contract Both Standardized and Customized
products are available
Margins are paid by both parties No margin is paid by the Buyer.
User of Derivatives
 Hedger
 Speculator
 Arbitragers
Uses of Derivatives
 It helps in control, avoid, shift and manage efficiently
different types of risk
 Derivatives serves as a barometers of the future
price trend (Price Discovery)
 Helps in proper allocation of assets
 Enhance liquidity
 Market Completeness
 Cash Market Development
 Disseminating Information
 Price Stabilization
 Encourage competitive trading in the markets
Risk and Rewards of Risk and
Risk & Rewards of Derivatives
Global Derivatives Market
THE GLOBAL DERIVATIVES INDUSTRY-
CHRONOLOGY OF INSTRUMENTS
Year Instrument

Commodity Futures
1874
Foreign currency futures
1972
1973 Equity options

1975 T-bond futures

1981 Currency swaps

1982 Interest rate swaps; T-note futures; Eurodollar futures; Equity index
futures; Options on T-bond futures; Exchange–listed currency
options
1983 Options on equity index; Options on T-note futures; Options on
currency futures; Options on equity index futures; Interest rates caps
and floors
1985 Eurodollar options; Swaptions

1987 OTC compound options; OTC average options

1989 Futures on interest rate swaps;

1990 Equity index swaps

1991 Differential swaps

1993
Captions; Exchange-listed FLEX options

1994 Credit default options

 GROWTH AND VOLUME OF F&O

The growth of derivatives market activity accelerated in 2007,

at the fastest rate (29 %) as compared to 20 % in 2006.
Total size of global derivative industry has reached to
a historical level of US $ 15.3 billion in 2007 from
$billon in 2002
Size of Global Derivative
market
Product wise Comparison of
Volume between 2006 & 2007
Region wise Distribution of Derivatives volumes
 Percentage Change of Region wise
distribution of volume in 2007 and 2006
 Comparison of Growth of Various
Equity Products

 Since 2005, an impressive increase in the volume of stock index futures is noticeable. Single stock futures
have also shown very high growth rates, but the volumes remain much lower than on other products. On
the whole, the growth rate of volume was higher in 2007 than the previous year for all equity products.
 The Top Derivatives Exchanges Worldwide
Ranked by 2007 Futures and Options Volume
Top 20 Exchange-Traded Derivatives Contracts
Worldwide Ranked by Number of Contracts
Traded in 2007
 Top 20 Equity Index Futures and Options
Worldwide Ranked by Number of Contracts
Traded in 2007
FINANCIAL DERIVATIVES
MARKET IN INDIA
Derivatives in India : A
Chronology
Derivatives in India : A
Chronology contd…
Derivatives Products Traded in
India
 OTC
 1980s – Currency Forwards
 1997 – Long Term FC-Rupee
Swaps
 July 1999 – Interest Rate
Swaps and FRAs
 July 2003 – FC-Rupee Options
Exchange Traded
 June 2000 - Equity Index futures
 June 2001 - Equity Index Options
 July 2001 - Stock Options
 June 2003 - Interest rate futures
 September 2004- Weekly Options
 January-2008 – Mini Index
Trading at BSE
 March 2008- Introduction of long
Term Option contracts on S&P
CNX Nifty Index
 August 2008- Currency
Derivatives
Derivative Trading in India
 BSE and NSE are two important exchanges
where trading of derivatives takes place
under Derivatives & F&O segment
respectively.
 95% of the trading volume are captured by
NSE in F&O segment.
 Growth of derivatives market is tremendous
since their introduction from year 2000.
 Products Traded at NSE
 Index Futures
 Index Options
 Futures on Individual Securities-228 Securities
 Options on Individual Securities-228 Securities
 Mini Index Futures
 Mini Index Options
 Long Term Index Options
 Currency Futures
Products Traded at BSE
 Index Futures
 Index Options
 Stock futures available on 126 Securities
 Stock Options available on 126 Securities
 Weekly Options on 4* securities and on
Sensex

*RIL,TISCO, SBI & Satyam

Business Growth of
Derivatives at NSE
Liquidity
 Derivatives segment in India has captured a
record level of turnover as compared to cash
segment. Derivative segment is more liquid as
compared to cash segment /spot market. Table
summaries the liquidity of cash derivatives
segment of NSE. NSE is ranked No I. Stock
exchange in India in terms of derivative trading
as it captures 99% market share in derivative
segment.*
(* NSE Fact book -2007)
Turnover in the cash and F&O
Segment in NSE
Liquidity in Cash V/s
Derivatives Market
Turnover in Derivatives Market
 If we compare the turnover of BSE and NSE in India,
trading volume in derivative segment in BSE is lower
than as of NSE.
 NSE's derivatives market has been witnessing a
tremendous advancement in terms of volumes and array
of products accessible for trading. The market has
achieved a growth of 52% over the past one year where
the turnover has augmented to Rs. 73,562,711 million
(US $ 1,687,605 million) in 2006-07 from Rs. 48,242,504
million (US $ 1,081,428 million) in 2005-06. Trading in
Index Futures and Options contracts has been extended
to three other indices viz. Nifty Junior, CNX 100 and Nifty
Midcap 50.
COMPARISON OF THE DERIVATIVE SEGMENT AT
BSE AND NSE (Rs. in Crore)
Number Of Contract Traded At BSE And
NSE

(All Products)
Distribution of Turnover
Distribution of turnover also shows the
awareness level of derivatives trading in other
cities. Derivatives trading is concentrated in
few big cities only. But as the concept is
becoming mature in India, the share of other
cities is also increasing day by day. NSE has
started various Investor Awareness and
Training program in order to make the concept
familiar among the Investors
City Wise Distribution Of
Derivatives Turnover
Indian Derivatives Market and
International Market
Futures on Individual Equities
(Stock Futures)
STRENGTHS AND WEAKNESS
OF INDIAN DERIVATIVE
MARKET
 STRENGHTS

1. Vibrant economy (liberalized and globalised)

2. Adequate financial infrastructure
3. Well diversified financial markets (Depth and
width)
4. High liquidity
5. Potential for growth
Weaknesses
 No Proper Regulatory Framework-No specialized agency
is there to regulate the Market unlike in case of USA SEC,
FMC
 Non availability of Complete range of Products
 Accounting and Disclosure-Very recently ICAI issues
guidelines regarding Accounting Treatment of Derivatives
Profits Losses under IAS 32
 Investor Awareness
 Inefficient Capital Market
 Pricing Problems
 Lack of institutional participation
 Transparency in Case of OTC Derivatives
 Geographical Spread of the Derivatives
CONCLUSION
 The growth of financial derivatives is an important
milestone in India’s financial sector development since it
has also emerged as an important avenue for price
discovery.
 However, the derivative market in India is very small by
world standards because it has introduced only a limited
range of products: index futures, index options .Whereas
options and futures in individual securities are available
only in selected 228 Scrips. Thus, there is an urgent
need to popularize derivative trading in the retail
community.
Conclusion
 Transparency, liquidity and Investor awareness are three
important issues for the success of derivatives.
 “Although the benefits and costs of derivatives remain
the subject of spirited debate, the performance of the
economy and financial system in recent years suggests
that those benefits have materially exceeded the Cost.”
-- Alan Greenspan
 There is also a word of caution. Derivatives are like a
nuclear energy having immense potential for both, the
good and the bad for the mankind. It depends on that,
who is using them and for what purpose.