Futures Contract – A Futures Contract is an agreement between two parties to buy or sell a specified

quantity of an asset at a specified price and at a specified time and place. Futures Contract are normally
traded on an exchange which sets the certain standardized norms for trading in the futures contract.
These are transferable specific delivery forward contracts, they are agreement between two
counterparties to fix the terms of an exchange in the price today of an exchange that will take place
between them at some fixed future date. They obligate the seller to deliver and the latter to receive the
assets in a specified quantities of specified grades. The period of Contract may vary between 3 to 21
months, depending on the underlying assets they could be commodity/financial futures and stock index
futures.

Futures are transferrable legal agreements and their terms cannot be changed during the term of the
contract. There is no deliverable asset in the case of a bond/equity index futures, the value of contract in
such case is some multiple of the value of the index and the settlement of such contracts has to be in
cash. Features of Futures Contract –

1) Standardization – the most important feature of futures contract is that the contract has certain
standardized specifications i.e quantity of the asset, quality of the asset, size, expiration and
date of contract, the units of price quotation, and location of settlement.
2) Clearing Houses – In the Futures Contract, the exchange clearing house is an adjunct of the
exchange and acts as an intermediary or middleman in futures. It gives the guarantee of
performance of each transaction. The clearing house has members, a clearing house acts as a
counter party to every contract.
3) Settlement Price – since the futures contract are performed through a particular exchange so at
the close of the day of trading, each contract is marked to market. For this the exchange
establishes a settlement price, this settlement price is used to compute the profit or loss on each
contract for that day. Accordingly, the member’s accounts are credited or debited.
4) Daily settlement and Margin - When a person enters into a contract he has to deposit funds with
the broker, called as margin. The exchange usually sets the minimum margin required for
different assets, but the broker can set higher margin limits for his clients which depend upon
the credit worthiness of the clients. The basic objective of the margin account is to act as
collateral security in order to minimize the risk of failure by either party in the futures contract.
5) Tick Size - The Futures Price are expressed in currency units with a minimum price movement
called a tick size. This implies that the future prices must be rounded off to the nearest tick size.
6) Cash Settlement - Most of the futures contract are settled in cash by having the short or long to
make cash payment on the difference between the futures price at which the contract was
entered and the cash prize at expiration date. This is done as it is inconvenient to deliver the
underlying asset.
7) Delivery – The Futures Contract are executed on the Expiry Date. The Counter Parties with a
Short Position are obligated to make delivery to the exchange, whereas the exchange is
obligated to make deliveries to the longs. The Period during Which the delivery will be made is
set by the exchange which varies from Contract to Contract
8) Regulation – The important difference between the futures and forward contracts is that the
futures contract are regulated through a exchange, but the forward Contracts are self-regulated
by the counter parties themselves. The Various Countries have established commissions in their
country to regulate the futures market both in stocks and commodities.
Options – Options are Contracts that give the holder the right (but not the obligation) to buy (call
option) or sell (put option) securities at a pre-determined price (strike/exercise) within or at the end
of a specified period. For the Holders of the options contract, the exercise of the rights would be
worthwhile only if the price of the underlying securities, of the respective option price rises/falls
above / below the exercise price. It is the Contract between the two Parties whereby one party
obtains the right, but not the obligation to buy or sell a particular asset, at a specified price on or
before the specified date. The person who acquires the right is known as the Option Buyer or option
Holder, while the other person is known as option seller or option writer.

Options premium – The Seller of the Option for giving such option to the buyer charges an amount
which is known as the Option Premium.

Options can be divided into 2 types : Put and Call

A call option gives the Holder the right to buy an asset at a specified date for a specified price.

A Put option gives the holder the right to sell an asset at a specified price and time.

The Specified Price in such a contract is known as Exercise Price or the strike price and the date in
the contract is known as the expiration Date or the exercise date or the Maturity date. The asset or
security instrument or commodity covered under the contract is called as the underlying asset,
these include shares, stocks , stock indices, foreign currencies , bonds , commodities etc. The holder
may exercise the option or may not , the holder can make a reassessment of the situation and seek
either the execution of the contracts or its non-execution as be profitable to him. There can be
options on Commodities, stocks, currencies, securities and even on futures. In order to acquire the
right of options, the buyer pays the option seller an option premium, which is the price paid for the
right. The Buyers loss is limited and profit is unlimited. The buyer of an option can lose no more than
the option premium paid but his maximum gain is unlimited. Whereas, the option writer’s possible
loss is unlimited but his maximum gain is restricted to the premium charged by him to the holder.
The availability of both the Financial Futures and the Options Contract provides the wider choice of
hedging instruments. A sound derivative market requires the presence of both hedgers and
speculators.

WARRANTS AND CONVERTIBLES

Warrants are just like options that gives the buyer the right to buy shares of a specified company at
a certain price during the given time period. The holder of a warrant instrument has the right to
purchase a specific number of shares at a fixed price from an issuing company. If the holder
exercised the right, it increases the number of shares of the issuing company and dilutes the equities
of the shareholders. Warrants can be detached and are traded separately , they are highly
speculative and leverage instruments , so trading in them must be done cautiously.

Convertibles are Hybrid Securities which combine the basic attributes of interest and variable return
securities. Eg- Convertible debentures, convertible preference shares , Convertible bonds. They are
also called as Equity derivative security. They can be fully or Partially be converted into the equity
 shares of the issuing company at the predetermined specified terms with regards to the conversion
period, conversion rate and conversion price.

SWAP Contracts – A swap contract is an agreement between two counter parties to exchange cash
flows in the future. Under the Swap Agreement, various terms like the dates when the cash flows
are to be paid, the currency in which to be paid and the mode of the payment are determined and
finalized by the parties. The calculation of the cash flows involves the future values of one or more
market variables. There are 2 popular forms of swaps

1 Interest Rate Swaps – In the interest rate swap one party agrees to pay the other party interest at
a fixed rate on a notional principal amount and in return it receives interest at a floating rate on the
same principal notional amount for a specified period.

2 Currency Swaps - In Case of a currency swap, it involves exchanging of interest flows in one currency
for interest flows in other currency. It requires the exchange of cash flows in two currencies.

HISTORY OF DERIVATIVES MARKET

The Indian Derivatives Market has been a controlled economy and has moved towards a market where
price fluctuates every day, the introduction of risk management instruments gained momentum in the
last few years due to liberalization process and efforts of the central Bank, Reserve Bank of India(RBI) in
creating currency forward market.

1) Derivatives are an integral part of the liberalization process and have gained momentum to
manage risk, the National Stock Exchange of India gauged the market requirements and initiated
the process of setting up the derivatives markets in India.
2) In 1996, NSE submitted the proposal to the Securities and Exchange Board of India for the
Introduction of derivatives.
3) The SEBI Constituted the LC Gupta Committee for policy formulation in the area of stock index
futures.
4) In 1998, the committee submitted its report approved by the SEBI, following which in 1999
derivatives operations began in interest rate swaps and forward rate agreements.

1875 Cotton Trade Association started futures trading.

1900 Derivatives trading started in oilseeds in Mumbai.

1912 Derivatives trading started in raw jute and jute goods in Kolkata.
1913 Derivatives trading started in wheat in Hapur.

1920 Derivatives trading started in bullion in Mumbai.

1952 Commodity options trading and cash settlement of commodity futures were
banned on fear of speculation.

1960s Forward trading banned in many primary/essential commodities.

Dec. 95 Permission sought by the Exchanges from SEBI to start trading in derivatives.

Nov. 96 Setting up of L.C. Gupta Committee to design of policy framework for derivatives
trading in India.

July 99 RBI permitted OTC forward rate agreements (FRAs) and interest rate swaps.

May 00 S&P CNX Nifty was chosen by SIMEX for trading futures and options.

May 00 SEBI permitted the Exchanges (NSE and BSE) to start trading in derivatives.

9 June 00 BSE commenced trading of Index futures based on Sensex 30 Index.

12 June NSE commenced trading of Index futures based on S&P CNX Nifty Index.
00
25 Sept. S&P CNX Nifty futures commenced trading at SGX.
00

June 01 Index Options introduced on NSE based on S&P CNX Nifty Index.

July 01 Stock Options introduced on NSE on 31 securities only. The list has been
broadened to include 119 securities.

Nov. 01 Stock futures introduced on NSE on 31 securities. The list now has been
broadened to include 119 securities.

2002 Future trading in commodities re-introduced.

The most notable development concerning the Indian capital market was the introduction of
derivatives trading in june 2000. The SEBI approved derivatives trading based on futures contracts in
BSE and NSE in accordance with the rules and regulations of the stock exchange while derivatives
trading was on sensitive index (Sensex) commenced at BSE on June 9 2000 , derivatives trading
based on S&P CNX NIFTY commenced at the NSE on June 12 ,2000.

ECONOMIC FUNCTIONS

1) Risk Management – The primary purpose of risk management is to protect the existing profits
not to create new profits. Risk Management involves the structuring of financial contracts to
produce gains (or losses) that counter balance the losses (or gains) arising from movements in
financial prices. Thus, by virtue of financial derivatives application, risks are reduced and profit is
increased over a wide sphere of financial enterprise and various ways – from businesses whose
efficiency is enhanced to banks where depositors and borrowers are benefitted, from
investment managers who increase their performance for clients, to farmers who protect their
crops, from commercial uses of energy to retail users of mortgages.
2) Price discovery – It represents the ability to achieve and disseminate the price information.
Without the price information, the investors, consumers and producers cannot take informed
decisions. They are then inhibited and deterred from directing their capital to efficient uses.
Derivatives are exceptionally well suited for the role of providing rice information, they are the
 tool that assist everywhere in the market place to determine value. The wider the use of
derivatives, the wider the distribution of price information.
3) Transactional efficiency - Inadequate results in the transaction costs (high), this impedes the
investments and deters the accumulation of capital. Transactional Efficiency is the product of
Liquidity, derivatives facilitate the opposite results. They significantly increase market liquidity,
as a result market transactional costs are lowered, the efficiency in doing business is increased
the cost of raising capital is lowered and the amount of capital available for productive
investment is expanded.

USES OF DERIVATIVES MARKET

1) One of the most important services provided by the derivatives is to control, avoid, shift and
manage efficiently different types of risks through various strategies like hedging,
arbitraging, spreading etc. Derivatives assist the holders to shift or modify suitably the risk
characteristics of their portfolios. These are specifically useful in highly volatile financial
market conditions lie erratic trading, highly flexible interest rates, volatile exchange rates
and monetary chaos.
2) Derivatives serve as barometers of the futures trends in prices which results in the discovery
of new prices both on the spot and futures market. Further, they help in the dissemination
of different information regarding the futures market trading of various commodities and
securities to the society which enable to discover or form suitable or correct or true
equilibrium prices in the market. They assist in appropriate and superior allocation of
resources in the society.
3) In Derivatives trading no immediate full amount of the transactions is required since most of
them are based on margin trading. Large numbers of traders, speculators arbitrageurs
operate in such markets. So derivatives trading enhance liquidity and reduce transaction
costs in the market for underlying assets.
4) The Derivatives assist the investors, traders and managers of large pools of funds to devise
such strategies so that they may make proper asset allocation increase their yields and
achieve other investment goals.
5) It has been observed from the derivatives trading in the market that the derivatives have
smoothen out price fluctuations, squeeze the price spread, integrate price structure at
different points of time and remove guts and shortages in the market.
6) The derivatives trading encourage the competitive trading in the markets, different risk
taking preference of the market operators like speculators, hedgers, traders resulting in
increase in trading volume in the country. They also attract young investors, professionals
and other experts who will act as catalysts to the growth of financial markets.
7) It is observed that derivatives trading develop the markets towards ‘complete markets.
‘Complete Market concept refers to that situation where no particular investors be better
off than others , or partners of returns of all additional securities are spanned by the already
existing securities in it, there is no further scope for additional security.

Critiques of derivatives
1) Speculative and gambling motives – one of the most importanat arguments against the
derivatives is that they promote speculative (gambling) activities in the market. 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 asset and hardly one to two percent
derivatives are settled by the actual delivery of the underlying assets. As such speculation has
become the primary purpose of the origination, exsistence and growth of derivatives. The
speculative buying and selling by the amateurs and professionals adversely affects the genuine
producers and distributors.
Merit – Some financial experts and economists believe that speculation brings about a better
allocation of supplies overtime , reduces the fluctuations in prices, make adjustment between
demand and supply, removes periodic gluts and shortages and brings efficiency to the market.
Most of the speculative activities are ‘professional speculation’ or ‘movement trading’ which
lead to destabilization in the market. There has been a variation in prices due to common,
frequent and widespread consequences of speculation.

2) Increase in Risk – The derivatives markets are supposed to be efficient tools of risk management
in the market, the derivatives markets like OTC markets, as particularly customized, privately
managed and negotiated are highly risky. Empirical studies in this respect have shown that
derivatives used by the banks have not resulted in the reduction in risk, and rather these have
raised new types of risk. They are powerful leveraged mechanism used to create risk.
3) Instability of the Financial system - The derivatives have increased risk for users as well as the
whole financial system. The fears of micro and macro financial crisis have caused to the
unchecked growth of derivatives which have turned many market players into big losers. The
malpractices , desperate behavior and fraud by the users of derivatives have threatened the
stability of the financial markets and the financial system.