Unit - Introduction To Derivatives

FINANCIAL DERIVATIVES
FINANCIAL DERIVATIVES SYLLABUS AT A GLANCE: -
Financial Derivatives
Derivatives & Its Features, Types of Unit - I Role of derivative

Derivatives, Development & Growth Introduction to Derivatives market, Uses & Misuses
Of derivative market, Linkages b/n of derivatives
Spot & Derivative Markets
Mechanics of future market, structure Determination of

Of future & forward markets, forward & future prices
Unit - II
Hedging Strategies, Interest rate futures
Future and Forward
Currency futures &
Market
Forwards
D/b/n Options & Futures, Structure Option pricing models
Of Options, principles of option 1 Binomial model,
Unit - III
Pricing, 2 Black ScholesMerton
Options
Model
Advanced option strategies, Unit - IV hedging with options,

Trading with options, Basic Option Strategies Currency options
Concept & Nature of Swaps, features Unit - V Major types of swaps

Of swaps, evolution of swaps Swaps 1 Interest rate swaps,
2 Currency swaps,
3 Commodity swaps,
4 Equity index swaps,
5 Credit risk in swaps,
Using swaps to manage risk, pricing & valuing swaps
Mr. B. Sudheer Kumar, MBA, M.Sc (Maths), (Ph.D) Page 1
Assistant Professor and Training & Placement Officer,
Dept of MBA, VITS, PDTR,
E Mail Id: - bskmba06@gmail.com, Mobile No: - 09177873363, 09154779155.
UNIT I
INTRODUCTION TO DERIVATIVES
The past decades has witnessed the multiple growths in the volume of international trade
and business due to the wave of globalization and liberalization all over the world. As a result,
the demand for the international money and financial instruments increased significantly at the
global level. Due to unexpected changes in foreign exchange rates, interest rates and commodity
prices, stock market prices at the different financial markets, corporate world exposed to
financial markets. Price fluctuations make it hard for business to estimate their future production
costs and revenues. Adverse changes have even threatened the very survival of the business
world. It is therefore to manage such risks, the new financial instruments have been developed n
the financial markets which are also popularly known as financial derivatives.
As instruments of risk management these generally do not influence the fluctuations in
the underlying asset prices. However, by the locking in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of
risk averse investors.
Today the financial derivatives have become increasingly popular and most commonly
used in the world of finance. This has grown with so phenomenal speed all over the world that
now it is called as the derivatives revolution. In an estimate, the present annual trading volume of
derivative markets has crossed US $ 30,000 billion representing more than 100 tones gross
domestic product of India.
WHAT ARE DERIVATIVES? OR DEFINITION OF FINANCIAL DERIVATIVE: -
The word derivative originated in mathematics and refers to a variable that has been from
another variable. In financial sense, a derivative is financial product which had been derived
from a market for another product.
For example, you have purchased a gold future on May 2003 for delivery in August
2003. The price of gold May 2003 in the spot market is 4,500 per 10 grams and for future
delivery in August 2003 is 4,800 per 10 grams. Suppose in July 2003 the spot price of gold
changes and increased to 4,800 per 10 grams. In the same line value of financial derivatives or
gold futures will also change.

DEFINITION OF DERIVATIVES: -
A derivative is financial instrument or financial contract whose value is derived from the
value of an underlying asset. Hence, the name derivatives come into existence. The price of
derivatives in dependent on the behavior of the price of one or more basic underlying assets,
these contracts are legally binding agreements made on the trading on the screen of stock
exchanges to buy or sell an asset in future. The asset can be a share index, interest rate, equity
shares, treasury bills, bond, rupee, dollar exchange rate, sugar, crude oil, soya bean, cotton,
coffee and what you have.
Derivative can be also defined as a financial instrument or contract between two parties
that derived its value from other underlying asset or underlying reference price, interest rate or
index. A derivative by itself does not constitute ownership; instead it is a promise to convey
ownership.
In the Indian context the Securities Contract (Regulation) Act, 1956 (SCR or SCA)
defines derivative includes,
1. 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.
2. A contract which derives its value from the prices or index of prices of underlying
securities.
DIFFERENCE BETWEEN SHARES AND DERIVATIVES: -
PARAMETER SHARES DERIVATIVES
Nature Assets(Except warrants & Contracts
Convertible bond)
Standardization Standardized with securities Not standardized
law
Risk High Low
Return High Moderate return
Initial Investment Minimum Measurable Minimum or Zero

The above definition conveys that,

1. The derivatives are financial products,
2. Derivatives is derived from another instrument / contract called the underlying,
A very simple example of derivatives is curd, which is derivative of milk. The price of curd
depends upon the price of milk which in turn depends upon the demand and supply of milk.
General Characteristics of Derivatives: -
Derivative defined as per Accounting Standard SFAS 133 is a financial derivative or
other contract with the following features,
1. It has one or more Underlying asset,
2. It requires negligible initial investment or no initial net investment compared to other
types of financial contracts,
3. Should provide for net settlement i.e., offsetting of initial contract position,
4. The value of derivative depends on their underlying asset price movements,
5. The instrument relates to the future contracts and settlement of terms between the parties
involved, normally called maturity in case of forwards contract,
6. The parties involved may be obliged to exercise their contracts or offset then(Forwards,
futures) or may have rights(Like options buyers),
7. The contracts are fulfilled or transacted through a recognized exchange(Futures
contracts), through the clearing house or they may be private bio lateral
contracts(Forwards, Swaps) or other counter contracts(Options),
8. These are contingent asset or liabilities i.e., off balance sheet to instruments,
9. Derivatives are also known as delivery or deferred payment instrument. It means that it
is easier to take short or long position in derivatives in comparison to other assets or
securities. They are more easily amenable to financial engineering,
10. Derivatives have little usefulness in mobilizing fresh capital or corporate world except
warrants and convertibles.
TYPES OF DERIVATIVES: -
Common derivatives include options, forward contracts, futures contract and swaps
common underling assets include interest rates, exchange rates, commodities, stocks, stock
indices, bonds and bond indices, treasury bills (Short term debt securities).

Derivatives
Financials Commodities
Basic Complex Futures Forwards
Forwards Futures Options Warrants & Convertibles
Swaps Exotics
Stock Futures Stock Index
Classification by Nature of the Underlying Asset: -

Another important way of classifying derivatives is according to the underlying from
which the derivatives derives its value as shown in table below,
STOCKS FOREIGN INTEREST COMMODITIES NATURAL
EXCHANGE RATE BONDS PHENOMENA
/ CREDIT
Single Stock Foreign Bond Futures Futures and Weather
Futures exchange, and options options on derivatives
forward contacts agricultural related to rainfall
commodities like and temperature
wheat, soya bean
and milk
Single Stock Currency futures Forward rate Energy derivatives Derivatives
Options agreements and like Crude oil, related to natural
interest rate natural gas and calamities like
futures electricity Earth Quakes
and Hurricanes
Stock Index Currency options Caps, floors, Futures and
Futures swaps and Options on
Swaptions precious metals ----
like Gold and

Silver
Stock Index Currency Swaps Credit default Futures and
Options swaps and other options on
credit derivatives industrial metals ----
like Copper and
Aluminum
Another classification based on nature of the market in which the derivative is traded,
S. No Parameter Exchange Traded Over the counter (OTC)
Derivatives Derivatives
1. Type of products Futures contracts on Forward contracts on
stocks, Currencies and stocks, currencies and
commodities commodities OTC options
on stocks currencies and
commodities
2. Options Exchange traded OTC options on stocks,
options on stocks, currencies and commodities
currencies and
commodities
3. Nature of Derivative Swap note futures and Interest rate swaps, caps,
interest rate futures floors, and forward rate
agreements
4. Place of agreement & Recognized exchange Negotiated deals between
Parties the buyer and sellers, no
definite place where this
market exist
5. Customized contract Terms and conditions All contracts are customized
are not customized, contract that exactly
they are standardized requirements of counter
parties in the best possible
way little or less liquidity
6. Liquidity More liquidity Little or Less liquidity
7. Money Exchange Small amount has to No exchange of money at
be remitted as margin the time of entering contract
money
8. Counter party risk Counter party risk is Counter party risk
absent associated

1. FORWARDS: -
A forward contract is among the oldest and simplest of derivative contracts. It is a
simple customized contract between two parties to buy or sell an asset at a certain time in the
future for a certain time in the future for a certain price.
It is simply a purchase or sale transaction in which the price and other terms have
been agreed upon, but the delivery and payment are postponed to a later date.
A stock market transaction in which delivery takes place after two or four weeks
would normally be regarded as a forward transaction because the norm there is to settle within a
couple of days.
DIFFERENCE BETWEEN FORWARD AND SPOT MARKET: -
PARAMETER FORWARD MARKET SPOT MARKET
1. Payment Deferred till the expiry of the Immediately
contract
2. Delivery Deferred till the expiry of the Immediately
contract
3. Completion of Successful completion of Delivery and payment take
transaction transaction on maturity place simultaneously
depends upon two parties
FEATURES OF A FORWARD CONTRACT: -

The basic features of a forward contract are given below,
1. Forward contracts are bilateral contracts and they are exposed to counter party risk,
2. Each contract is custom designed and hence is unique in terms of contract size, expiration
date, the asset type, quality etc,
3. In forward contract, one of the parties takes a long position by agreeing to buy the asset at
a certain specified future date. The other party assumes a short position by agreeing to
sell the same asset at the same date for the same specified price,
4. The specific price in a forward contract is referred to as the delivery price. The forward
price for a particular forward contract a particular time is the delivery price that would
apply if the contact were entered into at that time both are equal at the time the contract is
entered into. However, as time passes, the forward price is likely to change whereas the
delivery price remains the same,

5. In the forward contract, derivative assets can often be contracted from the combination of
underlying assets, such assets are often known as synthetic assets in the forward market,
6. In the forward market, the contract has to be settled by delivery of the asset on expiration
date. In case the party wishes to reverse the contract, it has to compulsory go to the same
party, which may dominated and command the price it wants as being in a monopoly
situation,
7. Forward contracts are very popular in foreign exchange market as well as interest rate
bearing instruments. Most of the large and international banks quoted the forward rate
through their Forward Desk lying within their foreign exchange trading room,
8. As per the Indian forward contract act 1952 forward contracts are (i). Hedge contracts,
(ii). Transferable specific delivery (TSD) contracts and (iii). Non transferable specify
delivery (N - TSD),
9. A forward contract has to be settled in delivery or cash on expiry date,
Example: - An Indian company buys automobile parts from USA with payment of one million
dollar due in 90 day. The importer thus is short of dollar that is it owes dollars for future
delivery. Suppose present price of dollar is 48. Over the next 90 days, however dollar rise
against 48. The importer can hedge thus exchange risk by negotiating a 90 days forward
contract with a bank at a price of 50. According to forward contract in 90 days the bank will
give importer one dollar and importer will give to the bank 50 million rupees on due date
irrespective rate of dollar at that time. This is a typical of forward contact currency.
2. FUTURE CONTRACTS: -
Like a forward contract, a futures contract is an agreement between two parties to buy or
sell a specified quality of an asset at a specified price and at a specific time and place. Future
contracts are normally traded on an exchange which sets the certain standardized norms for
trading in the futures contracts. Futures often are settled in cash or cash equivalence, rather than
requiring physical delivery of the underlying asset. Parties to a futures contract may buy or write
options on futures.
As forward contracts entail credit risk, these are mainly suitable for large companies and
institutions that are well known to each other or to their banks. They are less suited to individuals
and other small entities. The Nobel Prize winning economist Milton Friedman anticipated a

devaluation of the British pound and wanted to sell the pound forward. He found that banks that
were not willing to transact with him were willing to oblige companies that wanted to undertake
similar transactions.
The most effective way to provide open and equal access to all is to organize the activity
of trading in an exchange.
Exchange traded contracts for delivery at a future date are known as future contracts to
distinguish them from forward contracts.
Pricing can be based on an open cry system or bids and offers can be matched
electronically. The future contract will state the price that will be paid and the date of delivery.
Example: -
A Silver manufacturer is concerned about the price of silver he will not able to plan for
profitability. Given the current level of production he expects to have about 20,000 ounces of
silver ready in next two months. The current price of silver on May 10 is 1052.5 per ounce and
July futures price at FMC is 1068 per ounce which he believes to be satisfied price. But he
fears, that price in future may go down. So, he will enter into a future contract.
The features of future contracts: -
1. Exchange traded: -
Futures contracts are traded in an exchange. In India, the futures and options trading
system of NSE called NEAT F and O trading system which is a great deal of transparency
about past trades, prices and volumes.
2. Standardization: -
One of the most important features of future contract is that the contract has certain
standardized specification i.e., quality of the asset, the date and month of delivery, the units
of price quotation, location of settlement etc. For,
Example: - The largest exchanges on which futures contracts are traded are the Chicago
board of trade (CBOT) and the Chicago mercantile exchange (CME).
3. Daily Settlement or Market to Market: -
Since the futures contracts are performed through a standard exchange, so at the close
of the day of trading, each contract is marked to market. The system of daily mark to market

is that the gains and losses are paid out daily; instead of waiting for maturity accordingly the
members accounts are credited.
4. Initial Margins: -
The daily mark to market reduces credit risk dramatically, but does not eliminate it
completely. The remaining credit risk is that the buyer or seller may default in making the
mark to market payment. The exchange deals with this risk by collected an initial margin
from both buyer and seller. The margin has to be collected from both because the exchange
does not know beforehand whether the price will move up or down and therefore, whether
the market to market payment will have to come from buyer or seller.
5. Novation: -
Yet another feature of most futures exchanges is the concept of Novation. This means
that the exchange becomes a counter party for all trades. Thus if A buys a futures contract
from B, the exchange replaces this transaction with two transactions. In one transaction, the
exchange buys from B and in another transaction the exchange sells to A. Even if A defaults
the exchange has to fulfill its obligation to B and try and sell the asset in the market at risk is
thus intermediated by the exchange just as in may forward markets the credit risk is
intermediated by banks. As the exchange relies on sophicated margining system to manage
the credit risk, it does not have to charge a large fee to cover the risk, it does not have to
charge fee to cover the risk.
6. Anonymous Trading: -
One advantage of Novation is that it allows anonymous trading. A person buying a
futures contract in an exchange does not care who is selling the contract. The exchange needs
to know the identity of the traders to implement the margining system while the regulator
needs this information to investigate market irregularities that may occur.
7. Easy close out: -
Another advantage of Novation is that it makes it very easy to unwind a futures
transaction. If an investor has bought a future contract, he can go back to the market
whenever he wishes and sell the future.

8. Delivery rare or Expire date: -

The future contracts are executed on the expiry date. The period which the delivery
will be made is set by the exchange which varies from contract to contract. Typically 95 98
% of futures trades are closed out before maturity. Only the remaining 2 5% of all
transactions actually results in payment and delivery.
9. Basis & Tick Size: -
The future prices are expressed in currency units with a minimum price movement
called a tick size. This means that the futures prices must be rounded to the nearest tick. The
difference between a future price and cash prize of the asset is known as the Basis.
DIFFERENCE BETWEEN FORWARDS AND FUTURES: -
S. NO PARAMETER FORWARDS FUTURES
1. Trading Traded by telephones or telex Traded in an competitive
(OTC) bilateral contracts OTC area (Recognized Exchange)
2. Size of Contract Customized depend upon Standardized in each future
buyer and seller market
3. Price of contract Remains fixed till maturity Changes every day
4. Delivery date Normally one specified Range of delivery dates
delivery date
5. Mark to Market Not done Mark to Market every day
6. Margin No margin required Margins are to be paid by
both buyers and sellers
7. Counter party risk Present Not present
8. Settlement Settled at end of contract Settled daily
9. Credit risk Some credit risk Virtually no credit
10. Terms Decided by both parties Standardized with respect to
mutually & tailor or the quality of the asset
individually made future period and future
place
11. Marginal Payment No marginal money required Margin payments are

required
12. Cash Settlement Delivery or final cash Contract is usually closed
settlement usually takes place out prior to maturity
13. Payment Cost of forward contract based They entails brokerage fee
on bid ask spread for purchase and sales
orders
14. No. of contracts in a There can be any number of Number of contracts in a
year contracts year are fixed
15. Frequency of 90% of all forward contracts Very few futures (<5%)
Delivery are settled by actual delivery contracts are settled by
actually delivery
16. Hedging These are tailor made for Hedging is by nearest month
specific date and quantity so it and quality contracts so it is
is perfect not perfect
17. Liquidity No liquidity Highly liquidity
18. Mode of delivery Specifically decided most of Standardized, most of the
the contracts result in delivery contracts are cash settled
19. Transaction cost Costs are based on bid ask Include brokerage fees for
spread buy and sell orders
20. Regulation Self regulatory and no need Respective changes where
registration they are registered
3. OPTIONS: -
The derivative security is a security or contract or instrument designed in such way that
its price is derived from the price of underlying asset. Hence, the price of a derivative security is
not arbitrary; rather it is linked to the price of the underlying asset.
A price of a derivative security is affected by its features, rights and obligations arisen out
against the underlying parties. That is way the price of security would different as per related
derivatives features. For,

Example: - The primary difference between an option and a future or forward contract is that
options confer a right rather than obligation to buy or sell the underlying asset. As a result pay
off under options will be different to futures or forwards.
Concept of options: -
Option is a specific derivative instrument under which one party gets the right, but no
obligation, to buy or sell a specific quantity of an asset at an agreed price on or before a
particular date. For,
Example: - One person buys an option contract to purchase 100 shares of SBI at 300 per share
for a period of 3 months. It means that said person has the right to purchase the share of SBI at
300 per share within 3 months from the date of the contract. If the price of SBI increases, he
will exercise the option and if the price below 300 then he will not exercise the optionally when
he is in profit. In case of loss he will not exercise the option. The specified price at which the
option holder has the right to trade is known as the strike price or the exercise price. All options
have a maturity or expiry data after which the option to trade cannot be exercised.
Option is itself an asset that can be bought and sold. Just as one can be buyer or a seller
of gold, one can be a buyer or a seller of gold call option. It is the holder (buyer) of the option
who decides whether to exercise it or not. The seller simply has to accept whatever decision the
buyer takes and perform his side of contract. Thus the seller of an option has an obligation to
trade when the buyer himself has no right to trade.
Today options are traded on a Varity of instruments like commodities, financial assets as
diverse as foreign exchange, bank time deposits, treasury securities, stocks, stock indexes,
petroleum products, food grains, metals etc.
Options are the most flexible of all types of derivatives because they give an option
holder a multiple choice at various moments during the life time of the option contract. However,
an option seller does not have such flexibility and always has to fulfill the option holders
requests. For this reason, the option buyer has to pay a premium to the option seller.
PARAMETER BUYER SELLER
1. Call Option Right to buy at the exercise Obligation to sell at the
price exercise price
2. Put option Right to sell at the exercise Obligation to buy at the

price exercise price

3. Risk Limited because he cannot The maximum loss for the
lose more than premium paid writer of a put option is equal
as he can abandon the option to the strike price. In general,
the risk for writer of a call
option is unlimited
4. Profit His potential gain is the The maximum profit for the
erotically unlimited writer of a put option is equal
to premium of options
Difference between OPTIONS VS FORWARDS contract: -

PARAMETER OPTIONS FORWARD CONTRACT
1. Right & Obligation Buyer (Option holder) has Buyer has right and obligation
right to sell or buy at the to buy at the forward price.
exercise price or strike price. Seller has right and obligation
Seller has obligation to buy or to sell at the forward price.
sell at the exercise price. A Both buyer as well as the
right is a privilege or a claim seller is under compulsion.
conferred upon the buyer
where as an obligation is a
compulsion.
Buyer gets this right at price a
price known as the options
price or premium.
2. Risk Little or more risk, because he Every transaction has a risk
can go for sell / buy / drop the which is equal to delivery cost
option depend upon the at the maximum.
exercise price before the
expiry date.

Difference between OPTIONS VS FUTURES contract: -

PARAMETER OPTIONS FORWARD CONTRACT
1. Premium In case of one party (Option No cash is transferred to either
Buyer) has to pay in cash the party at the time of the
option price (Premium) to the formation of the contract.
other party (Seller) this is not
returned to the buyer whether
he invests for actual
performance of the contract or
not.
2. Risk Reward Systematic risk or reward The buyer of the contract
relationship does not arise. realizes the gain in cash when
price of the future contract
increases and incurs losses in
case of fall in the prices. The
position is opposite in case of
the seller of the futures
contract.
3. Number of Contracts There is no limit to the There is process of closing out
number of option contracts position which causes
that can be in existence at any contracts to cease to exist,
time. hence diminishing the total
number in comparison to
potions.
4. SWAPS: -
Swap means Barter, Swaps are private agreements between two parties to exchange
cash flows in the future according to a prearranged formula. Swaps are used by different
companies / institutions / governments. Some institutions / organizations have access to some
form of financial instruments but they need different financial instruments.

They can be regarded as portfolios of forward contracts. The two commonly used
Swaps are:
1. Interest rate swaps: These entail swapping only the interest related cash flows between
the parties in the same currency.
2. Currency Swaps: These entail swapping both principal and interest on different currency
than those in the opposite direction.
Swaptions: Swaptions are options to buy or sell a swap that will become operative at the expiry
of the options. Thus a Swaptions is an option on a forward swap. Rather than have calls and puts,
the Swaptions market has receiver Swaptions and payer Swaptions. A receiver Swaptions is an
option to receive fixed and pay floating. A payer Swaptions is an option to pay fixed and receive
floating.
EVOLUTION OF DERIVATIVES: -
Derivatives are definitely not a modern invention. Derivatives have probably been around
for as long as people have been trading with one another. Forward contracting dates back at least
to the 12th century and may well have been around before then. Merchants entered into contracts
with one another for future delivery of specified amount of commodities at specific prices. A
primary motivation for pre arraigning a buyer or seller for a stock of commodities in early
contracts was to lessen the possibility that large swings would inhibit marketing the commodity
after a harvest.
It has been claimed that the worlds first organized futures exchange was the Dojima rice
futures market officially set up in 1730 in Osaka Japan when the fendal land lords in Japan
needed money for their annual tribute to Tokyo, they said rice tickets representing rice in the
warehouse or in the fields. These tickets were bought and sold in the Dojima market and could
be regarded as the forerunners of modern exchange traded in future contracts.
In 1848, the future contracts came into existence with establishment Chicago board of
trade in 1848. In the year 1898, the butter and egg dealers of Chicago produce exchange joined
hands to form Chicago mercantile exchange for trading futures to hedge their risks of price
volatility. Gradually the exchange also provided the future markets for other commodities like
pork bellies (1961), little cattle (1964), live hogs (1966) and feeder cattle (1971). This success in
trading of foreign currencies (1972), T bond futures (1975) and equity index futures (1982),

Futures contracts were initially traded on agricultural commodities in 1864, Chicago board of
trade (CBOT) begins trading on these products involving gold, silver and food items.
Trading in financial futures like stock futures originated with international monetary
markets (IMM) in 1972 followed by the interest rate futures being introduced in CBOT in 1975.
Stock index futures were introduced in the USA in 1982. In the global scenario, the five leading
futures markets and their underlying securities are given in below table,
MAJOR FUTURES MARKET GLOBALLY: -
Name of the Futures Market Major Contracts Traded
1. Chicago Board of Trade (CBOT) Commodities, metals
2. International Monetary Market (IMM) Currencies, Debt, Stock Index
Chicago
3. International Petroleum Exchange, Petroleum
London
4. New York mercantile exchange Commodities & Metals
(NYMEX)
5. Singapore International Monetary Commodities, Currency, Debt and Index
Exchange
Options trading occurred later than futures trading until, 1973, options on equity stock
were traded on the OTC (over the trade counter) market only. The major boost came in 1973
when Chicago board options exchange (CBOE) was established entirely dedicated for trading of
options contracts in standardized forms. The first trading in swaps occurred in 1981 between
World Bank and IBM (Currency swap). And the following table lists the major developments in
financial derivatives,
The global derivatives industry chronology of instruments: -
YEAR FINANCIAL INSTRUMENTS
1. 1972 Foreign Currency Futures
2. 1973 Equity futures: futures on mortgage backed
bonds

3. 1974 Equity futures, equity options

4. 1975 T bill futures on mortgage backed bonds
5. 1977 T bond futures
6. 1979 Over the counter currency options
7. 1980 Currency Swaps
8. 1981 Equity index futures: options on T bond
futures, Bank CD futures T note futures,
Euro dollar futures, Interest rate swaps
9. 1982 Exchange listed currency options
10. 1983 Interest rate caps and floor options on T note,
futures, currency futures, equity index futures
11. 1985 Euro dollar options, swap options, futures on
US dollar and Municipal bond indices
12. 1987 Average options, commodity swaps, bond
futures, compound options, OTC compound
options, OTC average options
13. 1989 Three month Euro DM futures, captions
14. 1990 Equity index swaps
15. 1991 Portfolio Swaps
16. 1992 Differential swaps
17. 1993 Captions Exchange listed flex options
18. 1994 Credit default options
19. 1995 Credit derivatives
20. 1996 98 Exotic derivates
21. 2003 04 Energy derivatives, weather derivatives
The first financial derivatives were created only in the 1972, but within a couple of
decades, they grew rapidly to dominate the global derivatives market. By around 1990, financial
derivatives accounted for three fifths of derivative trading and financial contracts for,

Example: - US trading bond futures and Euro dollar futures.

These were the most actively traded futures in the world. Despite rapid growth in
absolute volume, agricultural commodities constituted only a fifth of the market with energy and
materials accounting for the remaining one fifth since, then financial futures have continued to
growth very rapidly and in 2005, they accounted for over 90% of the worlds futures markets and
all the 20 most actively traded futures contracts in the world.
The latest terminal bank for international settlement (BIS) survey published in 2005
reports that the outstanding amount of OTC derivatives in global financial markets reached $248
trillion as at the end of 2004. This represents a 26%. Increase for 2004 and follows a 39%
increase in 2003. Also the growth in global OTC derivatives markets has averaged 31.6% since
1990. The total amount of derivatives outstanding in global market at $295 trillion world gross
domestic product is $40.8878 trillion at the end of 2004. Hence world derivative market is seven
times world gross domestic product.
OVERVIEW OF THE INDIAN DERIVATIVES MARKET: -
(OR)
EVOLUTION OF DERIVATIVES IN INDIA: -
In India, derivatives markets started in the late 1890s and were futures based markets
with commodities, primarily, agricultural commodities as the underlying assets. The first
organized futures market came up in 1875 with the establishment of Bombay cotton trade
association ltd. Subsequently may future exchange predominantly commodity based futures
sprang up viz. Bombay cotton exchange ltd in 1893. Gujarati vyapari mandali in 1900, Calcutta
hessian exchange ltd in 1919 and most of them did not last till the second world war in 1939. In
1969 central government imposed the ban on trading in derivatives to prevent speculation on the
prices of agricultural commodities. The late 1990s shows this signs of opposite trends - a large
scale revival of futures markets in India and hence the central government revoked the ban on
futures trading in October 1995. The civil supplies ministry agreed in principle for starting of
futures trading in Basmati rice, further in 1996, the government granted permission to the Indian
pepper and spice trade Association to convert its pepper futures exchange into an international
pepper exchange. On November 17, 1997 Indias first international futures exchange at kochi

known as the India pepper and Spice trade association International Commodity Exchange
(IPSTA ICE) was established.
Similarly the Cochin oil millers association in June 1996 demands the introduction of
futures trading in coconut oils. In August 1997, the central government proposed that Indian
companies with commodity price exposures should be allowed to use foreign futures and option
market.
Securities and Exchange Board of India (SEBI) appointed a committee named the Dr. L.
C. Gupta committee (LCGC) in 1996 in order to develop appropriate regulatory frame work for
derivatives in India.
The board of SEBI on May 11, 1998 accepted the recommendations of the Dr. L. C.
Gupta committee and approved introduction of derivatives trading in India in the phased manner.
The recommendation sequence is stock index futures, index options and options on stocks.
Subsequently the SEBI appointed Professor J. R. Verma Committee (1998) to look into the
operational aspects of derivatives market especially to prescribe risk containment measures to
new derivative products.
To remove the road block of non recognition of derivatives as securities under
securities law (Amendment) Bill, 1999 was introduced to bring about the much needed changes.
Accordingly in December 1999, the new frame work has been approved and derivatives have
been accorded the status of securities.
The most notable of development in the history of secondary segment of the Indian stock
market is the commencement of derivatives trading in June 2000. The SEBI approved derivatives
trading based on futures contracts at National Stock Exchange (NSE) and Bombay Stock
Exchange (BSE) in accordance with the rules / bye laws and regulations of the stock
Exchanges. To begin with, the SEBI permitted equity derivatives named stock index futures. The
BSE introduced on June 9th 2000 stock index futures based on the sensitive index (also called
SENSEX comprising 30 Scripts) named BSX and NSE started on June 12 2000 stock index
future based on its index S&P CNX NIFTY (Comprised 50 Scripts) in the name of
NFUTIDXNI.
In the year July 2001, index options, options on individual securities and futures on
individual securities on both the NSE and the BSE are introduced.

Interest rate a future trading was introduced on the NSE in June 2003, the underlying
assets were taken to be notional treasury bills or notional 10 year bonds (both Zero coupon and
Coupon bearing)
The chronology of the events is presented below in the form of table
1. 1952 Enactment of the forward (Regulation) Act
2. 1953 Setting up of the forward markets commission
3. 1956 Enactment of SCRA
4. 1969 Prohibition of all forms of forward trading
under section 16 of SCRA
5. 1972 Informal carry forward trades between two
settlement cycles began on BSE
6. 1980 Khuso committee recommendation
reintroduction of futures in most commodities
7. 1983 Government amends bye laws of exchanges of
Bombay, Calcutta, Ahmadabad and introduced
carry forward trading in specified shares
8. 1992 Enactment of the SEBI act
9. 1993 SEBI prohibits carry forward transactions
10. 1994 Kabra committee recommends further trading
in nine commodities
11. 1995 G. S. Patel committee recommends revised
carry forward system
12. 1996 Revised system restarted on BSE
13. 18 November 1996 SEBI set up L. C. Gupta committee to draft a
policy frame work for index futures
14. 11 May 1998 L. C. Gupta committee submitted report
15. 1998 Varma committee to recommend risk
containment measures for derivatives trading
16. 1999 Securities law (Amendment) Act, 1999 permits

legal frame work for derivatives trading in

India
17. 7 July 1990 RBI gave permission for OTC forward rate
Agreement (FRAs) and interest rate swaps
18. 24 May 2000 Singapore international mercantile exchange
(SIMES) choose NIFTY for trading futures
and options on an Indian index
19. 25 May 2000 SEBI gave permission to NSE and BSE to do
index futures trading
20. 9 June 2000 Trading of BSE Sensex futures commended at
NSE
21. 12 June 2000 Trading of NIFTY futures commended at BSE
22. 31 August 2000 Trading of futures and options on NIFTY to
commence at SIMES
23. July 2001 Trading on equity futures at NSE on 31
Securities
24. June 2003 Trading on interest rate futures commenced at
NSE
25. July 2003 Trading on FC rupees options started
Derivative products in Indian financial markets: -

1. Index Index futures and index options
2. Stock Stock futures and stock options
3. Currency Currency futures and forwards 1980 (OTC)
4. Interest rate Interest rate futures
Calendar of introduction of derivatives products in Indian financial markets: -
OTC EXCHANGE TRADED
1980 Currency forwards June 2000 Equity index futures
1997 Long term foreign, Currency rupees June 2001 Equity index option
swaps
July 1999 Interest rate swaps and FRAs July 2001 Stock option
July 2003 FC rupee options June 2003 Interest rate futures

USES OF DERIVATIVES OR ECONOMIC BENEFITS OF DERIVATIVES OR

PRACTICAL SIGNIFICANCE OF DERIVATIVES: -
Derivative markets serve the society in two important ways provide risk management
and mitigation tools, there by contributing to the development of what economists call complete
markets. Complete market concept refers to that situation where no particular investors be better
off than others or patterns of returns of all additional securities are spanned by the already
existing securities in its or there is no further scope of additional security.
Secondly derivative assist in managerial decision making by providing some
information on future prices that will help in production decisions.
1. Risk Management,
2. Price Discovery,
3. Transfer of Risk,
4. Liquidity and Volume of trading,
5. Trading Catalysts,
6. Allocation of Resources,
7. Attractive large investors,
8. Better economic decisions,
9. Corporations use Derivatives,
10. Financial service firms, banks and other dealers use derivatives,
11. Mutual funds and investment institutions use Derivatives,
12. Mutual funds and investment institutions use derivatives,
13. Individual use derivatives.
1. Risk Management: -
One of the most important services provided by the derivatives is to control, avoid
shift and manage efficiently different types of risks through strategies like hedging,
arbitraging, spreading etc., Derivatives assist the holders to shift of modify suitably the risk
characteristics of their portfolios. These are specifically useful in highly volatile financial
conditions like erratic trading, highly flexible interest rates, volatile exchange rates or
monetary chaos. An oil refiner might find himself paying more for crude oil or a jewelry
manufacture for gold due to variation of prices beyond our control. Such movement may

adversely affect his or her business and even threaten its viability. Derivatives usually in the
form of options and futures are therefore used as means to protect against key business risks
which are beyond ones control.
2. Price Discovery: -
Another important function that is served by the derivative markets is price discovery,
which refers to the process of establishment of bench mark market prices that are used more
broadly in the economy.
Prices in an organized derivatives market reflection the perfection of market
participants about the future and lead the prices of underlying to the perceived future level.
The prices of derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus, derivatives help of future as well as current prices.
3. Transfer of Risk: -
The derivative market helps to transfer risks from those who have them but may not
like them to those who have an appetite for then i.e. from hedges to speculators.
4. Liquidity and Volume of trading: -
Derivatives due to their inherent nature are linked to the underlying cash markets with
the introduction of derivatives, the underlying market witness higher trading volumes
because of participation by more players who would not otherwise participate for lack of an
arrangement to transfer risk.
5. Trading Catalysts: -
The derivatives trading encourage the competition trading in the markets, different
risk taking preference of the market operators like speculators, hedgers, arbitrageurs etc,
resulting in increase in trading volume in the country. They also attract young investors
bright, creative well educated people with an entrepreneurial attitude, professional and other
experts who will act as catalysts to the growth of financial markets.
They often energize others to create new business, new products and new
employment opportunities, the benefits of which are immense.
6. Allocation of Resources: -
Prices of goods in the future are very important for production decisions because
these will help the producers and supplier in supplier allocation of resources because

derivatives serve as barometers of the future trends in prices which result in the discovery of
new price both on the spot and futures markets. For,
Example: - A cotton farmer in Andhra Pradesh would like to know what he produces will be
attractive he may chose to go for cotton crop. Otherwise he might opt for some other cash
crop.
This information will be available to him if cotton is trading in a future / forward
market, then the farmer can get some idea about likely price realization.
7. Attractive large investors: -
In the derivative trading no immediate full amount of the transaction is required since
most of them are based on margin trading. As result, large numbers of traders, speculators
arbitrageurs operate in such markets. So, derivatives trading enhance liquidity and reduce
transaction costs in the markets for underlying assets.
8. Better economic decisions: -
Derivatives reduce transaction cost because it is often easier to buy and sell in the
forward market than in the cash market (Spot market). Traders dont give delivery of the
asset at all. Hence derivative markets are much cheaper and more convenient for assets that
are hard to store and transport.
Lower transaction cost often lead to higher liquidity in the derivative market.
By reducing transaction costs and increasing liquidity, derivative market improve
price discovery and lead to more accurate prices in the cash market. This leads to better
economic decisions.
9. Corporations use Derivatives: -
Companies use currency forwards and other derivatives to hedge their exports,
imports and other foreign exchange exposures. They use commodity derivatives to hedge raw
material consumption and inventories as well as their output prices and inventories. For,
Example: - An electrical goods manufacturer might use copper futures to hedge the cost of
copper which is a major raw material for it. A gold mining company might use gold futures
to hedge the selling price of its output. Companies also use interest rate derivatives to hedge
their borrowing costs.

An exporter of prawns to a foreign country may find that his supply may be
competitive if the rupee exchange is more than 44 per US dollar at the time of his foreign
currency receipts. If there is a forward market, he can gang the going forward exchange rate
3 months hence and if the forward market is over 44 per US dollar he may undertake the
contract. If the rate is less than 44, he may not enter into agreement with the foreign buyer to
supply.
10. Financial service firms, banks and other dealers use derivatives: -
Bank and securities firms use derivatives to hedge their inventories of securities for,
Example: - A stock broker might carry large inventories of shares as part of his trading
activities. He might use stock index futures to eliminate the market risk of these inventories.
Banks often act as dealers in derivative markets to earn dealer spreads by buying a
derivative from one customer and selling the same to another at a higher price. They may
also seek to make profits by carrying on arbitrage between different markets. Some firms
may also speculate on different prices and earn trading profits by taking positions.
11. Mutual funds and investment institutions use Derivatives: -
Bank and securities firms use derivatives to hedge their inventories of securities for,
Example: - A stock broker might carry large inventories of shares as part of his trading
activities. He might use stock index futures to eliminate the market risk of these inventories.
Banks often act as dealers in derivative markets to earn dealer spreads by buying a
derivative from one customer and selling the same to another at a higher price. They may
also seek to make profits by carrying on arbitrage between different markets. Some firms
may also speculate on different prices and earn trading profits by taking positions.
12. Mutual funds and investment institutions use derivatives: -
Investment institutions use currency forwards and other derivatives to hedge their
internal asset and liability portfolios. The use swaps and other interest rate derivatives to
protect their portfolios from the effects of from the effects of interest rate risk. They use
commodity futures to invest in asset classes in which they find it difficult to invest directly.
Investment institutions also sell options to earn premium income and enhance the returns on
the portfolio. Hedge funds and other aggressive investors use derivatives to speculate in
various financial markets or to arbitrage between different markets.

13. Individual use derivatives: -

Many individuals do speculate on asset prices. A famous
Example: - The late Nobel Prize winning economist Milton Friedman who wanted to short
sell the British pound in 1969 when his economic analysis convinced him that a devaluation
of that currency was imminent. He was unable to do so in the OTC markets available at the
time and this experience made him a strong supporter of financial futures in Chicago.
Individuals who manage their own investment portfolios might also use derivatives
for the same reasons as investment institutions. In addition, they may use derivatives to
hedge their non tradable assets. For,
Example: - An individual who holds non transferable employee stock options granted by
his employer might use derivatives to hedge the risk of these options.
MISUSE OF DERIVATIVES OR CRITIQUES OF DERIVATIVES: -
Besides from the important services provides by the derivatives, some experts have
raised doubts and have become critique on the growth of derivatives. They have warned
against them and believe that the derivatives will cause to destabilization, volatility, financial
excesses and oscillations in the financial markets.
1. Speculative and Gambling Devices,
2. Increase in risk,
3. Instability of the financial system,
4. Price stability,
5. Displacement effect,
6. Increased regulatory burden.
1. Speculative and Gambling Devices: -
It is witnessed from the financial markets throughout the world that the trading
volume in derivatives have increased in multiples of the value of the underlying assets and
hardly one to two percent derivatives are settled by the actual delivery of the underlying
assets. Sometimes these speculative buying and selling by professionals and amateurs
adversely affect the genuine producers and distributors.

2. Increase in risk: -
It has been observed that the derivatives market especially OTC markets, as
particularly customized privately managed and negotiated and thus they are highly risky.
Empirical studies in this respect have that derivatives used by the banks have not resulted in
the reduction in risk and rather these have risen of new types of risk. They are powerful
leveraged mechanism used to create risk.
3. Instability of the financial system: -
It is argued that derivatives have increased risk not only for their users but also for the
whole financial system. The malpractices, desperate behavior and fraud by the users of
derivatives have threatened the stability of the financial markets and the financial system.
4. Price stability: -
Some expert agrees that derivatives have caused wild fluctuations in the price. The
derivative may be helpful in price stabilization only if there exist a properly organized,
competitive and well regulated market. Further the traders behave and financial in
professional manner and follow standard code of conduct.
5. Displacement effect: -
Growth of the derivatives will reduce the volume of the business in the primary or
new issue market specifically for the new and small corporate units. It is apprehension that
most of investors will divert to the derivative markets, raising fresh capital by such units will
be difficult and hence, this will create displacement effect in the financial market.
6. Increased regulatory burden: -
The derivatives create instability in the financial system as a result; there will be more
burdens on the government or regulatory authorities to control the activities of the traders in
financial derivatives.
ROLE OF DERIVATIVE MARKET OR FUNCTIONS OF DERIVATIVE MARKET: -
Globally derivatives markets are huge and growing rapidly and expansion is probably
going at a scorching pace in the developing countries. Securities markets are dwarfed by the
derivatives markets.
The latest terminal bank for international settlement (BIS) survey published in 2005
reports that the outstanding amount (Notional principal) of OTC derivatives in global

financial market reached $248 trillion as at the end of 2004. This represents a 26% increase
for 2004 and follows a 39% increase in 2003.
The BIS also reports that the outstanding amount of exchange traded derivatives (i. e.
futures and options) reached $46.6 trillion at the years end. Together with the amount of
OTC derivatives, this put the total amount of derivatives outstanding in global market $295
trillion.
Ever since their introduction, derivatives market in India shown a phenomenal growth
in exchange traded and OTC segments. It can be noticed that market for interest rate
derivatives is now comparable with that for government securities in India while the equity
derivatives turnover is more than turnover in the spot market. National stock exchange
ranked as the 17th largest derivatives exchange in the world based on futures and options and
10th largest in the future segment. In the year 2005, the NSE traded 35 times the number of
equity futures contracts as were traded on one Chicago.
Functions or role of derivative market: -
1. Hedging,
2. Price stabilization function,
3. Liquidity Function,
4. Price discovery,
5. Financing Function,
6. Disseminating Information.
1. Hedging: - The primary function of the future market is the hedging function which is
also known as price insurance, risk shifting or risk transference function.
2. Price stabilization function: - Derivative market reduces both the heights of the peaks
and the depth of through the major causative factors responsible for such price stabilizing
influence are such as speculation, price discovery, tendency to panic etc.,
3. Liquidity Function: - Under derivative market the buyer and the seller have to deposit
only a fraction of the contract value say 5% or 10% known as margins. It means that the
traders in the futures market can do the business a much larger volume of contracts than
in a spot market and thus makes market are more liquid.

4. Price discovery: - Another important use of derivatives market is the price discovery
which is revealing of information about futures cash market prices through the future
market. If these expectations are properly published then they also perform an
information or publicity function for the users and the society. In this way, a user of the
futures prices can make consumption or investment decisions more wisely.
5. Financing Function: - Another important function of a futures market is to raise finance
against the stock of assets or commodities lenders are often more interested to finance
hedged asset stock rather un hedged stock because the hedged asset stock are protected
against the risk of loss of value.
6. Disseminating Information: - Futures markets disseminate information quickly,
effectively and inexpensively and as a result, reducing the monopolistic tendency in the
market. Further such information disseminating service enables the society to discover or
form suitable true / correct / equilibrium prices. They serve as barometers of futures in
price resulting in the determination of correct prices on spot markets now and in futures.
They provide for centralized trading where information about fundamental supply and
demand conditions are efficiently assimilated and acted.


Unit - Introduction To Derivatives

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FINANCIAL DERIVATIVES

FINANCIAL DERIVATIVES SYLLABUS AT A GLANCE: -

Derivatives & Its Features, Types of Unit - I Role of derivative

Mechanics of future market, structure Determination of

Advanced option strategies, Unit - IV hedging with options,

Concept & Nature of Swaps, features Unit - V Major types of swaps

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The above definition conveys that,

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Basic Complex Futures Forwards

Forwards Futures Options Warrants & Convertibles

Stock Futures Stock Index

Classification by Nature of the Underlying Asset: -

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FEATURES OF A FORWARD CONTRACT: -

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8. Delivery rare or Expire date: -

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price exercise price

Difference between OPTIONS VS FORWARDS contract: -

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Difference between OPTIONS VS FUTURES contract: -

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3. 1974 Equity futures, equity options

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Example: - US trading bond futures and Euro dollar futures.

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legal frame work for derivatives trading in

Derivative products in Indian financial markets: -

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USES OF DERIVATIVES OR ECONOMIC BENEFITS OF DERIVATIVES OR

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13. Individual use derivatives: -

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