Introduction to

Derivatives

Introduction: Risk
Management
Risk is inherent in all our day to day activities
and is defined as deviation from expected
It is not possible to eliminate all the risks,
however one can manage the risks
The impact or magnitude of risk is estimated
from the following two factors:
1. The probability of an adverse event
happening
2. In case the even occurs, the magnitude of
loss it can cause

..contd.
From
the
perspective
of
its
management, risk can be viewed in
two ways:
I. Risk of small losses with high
probability:
eg.
Changes
in
commodity prices, exchange rates,
interest rates etc.
II. Risk of large losses with low
probability: strategic in nature like
capital budgeting, capital structure

Types of Business Risks

Risks with large probabilites of
small losses are:
Price Risk
Exchange Rate Risk
Interest Rate Risk

Derivative Instruments
A derivative (or derivative security) is a
financial instrument whose value
depends upon the value of other, more
basic, underlying variables.

Underlying Price Change

Derivative Price Change

Origin of Derivatives

Ancient Greece in some form

Farmers need to protect their crops therefore
derivatives market initially developed in
commodities.
First futures contract traced back to Yodoyo rice
market in Osaka, Japan in 1650
In 1848 Chicago Board of Trade (CBOT) was
established to facilitate trading of forward contracts
in various commodities

Indian derivatives market

Notable early exchanges
Bombay Cotton Trade Association Ltd
1875
Gujarati Vyapari Mandali 1900 for
oilseeds
Futures market in raw jute, Calcutta 1912
Chamber of Commerce, Hapur 1913 for
wheat
Bullion futures market, Bombay - 1920

Forward Contracts Regulation Act,

1952
7

Indian Commodity
Exchanges
The National Level Multi Commodity Exchanges:

National Commodity & Derivatives Exchange Limited

(NCDEX) since 2003
Multi Commodity Exchange of India Ltd (MCX) since 2003
National Multi Commodity Exchange of India Limited
(NMCEIL) since 2002
National Board of Trade Limited (NBOT) since 1999

In addition, there are about 25 recognized

commodities exchanges.
All the exchanges have been set up under overall
control of Forward Market Commission (FMC).
There are more than 100 commodity derivatives
trading on these exchanges.
Trading is fragmented over multiple market venues
due to lack of free movement of commodities and
differential taxation in different states.
8

Trading in futures &

Precursors to modern day instruments
options

Teji (call), mandi (put), fatak (straddles), etc. Operating in

unorganized markets all kinds of options banned in 1956.
Badla trade involving some elements of forward trading banned by
SEBI in 2001.

Securities Contracts Regulation Act, 1956: amended in 1995

derivatives were declared securities
withdrew prohibition on options in securities.

Securities and Exchange Board of India Act, 1992

L C Gupta Committee (1996) set up by SEBI to develop
appropriate regulatory framework
recommended phased introduction of derivatives
bi-level regulation (self-regulation by exchange with SEBI providing a
supervisory and advisory role.

J R Verma Committee (1998) worked out various

operational details for derivatives trading such as margining
system.

Trading in futures &

options
1999 RBI permitted OTC trades in currency
(forwards, swaps, options) and interest rate
derivatives (FRA, swaps) deep & liquid market,
except in currency options.
2000 - Derivatives segments of NSE and BSE were
approved by SEBI.
2000-01 Trading commenced at NSE/BSE

June 2000: Index Futures at NSE and BSE

June 2001: Index Options
July 2001: Options in Single Stocks
November 2001: Futures on single stocks

2003 Interest rate futures at NSE not very

successful due to faulty contract specifications.
2008 Currency futures at NSE
10 at NSE
2009 Interest rate futures reintroduced

Classification based on
Underlying Asset

Commodities
Currencies
Interest Rates
Equity Shares
Indices
Credit: eg: credit default swaps
Weather

Derivatives Classification based on Trading

Exchange traded:
Traditionally an open outcry system, but
gradually switching to electronic system
No credit risk due to default because of
standard contracts

Over-the-counter (OTC):
A network of dealers at financial
institutions, corporations and fund
managers
Contracts are non-standard and there is
some credit risk involved
12

Classification based on Product

Forwards
Futures
Options
Swaps

Functions of Derivatives
Market
Price Discovery
Risk Transfer

14

Nature of the instruments

Underlying assets:
Real asset Physical assets such as wheat and
oilseeds
Financial asset Interest rate, bond, stock,
exchange rate
Other assets Weather, electricity, credit

Unlike financial markets, derivative markets

do not create or destroy wealth they
merely provide a means to transfer risk.

15

Why do we use
derivatives
Three Purposes

Speculation

Hedging

Arbitrage

16

Traders in derivative
markets
Hedgers:
Hedgers face risk associated with the price of an asset;
they use these instruments to reduce or eliminate that
risk.
These are firms that face a business risk. They wish to get rid

of this uncertainty using a derivative. For example, an airline

might use a derivatives contract to hedge the risk that jet fuel
prices might change.

Speculators:
They bet on the future movement in the price of an
asset.
These instruments give them large leverage by putting
small amount of money, they can take large positions
large potential gains / losses.
Arbitragers:
They trade to profit from the disequilibrium or
imperfections in prices in different markets cash and
derivative.
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Global Exchange Traded Derivatives by

Category
Category

Jan Dec 2010 (in

$mn)

Jan Dec 2011 (in

$mn)

Equity Index

7,416

8,460

Individual Equity

6,295

7,062

Interest Rate

3,205

3,491

Agriculture

1,306

991

Energy

724

815

Currency

2,526

3,147

Precious Metal

175

341

Non Precious Metal

644

435

Other

138

230

Total Volume

22,425

24,972

Global Futures and Options Volume

Rank Exchange
2011

Jan Dec 2011

(in $mn)

Korea Exchange

3,928

CME Group (includes CBOT 3,387

and Nymex)

Eurex ( includes ISE)

2,822

NYSE Euronext

2,283

NSE

2,200

BM &F Bovespa

1,500

Nasdaq OMX Group

1,296

Chicago Board Options

Exchange Group

1,217

MCX (Multi commodity

Exchange of India)

1,196

10

Russian Trading Systems

Stock Exchange

1,083

Product-wise Turnover of Equity

Derivatives Market NSE (%)
Period

Index
Futures

Stock
Futures

Index
Options

Stock
Options

Total

2009-10

22.3

29.4

45.4

2.9

100

20101-11

14.9

18.8

62.8

3.5

100

2011-12

11.4

13.0

72.5

3.1

100

April Sep
2012

9.2

12.7

73.0

5.1

100