DER IV ATIVE ’S

Introductio n
The financial market have changed as a
result of the recommendations of the Chakravarti
Committee which was working on the changes of
the monetary system, the Vaghul Committee on
money market and the Abid Hussain Committee
on capital market. Financial markets in India are
extremely volatile and the risk factor is an
important concern for the financial institutions or
intermediaries. The concept of derivatives came
into existence in order to reduce the risk.
Derivatives have been used since long time when
people were trading with one another. Forward
contracting dates back at least 12th century.
Merchants used to enter into contracts with one
another for future delivery of specified amount of
 Derivatives performs a number of economic
functions. Derivatives help in transferring risk from risk
averse investors to risk takers. It helps in finding out the
future as well as current price of commodities or
securities. The volume traded in the market is increased
due to the participation of large number of risk averse
investors. Derivatives also help to increase saving and
investment of the country in the long run. Derivatives
are financial instruments whose value changes in
response to the changes in underlying variables. The
main types of derivatives are futures, forwards, options,
and swaps. Derivatives can be based on different types of
assets such as commodities, equities (stocks), bonds,
interest rates, exchange rates, or indexes. Their
performance can determine both the amount and the
timing of the pay-offs
Meani ng
Drivatives refer to a tool to hedge commercial and
financial risks. Risks arise when probable
changes in prices & rates in the future are not
known. Derivative are a special form of financial
assets that derive their value from the value of an
underlying asset.
Derivative can be defined as bilateral contracts or
payments exchange agreement that involves
payment or receipt of income generated by the
underlying asset on notional principal. Derivative
is a tool for risk management. It implies reducing
the risk not eliminating it. Risk is diverted from a
risk averse to a risk neutral entity. Thus
derivative is an innovative and tradable financial
instrument.
 FE ATUR ES OF
DERIV AT IV ES
• Financial instrument: Derivatives are the financial
instrument the value of which depend upon the
underlying asset on which it is created. It involves
trading in securities, commodity, currency etc
which can be bought and sold financially.

2. Risk management: Derivative act as a tool for risk

management because here the risk can be
minimized by purchasing these instrument.

3. Minimizes risk : In case of derivative the amount of

risk faced can be reduced but the risk cannot be
avoided completely.
4. Risk diversion: Risk is
diversified or channelised from
risk averse i.e. risk avoider to
risk taker entity or risk neutral
entity. Hence, it is beneficial to
both the parties as both are
satisfied.

5. Value: The derivative

instrument derives its value
from the value of underlying
asset i.e. according to the
 IM PO RTA NCE OF D ER IVA TIV ES
1 . To minimize risk arising from volatile
market situations by transferring risk to a
person who is willing to accept it or is
unaffected by it, i.e. from risk averse to
risk neutral entity.

2. To protect the interest of individual and

institutional investors. Provide incentives
to make profits with minimal amount of
risk capital.

3. Offer high liquidity and flexibility. Parties

can get out of the options contract if
market conditions are unfavorable and
exercise it when favorable.
4. Allows hedging by acting as a tool of risk
management. Do not create new risk. Minimize
existing risk.

5. Derivatives allow arbitrage and speculation.

They support short term gains. Being flexible a
suitable instrument or a combination of
derivative instruments can be used to speculate
in various assets. Arbitrageurs can operate in 2
or more markets, diversify risks and take
advantage of price difference.

6. Derivatives are convenient, low cost and

simple to operate.
 TY PE S OF DERIV ATIV ES
IN ST RUME NT

[A] Forward contract: It is the oldest and non-standardized

instrument. It refers to an agreement between 2 parties to
exchange an agreed quantity of an asset for cash at a
certain date in future at a predetermined price agreed and
specified in the contract.

The following are the major features of a forward contract

1.Unstandardized: These contracts are privately arranged

agreements and customized as per clients needs. Thus they
are informal agreements and are not standardized.

2.Over the counter (OTC): They are traded over the counter
and cannot be traded on an organized exchange as they are
informal & customized contract
3. No secondary market: Since the forward
contract is an unstandardized instrument that
cannot be traded on an organized exchange, no
secondary market exists for it.

4. No down payment: No payment is required at

the time of agreement. Payment is done only on
specified future date at the agreed price.
Settlement and delivery are to done on maturity
date only.

5. Linearity: It implies symmetrical gains or

losses E.g. If the spot or market price exceeds
the contract or agreed price, the buyer gains.
The gain is equal to the difference between spot
and contract price.
6. Intermediary: Third party intervention from
bank, F.I.s or others is necessary to agree and
execute contracts.

Depending on underlying asset, a variety of

forward contract can be made like financial
forwards, commodity forwards, forward rate
currency and interest rate contracts.

Examples:

Commodity forwards are commonly used in India.

On 7th June 2007, X enters into an agreement to
buy 50bales of cotton on 7th December 2007 for a
cash at a price of Rs.1000 per bale from Y, a
cotton dealer. On 7th December 2007 X will have
to pay cash of Rs.50000 for the 50 bales and will
have to supply the same.
[B] Futures: It is a special type of forward contract bought
and sold under the rules of an organized exchange. It is an
standardized, hedging instrument. It is legally enforceable
and can be traded on an organized exchange.

The following are its major features

1. Highly standardized: They are transacted as per the norms

of an exchange. It is a formal standardized contract that
cannot be modified according to tne needs of the contracting
parties.

2. Secondary market: Secondary market exists as futures are

issued and traded on an organized exchange.

3. Initial margin: No down payment at the time of agreement

is required. An initial margin is applicable. It implies that
contracting parties have to deposit a certain % of contract
price with the exchange. This gives the guarantee that

contract will be honored.

4. Settlement & delivery: Futures are marked to the market.
They are held till maturity. But the profit or loss is recorded in a
daily basis and adjusted in the margin account. Final settlement
and delivery is done on maturity date. Delivery of full asset is
not essential. Parties simply exchange the difference between
the future/contract price and spot price on maturity date.

5. Linearity: It exists as futures are similar to forward

contracts. Symmetrical gains or losses are borne by the parties
depending on the price fluctuations of the underlying asset.
Commodity futures and financial futures are common types of
futures.

Examples:

Commodity futures exchange like London metal exchange to

deal in gold, New York cotton exchange, International
petroleum to deal in crude oil and National Commodity
Derivatives Exchange in India is popular for futures in
agricultural products.
Financial futures in treasury bills, commercial papers, interest
rates and exchange rates. Hedging the risk is the primary
[C] Options: Options is a contract that gives a party the option
to buy or sell an underlying asset (stock, bond, currency etc.) at
a predetermined price on or before a specified future date. It is
a contract that gives the right but not the obligation to buy or
sell an underlying asset at a stated price on or before a
specified date in the future.

The following are the features of an option

1. Highly flexible: Options are both standardized as well as

customized. The standardized ones are traded on an organized
exchange as per its norms and customized ones are privately
arranged as per requirements of the parties and are traded over
the counter. Thus options combine the features of both forward
contracts as well as futures.

2. Premium: No down payment is required. However an option

premium has to be paid to hold the right to exercise the option
of buying or selling an underlying asset. If option is not
exercised the premium has to be given up. If the option is
exercised then premium is deducted from the net payoff due to
the option holder.
4. Settlement: It is done only when the holder exercises the
option. If the option is not exercised till maturity the contract
automatically lapses and no settlement is required in the case.

5. Non Linearity: Profits and losses are not symmetrical.

Amount of gain is not equal to amount of loss. It depends on
whether option is exercised or not and the market conditions
at that time.

Index based share option transactions are popular, followed by

currency options.

Example: Currency option agreed in Oct. and maturing in Dec.

the agreed/ strike rate is RS.30=$1. a premium of RS.2 is paid
per $ to hold the option.
Now if the spot rate is RS.35= $1, then it is profitable to
exercise the option as spot rate> strike rate.
Gross profit will be RS.5 per $, but net gain = spot price- (strike
price + premium)
i.e. 35-(30+2) =Rs.3 per $. (Non-linearity aspect).
[D] Swaps: It is a special type of forward contract. It
obligates the 2 parties to exchange a series of cash flow
at specified intervals i.e. settlement dates, based on
some notional principle amount called “swap”. It is a
combination of forwards by 2 counterparties. It has all
features of forwards.

The following is a brief description of some types of

swaps

1. Financial swap: It allows investor to exchange one

asset for another with a preferred income stream.

2. Interest rate swaps: In this one party agrees to

exchange a series of fixed interest rate payments to a

party with variable interest rate payments

3. Currency swap: It is an arrangement in which both
principal amount and interest on a loan in one currency
is swapped for the same in another currency.

Example:

If a borrower with low credit rating wants term funds at

fixed interest rate, then he has to swap his floating
interest rate for fixed interest rate with another
counterparty having high credit rating.
 Par ti ci pants i n deri va tive
mar ke t

Regulator/SEBI

Stock exchanges Custodian Clearing house Banks

Jobbers, Brokers

Speculators,
Arbitrageurs,
Hedgers
 Concl us io
n
Derivatives markets are a powerful regulator of
economic activity. In the absence of a government
mandate or even an explicit self-regulatory
organization, derivatives participants have behaved in
a responsible fashion to address the inherent risks of
derivatives transactions and the need for
improvements in risk management procedures and
practices as well as improved accounting and
disclosure.