21£00401a

FinancialDerivatives
UNITI
NTRODUCTION TO DERIVATIVES
The term Derivative" indicates that it
entirely derived fom the value of the underlying h£s no independent value, i.e., its
asset. The underlying asset can be. value is
commodities, bullion currency, livestock or anything securities,
forward, futures, option or other hybrid çontract of else In other words, derivative means
purpose of contrct fulfiment to the value of a predetermined fixed düration, linked for the
of securities. specified real or financial asset or to an index
Derivatives arc products whose value is derived from one or morc basic
underlying assets or base. In simpler form, derivatives variables called
are financial security such as an option
or future whose value is derived in
part from the value and
underlying asset. The primary objectives of any investor characteristics of another an
returns and minimize risks. Derivatives are contracts that are to bring an element of certainty to
originated from the
Derivative contracts can be standardized and traded on the stock need to limit risk.
Tderivatives are called exchange-traded derivatives. Or theycan be exchange. Such
of the user by negotiating with the other party customized as per the needs
inyolyed. Such derivatives are called over-the
counter (OTC) derivatives.
The term derivatives relate with a variety of financial
instruments which include the
following:
Short-term Debt securities
Interest rate
Common shares/stock
Bonds & Debentures
Stock index value
Foreign Currency
Other financial assets

Definition
The Securities Contracts (Regulation) Act 1956 defines "derivative" as under
A Derivative includes:
(a) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk
instrument of contract for differences or any other form of security;
(b) a coniract which derives its. value from the prices, or index of prices, of underlying
securities.)
Advantages of Derivatives:
1. They help in transferringrisks from risk adverse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyse entrepreneurial activity.
4. They increase the volume traded in markets because of participation of risk adverse people
in greater nuinbers.
5. They increase savings and investment in the long run.

HISTORY OF DERIVATIVES MARKET

Derivatives are not a modern invention. They were known and were used from ancient
times. The first organised commodity exchange was came into existencein the early 1700s in
Japan. The first formal commodities exchange, The Chicago Board of Trade(CBOT) was forms -to
in1848 in US to deal with the problems of Creditrisk and to-provide centralised location
Department ofMBA
E.Naveen Kumar Reddy Assistant Professor
 21E00401a Financial Derivatives
negotate forward contracts. From'Forward' trading in
"Futures'. The first Futures type contract was commodities emerged the commoaly
Ir¡ding in futures began CB0T in the called
1860s.
'to arrive at".
in 1865, CBOT listed the first "exchange
raded' derivatives contract known as the
for hedging the price risk futures contract, Futures trading grew out or ne i
involved in many commercial
Ihe Chicago Mercantile Exchange (CME), a spin-off operations.
though it did exist before 1874 under the name ofChicago Product of CBOT was formed in 1919
Butter and Egg Board'. The first Exchange' and Chicago
financial futures to emerge
n ae US. The first foreign currency futures contracts werewere the currency futures n1214
traded on May 16, 19T2 on the
International Monetary Market (IMM). a division of CME.
1ne currency futures traded on the IMM were the British Pound, the Canadian Dollar,
the Japanese Yen, the Swiss France, German Mark, Australian Dollar and the Buro Dollar.
Currency futures werc soon followed by interest rate futures.
Interest rate futures for the first timetraded on CBOT on October 20, 1975 in the Us.
Stock index futures emerged in 1982.
he. thatket foF futures and options gresy at rapid pace in the 1980s and 1990s. the
collapse uf the Brellon Wools reglite uf tlxed badtley ARid thà lntioductivn of llualitug tules for
cuFfeheies 0n lle interthaliotal fiuiucial tutkels bavei ihe wely for de tu i è ofwitlti tiuntiler
velopuettt
natkel
04.lW14ncldl cletivttlyes wielt setved is ellectve tisk b)igelitellt tools
uncertainties.
DEVELOPMENT OF DERIVATIVES MARKET
other for a long
Derivatives markets in India haye been in existence in one form or the futures trading
Association started
time. In the area of commodities, the Bombay Cotton Trade settlement and option trading,
way back in1875. In 1952,the Government of Indiabanned cash
Derivative trading shifted to informal forward markets)
favour of an increased role of market
(In recent years, government policy has shifted inThe first step towards introduction of.
based pricing and less suspicious derivativé trading. ordinance,
financial derivative trading)in India was the promulgation of the securities laws
1995. It provided for withdrawal of prohibitionon options in securities.SEBI granted the final
Derivatives trading commenced in India in June 2000 after
committee. SEBI
approval to this effect in May 2001 on the recommendations of L,C. GUPTA
permitted the derivatives segments of two stock exchanges, NSE3 and BSEA and their clearing
corporation tò commence trading and settlement in approved derivatives contract.)
Initially, SEBI approved trading in index futures contract based on various stock market
indices such as S&P CNX, NIFTY and Sensex. Derivatives have a fairly long history in India
too.
Date Progress
14 December 1995 NSE asked SEBI for penission to trade index fåbures.
18November 1996 SEBI sctup L C Gupta Committee to draft a policy framework for index futurcs.
11May 1998 L.C. Gupta Committee sobmitted report.
7 July 1999 RBI gave pernission for OTCforward rate agreements (1RAS) and intercst rate swaps
24 May 2000 SIMEX Chose Nifty for trading futures andoptions on an Indian index.
25 May 2000 SEBIgave permission to NSE and BSE to do index futurcs traing.
9 June 2000 Trading of BSE Sensex futures coramencod at BSE.
12 June 2000 Trading of Nifty futures conmenced at NSE.
31 August 2000 Trading of futures and options on Nifty to commence aa SIMEX.
June 2001 Truding of Equity IndexOptions at NZE
July 2001 Trading of Stock Options at NSE
November 9, 2002 Trading of Single Stock futures at BSE
June 003 Trading of Interest Rate Futures at NSE
September 13, 2004 Weekly Options at BSE
January l, 2008 Trading of Chhota(Mini) Sensex at BSE
Jantayl, 2008 Trading of Mini Index Futurcs & Options at NSE
August 29,2008 Trading of Currency Futures at NSE
Ociober 2,2008 Trading of Cumency FuEures at BSE
Source: Complied from BSE and NSE

E.Naveen Kumar Reddy Assistant Professor Department of MBA

 21E00401a
Financial Derivatives
GROWTH DERIVATIVES
(Equity derivatives markt in OF
to continuethe same in the
India has shown a years to MARKET
India h¡s registered an
"explosive
come. Introduced in 2000, growth" and is expected
remarkable
contracts NSE alone accounts forgrowth both in terms of financial derivatives market in
introduction of
derivatives 99 percent of the volumes gin and numbers of traded
derivativs gained
lpopularity
has
soon
been derivatives
well received by
stock trading - players.
Indian markets) The
derivatives market exceeded the after its
introduction. In due market.the turnOver Trading in
NSE
For example, in 2008, theturnover of the NSE course,
cash market.
of the

Cr. whereas the value of the value of the NSE

trading figures of:NSE and NSE cash markets wasderivatives markets wasCr. Rs. 130,90,477.75
only Rs. 3,551,038
BSE, performance of BSE is encouraging both If we compare the
volumes and numbers of not in terms of
traded on NSE in F& O contracts traded in all product categories.) Among all the products
popular in terms of volumes segment, single stock futures also known as equity futures, are most
and
turnover shares or SZ percent andnumber of
31 percent.contracts traded, Infollowed by index futures with
outperform stock futures. An respectively. case of BSE, index tuu
be observed is the huge gap important feature of the derivative segment of NSE which may
between average transactions of its derivatives segment and
cash segment. In sharp contrast to NSE, the daily
situation at BSE is just the opposite: iS cas
segment outperforms the derivatives segment.
The derivatives market growth for diferent derivative market
the following heads: instruments may be undos
Derivative Market growth for the Exchange traded Derivatives - The derivauY
market growth for equity reached $114.1 trilion. The onen interest in the futures ana
options market grew by 38% while the interest rate futures grew by 42%0. Henee
derivative market size for the futures and the options market was $49 trillion.
3 Derivative market growth for the Global Over-The-Counter Derivatives - The
contracts traded through OTC market witnessed a 249% increase in its face value and
the TC derivative market size reached S70.000 billion. This shows that the face value
of the derivatives contracts has multiplied 30 times the size of US econoay. Notable
increases were recorded for foreign exchange, interest rate, equity and.commodity
based derivatives following an increase in the slze of theOTC derivative market.
Derivatives Market growth for the credit derivatives - The credit derivatives grew
from $4.5 trillion to $0.7 trilliòn in 2001, This derivative market growth is attributed to
the increase in the trading in the synthetic collateral debt obligations and also to the
electronic trading systems that have come into existence. The total amount of Credit
Default swap witnessed a growth of 42%, credit derivatives grew by 54%. The single
name contracts grew by 11%. The OTC foreign exchange derivatives slowed by 5%,
The OTC equityderivatives slowed by 10%. Commodity derivatives also experienced
crawling growth pattern.

STRUCTURE OF DERIVATIVES MARKET

Derivatives Markets in India can be broadly categorized into two markets namely:
Financial Derivatives Market-Financial Derivative Marketsin India are eguilated
and controlled by the Securities and Exchange Board of India (SEBI). The SEBI is
authorised under the SEBI act to frame rules &regulations for financial futures trading
on the stock exchanges with the objective to protect the interest of the investors in the

E.Naveen Kumar Reddy Assistant Professor Department of MBA

 FinancialDerivativss
21E00401a
eie2sctsaSou6

h
Trnding)Derivtives matkt e
market, Purther cArry forward trading (3dla Plnancial
whlch ls traded on the stock exhanges, Wae,
fincial
forvwatis #l iutures, 1
optlons, interest rate futures, tIEIY reyulation f the BE:1
Major Stock Exchanges in Indis, underthe Some f the nher fir
products namely cquity and cary forwards,
futures #r
currenoy options and futures and interest rae
Derivatives Maskets
CoonoditiesPutures
Pinancial LDerivatives Murket
Market

Beyilated by
Cononission

Over-TheCounter (OTC)
Stock Exchanges Indiz by
Market-Commodity futures smarketare regulated in regulate
Commodittes Futuree PMC), The comunission is entrusted with to
Forward Market Commission India. Products like Potatoes, Pepper, Ctton, tc.
commodíties futures trading in Exchange and Calcutta CoOmodity
Exchenge.
Coimbatore Commodity
are traded on
PLAYERSIPARTICIPATES IN DERIVATIVES MARKET
type of individual will have an objective to particípae in the derivtive Trarke
Each based on their trading rnotives:
You can divide them into the following categoriesin stock markets. They zin at derivztive
Hedgers: These are risk-averse traders risk and price
markets to secure their investmert portfolio agairst the make derivetives tnarke
movements. They do this by assurming an opposite position in the
In this manner, they transfer the risk of loss to thoc others viho ae reedy to take it In
return for the hedging available, they need to pay a prerniun to the risk-zker.
Imagine that you hold 100 shares of XYZ compay wich are currenty priced t Rs.
120. Your aim is to sell these shares after three months. However, you dm't want to
make losses due to a fall in market price. At the sarne time, you don't want to lose an
opportunity to earm profits by selling them at a higher price in future. In thíssituztion,
you can buy aput option by paying anominal premíurn that will take care of both the
above requirernents.
Speeulators: These are risk-takers of the derivative marke They want to ernbrace risk
in order to earn profits. They have a conpletely opposite point of view 2s
the hedgers. This difference of opinionD helps them to make copared to
corect. In the above exarnple, you bought a put option to huge profits if the bets tum
eCure yourself frormn a fall in
stock prices. Your counterparty ie. the speculatot will bet that
the stock price won't

E.Naveen Kumar Reddy

E.Naveen
Reddy
Kumar

corporate.
scalpers, 21E00401a
derivatives
isalternative their the
Other Individuals: 50.Rssell
futures
Suppose
prices
important simultaneously
Arbitrageurs:
in biggerbiggerImagine the
intradesgains Margin
speculator fll.
botFinancinl
h alsparticular contracts.
yield it another the
o market.Banksprofitmarket
Scalpers Participants: at in broker
on If
banks, market.
Rs an gains/lossesposition stock and
Speculators Individuals the
buyers find market. to or different that a
traders:
from
- to 1050 cquity market. maintain daily to keepsstock
ThereBanks who investing Individuals
perhaps They market.witha participate
themselves credit financial
- in An buyThese i.e.
Institutions
and basis A tprices
he
theholds Amaximise In
are th
arbitrageur¹ markets.
share This in Rs sum
may bid-ask Scalper order All to low-priced a margin preimium
sellers orwould futures can
utilize However,
the 6 large as Participants don't
directly taclients
ke are is lakh of per in
industry. be a
institutions, resident derivative
Professor
Assistant in the to the
quoted happen position.
Rs. market threfers e
cases spread. position is
ensure out the withoutstanding 2 Participants Other and fall,
in aand typically a number in of market.would securities in derivative
similar
the speculative most lakh to
person Indians, assets trading at onlylow-risk the
the movements. the in
makes then
In that Rs market you Derivative you
market. NBFCs suchwhere for NBFCS, important Inbuy sam
derivative minimum
position be of 1000 when in buy market. a
a
trading the withoutmembers. this the market as profit.won't
a very participants NRIs, one amount.
case bank both derivative positions. process,stock in the compared 200
mutual market It
Financial buyers buying players the imperfections market, shares enables amount It Market exercise
the short in FIs at same A is
to believes
the They stock
Rs Derivatives
Financial
the bank he/she and slight used
and period and and A in 1000 security to you of to that your
banks equities funds, market market the to Arbitrageurs Hedgers
in derivative use the sell get you
the mutual holding price can ABC reflect put
stock
institutions will that
sellers of insurance market
earns in
them to leverage
functions derivatives the andis'quoted make change oWn Ltd. need option.
and wish it time or market a
is of options t
fundsprovideshe low-riskstock at atmarket. of your to
are who profits.a a Rs in deposit Hence,
epartmentMBA of thus overexposed
and buy
to credit incompanies to asset
Rs higher
at willthree 1000 derivative losses
an efficiently, can tobuy market 105
NBFCs and encompass profit different leadtimes
protection. risk attempt itself. enhance
them in priceThey each and with the
likely trade or
sell and the to
in futures an of
tomay tothe and it in
be a to
21E00401a Financial Derivatives

Trading Member- Amember of the exchange and one who trades on his own
oenalf and on behalf of his clients, On BSE they are called as Limited Trading
Members.
V Clearing Member -One who undertakes to setle his own trades as well as the
trades of the other non-clearing members, known as Trading Members, who
have agreed tosettle the trades through them.\
TYPES (er) CLASSIFICATION OF DERIVATIVES
Broadly Derivatives can be classified into below categories:
On the basis of Underlying Asset
options. A derivative is a
Underlying asset is a term used in derivatives trading, such as with underlying asset is a
asset. The
financial instrument whose price is based from a different
financial instrument on which a derivatives price is based. underlying equity securities.
derivatives derive their value. from one or more
Dquity
fulute$, upllons, wittabls, utd swps. the itost popilar iuslrtunelits by
The lypes lte
itures) ittyestors ciu lide ii iiüres utd ojpliotsof stucks atd
ltt ale oplions ilid detivaives as ätiiliërisitive t hedpe tisk. J'ur itislattce, l" at
indices, iliey ise eqilly u8eaervatve `ince these instruments
investor invests instocks then they can Can use
from the underlying stocks, hedging is possible. The investor can
derive thcir value
by entering into a put option.
protect them against potential lossfinancial the
Derivative is a instrument with a value that is linked to
(An Interest Rate These may include futures, options, or
swaps
interest rate or rates.
movements of an institutional investors,
Interest rate derivatives are' often used as hedges by
contracts.
individuals to protect themselves against changes in market
banks, companies, and increase or refine the holder's risk profile or
can also be used to
inlerest rates, but they
to speculate on rate moves. on
Foreign Exchange (FX) Derivative is a type of derivative whose payoff depends
trillions of
A currencies. The market for FX is measured
in
the FX rates of two or more derivative contracts. 80% of all FX
dollars, and includes a substantial amount of FX
involve the US Dollar, which is considered to be the world's premier reserve
trades is a reference
market, which
currency,)The majority of FX trades take place in the 'spot' quoted at the time of the
toa buyer or seller of foreign currency trading on the price
days of execution. Most FX
trade. Such trades are usually settled within two business FX
derivatives are short-dated with a maturity date of less than one year, meaning that
derivatives carry less credit risk than other types of derivative.
In Commodity Derivatives, the underlying asset is a commodity, such as cotton, gold,
copper, wheat, or spices. Commodity, derivatives were originally designed to protect
farmers from the risk of under- or overproduction of crops. Commodity derivatives are
investment tools that allow investors to profit from certain commodities without
possessing them) The buyer of a derivatives contract buys the right to exchange a
commodity for a certain price at a future date. The buyer may be buying or selling the
commodity.
 21E00401a Financial Derivatives

Types of Deriyatives in India

On the basis of on the basis of on the basis of on the basis
Underlying asset Financial Derivative Market
Complexity
Equity
Derivatives Exchange Traded
Interest rate " Forwards OTC Derivatives
derivatives Futures Hybrid /Exuties
Foreign Optlons
Weather
Exchange " Swaps
Derivatives Derivatives
Commodity
Derivatives
Credit
Derivatives

On the basis of Financial Derivative Trading in India

Forwards - Forward contract is a cash market transaction in which delivery of
the instrument is deferred until the contract has been made.
Futures -A Futures Contract is an agreement between two parties to buy or
sell an asset at a certain timne in future at a certain price.
ji Options- An option represents the right but not the obligation to buy or sell a.
security or other asset during a given time for a specified price.
iy. Swaps - A swap is a contract between two parties in which the first party
promises to make payment to the second and the second party promises to make
payment to the first.
On the basis of Market in which they trade
Exchange traded Derivative Market-As the word suggests derivatives that trade
on an exchange are called exchange traded derivatives. In the
exchange traded
derivatives market exchange act as the main party and by trading of derivatives
actually risk is tr¡ded between two parties. Exchange. traded are
standardized
contracts with predetermined exercise prices and standard expiration
Exchange traded derivative market has the following features: months.
An electronic exchange mechanism
Full TransapareDcy
Use of computer for order flow
Large investor base
Settlement guarantee
Better risk management
OTC Derivative Markets -A security traded in some
exchange such as NYSE, TSX, AMEX,etc. The phrasecontext other than a formal
be used to refer to stock exchanges that
trade via
"OverThe-Counter" can
a dealer network as opposed to on
acentralised exchange. The dealer act to
bring the counterparties together but have

E.Naveen Kumar Reddy Assistant Professor Department of MBA

 Financial Derivatives

no part in the OTC markets are the

participants of
transaction itself. The nainGovernmnent sponsored enterprises and
Investment
Hedge funds. Banks,
Commercial Banks,
W. On the basis of
Complexity Dertivatives
Hybrid / Exotic /5Sophisticated - These area specific type of
financial
aSsets. These are derivatives that do not have a standard pay-off, as in the case for a
gular call option. It refers to any derivative security which is not aEuropean or
American vanilla call or put on a single underlying security. Other types of cxotie
options includes:- (a) Barrier Options
(b) Asian Options
(c)Digital Options
(d) Compound Options organization of
that enable an
Weather Derivatives - these are financial products allow companies to control the
variable. They
oliset thefinancial risk due to weatherproducts. This hedging reduces the volatility of
elleels of weatltet ou deutend ortheir
Ruture tevetitie lo a itör brëdictiblë csl1 flow.

ROLE OF DERIVATIVES MARKET

commonly looked at, these
Inspite of fear & Criticism with which the derivatives markets are
markets perform a number of economicfunctions:
assets, as
Risk management: The prices of derivatives are related to their underlying
mentioned before. They can thus be used to increase or decrease the risk of owning the asset.
For example, you can reduce your risk by buying a spot item and selling a futures contract or
call option. This is how it works. If there is a fall in the spot price, the corresponding futures
and options contract will also fall. You can repurchase the contract at a lower price, which will
result in a gain. This can partially offset the loss on the spot item. The ease of speculation in
the derivatives market makes it easier for an investor seeking to protect a position or an
anticipated position in the spot market.
Price discovery: Derivative market servesas an important source of information about prices.
Prices of derivative instruments such as futures and forwards can be used to determine what
the market expects future spot prices to be. In most cases, the
reliable. Thus, the futures and forwards markets are especiallyinformation
is accurate and
mechanism. helpful in price discovery
Speculation: Youcan use a derivative contract to get exposure to price
underlying stock inexpensively and without holding a stock. You alsomovements
do
of an
account for the stock on your accounting books. It is not need to
especially
commodities. You do not need to store hundreds of barrels of crude oil in true in case of
to get exposure to the market. your back garden
Exploit Opportunities to Enhance
Returns:
forwards and futures can provide firms and Derivative securities such as potions,
returns that might not otherwise be investors to exploit opportunities to
investors and firms and they lower the cost ofDerivative aid in the allocation of riskenhance
available.
across
reveal information to investors that
can make diversifying portfolios.
financial markets moreDerivative prices
stable. It makes

E.Naveen Kumar Reddy

Assistant Professor
Department of MBA
 21E00401a Financial Derivatives
investors and firms to enter into the derivative contract to speculate on securities and
indexes.
Price Stabilisation: Derivative markets helps to keep a stabilising influence on spot
prices bý reducing the short-term fluctuations. In other words, derivatives reduces both
peak and depths and leads to price stabilisation effect in the cash market for the underlying
asset.

Efficiency in Trading: Financial Derivatives allow for free trading of risk components
and that leads to improving market efficiency. Traders can use aposition in one or more
financial derivatives as a substitute for aposition in the underlying instrüments. In many
instances, traders find financial derivatives to be'a more attractive instrument than the
underlying security. This mainly because of the greater amount of liquidity in the market
offered by derivatives as well as the lower transaction cost associated with trading a
financial derivative as compared to the cost of trading the underlying instrument in the
cash market. :

Higher Trading Volumes: Derivatives, due to their inherent nature, are linked to the
underlying cash markets. With the introduction of derivatives, the underlying market
witnesses highertrading volumes because of participation by more players who would not
otherwise participate for lack of arrangemient to transfer risk.
Control Market Activities: Speculative trades shift to a more controlled environment of
derivatives market. In the absence of an organized derivatives market, speculators trade
activities
in the underlying cash markets. Managing, monitoring and surveillance of the
markets.
of various participants become extremely difficult in these kinds of mixed trading is
Acts as Catalyst: An important incidental benefit that flows from derivativeshave a history of
that it acts as a catalyst for new entrepreneurial activity. The derivatives attitude.
attracting many bright, creative, well-educated people with an entrepreneurial employment
They often categorise others to create new businesses, new products and new
opportunities the benefit of which are immense.
investment in the
In anutshell, derivatives markets help to increase savings and of activity.
their volume
long-run. Transfer of risk enables market participants to expand
USES OF DERIVATIVES
Reflect Perception of Market Participants - Prices in an organized derivatives market
reflect the perception of market participants about the future and lead the prices of
prices of derivatives converge with the pricesin
underlying to the perceived future level. Thederivatives
the contract. Thus, derivatives help
of the underlying at the expiration ofprices.
discovery of future as well as current markets help to transfer risks from those who
Helps to Transfer Risks - The derivativewho have an appetite for them.
have them but may not like them to those the
Trading Volumes - Derivatives, due to their inherent nature, are linked to
Higher of derivatives, the underlying market
underlying cash markets. With the introduction would not
because of participation by more players who
witneses higher trading volumesarrangement
otherwise participate for lack of to transfer risk.
shift to a more controlled environment of
Controlled Environment -Speculative trades speculators trade
market. In the absence of an organised derivatives market,
I derivativcs
M£naging, Monitoring and survetlanceof the activities
inthe underlying cash markets,
participants become extremely difficult in these kinds of mixed markets.
of various
Entrepreneurial - An important incidental benefit that flows from derivatives
Attract
a for
catalyst new entrepreneurial.activity. The derivatives have a
trading is that it acts as
Department ofMBA
Assistant Professor
E.Naveen Kumar Reddy
 21E00401a Financial Derivatives
21E00

1
history of attracting many bright, creative, well-educated people with an entrepreneurial between
attitude. They often categòrise others to create new businesses, new products and ncw 2
employment opportunities the benefit of which are immense. parties,
opposite
Risk Inv
FINANCIAL DERIVATIVES
Fnancial Derivatives are financial instruments that are linked to a specific financial
Isuument or indicator or commodity and through which specific financial riskscan be traded t
in financial markets in their
own right.
1he financial derivatives were also known as off-balance sheet instruments because no
assets or liabilities underlying the contract was put on the balance sheet as such.
Features
*Transactions in financial derivatives should be treated as separate transactions rather
than as integralparts of the value underlying transactions to which they may be linked.
The value of a financial derivative derives from the price of an underlying item, Such
as an asset or index.
Financial Derivatives ue ised kör a ituibeB, ol purposes teluliug risk atwzetlent,
edging, arbiltage betweelt italtkels ancl speculaton.
FyiglalJerivativescottlets te Usally seltléd by ttet payluetlts of cisli, dlen lefute
Financial Derivatives allow considerable returns to be made in relation to the outlay.
This is known as gearing.
The risk embodied in a derivatives contract can be traded either by trading the contract
itself, such as with options, or by creating a new countervailing manner, those of the
existing contract owned.
Types of FinancialDerivatives
Basically, following financial derivatives are available for trading in India:
Forward Contracts: Aforward contract is an agreement between two parties - a buyer and a
seller to purchase or sellsomething at a later date at a price agreed upon today. Forward i deliv
contracts, sometimes called forward commitments, are very common in everyone life. Any
type of contractual agreement that calls for the future purchase of a good or service at a price
agreed upon today and without the right of cancellation is a forward contract. be sc
Future Contracts: A futures contract is an agreement betvween two parties - a buyer and a type
seller -to buy or sell tomething at a future date. The contact trades on a futures
is subject to a daily settlement procedure. Future contracts exchange and Fea
and possess many of the same characteristics. Unlike forward evolved out of forward contracts
on organized exchanges, called future markets. Future contracts, futures contracts trade
contacts in that they are subject to a daily sctlement contacts also differ from forward
investors whÍ incur losses pay them every day to procedure. the
In daily settlement,
investors
Options Contracts: Options arc of two types - calls and who make profits.
but not the obligation to buy a given puts. Calls give the buyer the right
quantity of the
before a given future date. Puts give the buyer the underlying asset, at a given price on or
quantity of the underlying asset at a given price on orright, but not the obligation to sell a given Ty
Swaps: Swaps are private agreements between before a given date.
according to a prearranged formula. two parties to exchange cash flows in
The two comnonly used They can be regarded as the future
swaps are interest rate swaps and portfolios of forward contracts.
currency swaps.
E.
 Financial Derivatives
21E00401a

swapping only the interest related çash flows

1. Interest rate swaps: Thesc involve
between the parties in the same currency. both principal and interest between the
2. Currency swaps: These entail swapping
in a different currency than those in the
parties, with the cash flows in onc direction being
oppositedirection.
RiskInvolved in Financial Derivatives
issuer of the
risk is the probability, for the commitments.
V Insolvency Risk - The insolvencywill no longer be able to meet its
transferable security, that the debtor very important as the issuer is
The quality of the issuur of a transferable security is
responsible for repayment of the initial capital.
associated with a change in interest
Interest Rate Risk-The /nterest rate risk is the risk instrument price. In the case of
the finatncial
rales in tho market, rusulting in a drop ininterest
fixed rate instruments such as bonds, the rate risk is expressed by the probability
that a change in rates will not result in'a change in the market price.
probability for the investor of encountering
Liquidity Risk- The liquidity risk is the capital invested before the maturity. The
diticulties when recouping the whole initial number of factors namely:
liquidity of an investment is affected by a market in which the product is traded.
the
o Thevolume of transactions on leaving an investment
o The cost associated with
o The tÉme required to recoup funds probability that the price of a variable yield
Volatility Risk- The Volatility risk is the severely, resulting in a capital gain or
loss.
investment will fluctuate more or less raises.
price drops and a capital gain if it
Investors willbooka capital loss if thecurrency other than euro, there is a inevitably an
Exchange Risk-When investing in probability a currency
currency risk. It is the that an adverse trend in the
exhange or trend in the currency
invested in will reduce the return of the investment. If the to the
being
return 'will be eroded following the short fall in profit due
is adverse, the
conversion to euro.
SPOT (OR) CASH MARKET
market, in which financial instrunments are traded and
Spot Market is a public financial
It is also known Cash Market.underlying equities and bonds may also
i delivered immediately.some
For Example, securities as wellas some sold in this
market environment. Many physical commodities are bought andmarket.
be sold in cash sold in cash
market. Metals are one example of a commodity that isoften
type of
paymnent
Features
market is buying strategy in which the buyer makes an immediate securities.
The Cash price for commodities and other types of
current market
that is equal to the
payment, the seller relinquishes allclaims to the property and
Upon the receipt of
bestows ownership upon the buyer. ownership.
Immediate satisfaction and transfer.offaced, since the turnaround time on a transaction
fast
Spot market tend to be somewhat
is so short.
Types of Spot Market
The cash market can be of two types: a highly organized market where
an Exchange An exchange is
l. Organized Market, commodities, foreign.exchange are sold-andbought.
tradablesecurities
DepartmentofMBA
Assistant Professor
E.Naveen Kumar Reddy
 Financial Derivatives
21E00401a
instruments such as
Over-The-Counter (0TC) - OTC trading. is to trade financial
between two parties.
Stocks, bonds, commodities or derivatives directly
undamental Linkage between Spot & Derivatives Market
.

for the purchase and

Instruments such as options, forwards and futures are available
of the derivatives are related
Sale of spot market assets, such as stocks and bonds. The prices important mechanisms.
o those of the underlying spot market instrurnents throughcanseveral
be explained in the following
Fundamental linkages between spot and derivative markets
ways:
Arbitrage and the Law of One Price - Arbitrage isa type of transaction in which an
individual
investor seeks to profit when the same good sells for two different prices. The
engaging in the arbitrage called Arbitrageur, buys the good at the lower price and
immediately sells it at higher price.
If a stok sells on one exchange at one price and another at a different price,
arbitrageurs will go to work buying at the lower price and selling at the higher price.
Tlte low price willbe driven up and the high price driven down until the two prices are
e<qual, Matkely ruledl ly the Jaw of oile prlce lyÇ the folluwiug tolt clsaractetistics:
luveskots ake always pieler ture wealth to less.
Given two investnent opportunities, investórs will always prefetone thät pèrfofms
atleast as well as the other in all states and better in atleast one state.
have
o If two investment opportunities offer equivalent outcomes, they must
equivalent prices. risk-free
An investment opportunity that produces the same return ini all states is
and must earn the risk-free rate.
In an efficient market, violationsof the law of one price should never occur. But occasionally
prices get out of line, perhaps through monetary oversight. Arbitrage is the mechanism that
keeps prices in line.
Storage Mechanism: Spreading consumption across time - Storage is an important
linkage between spot and derivatives market. Many types of assets can be purchased
and stored. Holding a stock or bond is a form of storage. Even making a loan is a form
of storage. One can also buy a commodity, such as wheat or corn, and store it in a grain
elevator. Storage is a form of investment in which one defers selling the item today in
anticipation of selling it at a later date. Storage spreads consumption across time.
Because prices constantly fluctuate, storage entails risk. Derivatives can be used to
reduce that risk by providing ameans of establishing today the item future sake price. This
suggests that the risk entitled instoring the item can be removed. In that case, the overall
investment should offer the risk-free rate. Therefore, it is not surprising that the prices of
the storable item, the derivative contract, and the risk-free rate will be related.
* Delivery and Settlement - Another important linkage between spot and derivatives
markets is delivery and settlements. At expiration, a forward or future contract calls for
either immediate delivery or cash payment of the same value. Thus, an expiring
or future contract is equivalent to a spot transaction. The price of forward
therefore, must equal to the spot price. expiring contract,