What are derivatives?

Derivatives are the financial contracts or instruments, which derive their value from some other variables. In
short, these are the instruments whose value depends on underlying asset. The underlying asset can be equity,
index, commodity, bond or currency. Some of the examples of Derivatives are Forwards, Futures, Options and
Swaps.
Derivatives are financial contracts, which derive their value off a spot price time-series, which is called "the
underlying". The underlying asset can be equity, index, commodity or any other asset. Some common examples
of derivatives are Forwards, Futures, Options and Swaps.
Derivatives help to improve market efficiencies because risks can be isolated and sold to those who are willing to
accept them at the least cost. Using derivatives breaks risk into pieces that can be managed independently. From
a market-oriented perspective, derivatives offer the free trading of financial risks.

Distinctive Features of Derivatives Market:

1. The derivatives market is like any other market.
2. It is a highly leveraged market in the sense that loss/profit can be magnified compared to the initial margin. The investor
pays only a fraction of the investment amount to take an exposure. The investor can take large positions even when he does
not hold the underlying security.
3. Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the
market view. Derivatives are double edged swords.
4. Derivatives contracts have a definite lifespan or a fixed expiration date.
5. The derivatives market is the only market where an investor can go long and short on the same asset at the same time.
6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire
value if it is not exercised.

Features of financial derivatives

It is a contract: Derivative is defined as the future contract between two parties. It means there must be a contract-binding
on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the
nature of contract, for example, short term interest rate futures and long term interest rate futures contract.
Derives value from underlying asset: Normally, the derivative instruments have the value which is derived from the values
of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of
derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets,
and sometimes, it may be nil or zero. Hence, they are closely related.
Specified obligation: In general, the counter parties have specified obligation under the derivative contract. Obviously, the
nature of the obligation would be different as per the type of the instrument of a derivative.For example, the obligation of the
counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract
would be different.
Direct or exchange traded: The derivatives contracts can be undertaken directly between the two parties or through the
particular exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low
transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jons, S&P 500,
Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock
Exchange, Bombay Stock Exchange and so on.
Related to notional amount: In general, the financial derivatives are carried off-balance sheet. The size of the derivative
contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in
the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares,
because the payoff of derivative products differ from the payoff that their notional amount might suggest.
Delivery of underlying asset not involved: Usually, in derivatives trading, the taking or making of delivery of underlying
assets is not involved, rather underlying transactions are mostly settled by taking offsetting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of underlying
assets.
May be used as deferred delivery: Derivatives are also known as deferred 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. Further, it is
possible to combine them to match specific, i.e., they are more easily amenable to financial engineering.

Secondary market instruments: Derivatives are mostly secondary market instruments and have little usefulness in
mobilizing fresh capital by the corporate world, however, warrants and convertibles are exception in this respect.
Exposure to risk: Although in the market, the standardized, general and exchange-traded derivatives are being increasingly
evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in
existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be
uncertainty about the regulatory status of such derivatives.
Off balance sheet item: Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be
used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a
structured note whose coupon is tied to the performance of a particular currency pair.
What is the importance of derivatives?
Derivative is best used as risk management tool by which you can transfer the risk associated with the underlying
asset to the party who is willing to take that risk. To simplify the risk term, it has been divided into three parts:

There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional
instruments and transfer these risks to parties willing to bear these risks. The fundamental risks involved in
derivative business includes:

Credit Risk
Credit risk arises when any of the parties fail to fulfil the obligation under the agreement. Such an event
is called a default. It is also known as 'default risk'.

This is the risk of failure of a counterparty to perform its obligation as per the contract. Also known as default or
counterparty risk, it differs with different instruments.

Market Risk

Fluctuation in the prices of the underlying asset contributes to market risk. Market risk comprises of four risk
factors: Equity risk, Interest rate risk, Currency risk and Commodity risk.
Market risk is a risk of financial loss as a result of adverse movements of prices of the underlying
asset/instrument.

Liquidity Risk

Liquidity risk is financial risk that arises due to uncertain cash crunch. An institution might lose liquidity if its
credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counter-parties to
avoid trading with or lending to the institution.
The inability of a firm to arrange a transaction at prevailing market prices is termed as liquidity risk. A firm faces
two types of liquidity risks
1.

Related to liquidity of separate products

2.

Related to the funding of activities of the firm including derivatives.

Legal Risk

Derivatives cut across judicial boundaries, therefore the legal aspects associated with the deal should be looked
into carefully.

Need and types of financial derivatives

There are several risks inherent in financial transactions and asset liability positions. Derivatives are risk shifting devices:
they shift risk from those who have it but may not want it to those who have the appetite and are willing to take it.
The three broad types of prices risks are:

1. Market risk: Market risk arises when security prices go up due to reasons affecting the sentiments of the whole market.
Market risk is also referred to as systematic since it cannot be diversified away because the stock market as a whole may go
up or down from time to time.
2. Interest rate risk: This risk arises in the case of fixed income securities, such as treasury bills, government securities, and
bonds, whose market price could fluctuate heavily if interest rates change. For example, the market price of fixed income
securities could fall if the interest rate shot up.
3. Exchange rate risk: In the case of imports, exports, foreign loans or investments, foreign currency is involved which gives
rise to exchange arte risk. To hedge these risks, equity derivatives, interest rate derivatives, and currency derivatives have
emerged.

Types of Financial Derivatives:

In recent years, derivatives have become increasingly important in the field of finance. Forwards, futures, options swaps,
warrants, and convertibles are the major types of financial derivatives. A complex variety of composite derivatives, such as
swap options, have emerged by combining some of the major types of financial derivatives:
1. Forwards: A forward contract is a contract between two parties obligating each to exchange a particular good or
instruments at a set price on a future date. It is an over the counter agreement and has standardized market features.
2. Futures: Futures are standardized contracts between the buyers and sellers, which fix the terms of the exchange that will
take place between them at some fixed future date. A futures contract is a legally binding agreement. Futures are special
types of forward contracts which are exchange traded, that is traded on an organized exchange. The major types of futures
are stock index futures, interest rate futures, and currency futures.
3. Options: Options are contracts between the option writers ad buyers which obligate the former and entitles (without
obligation) the latter to sell/buy stated assets as per the provisions of contracts. The major types of options are stock options,
bond options, currency options, stock index options, futures options, and options on swaps. Options are of two types: calls
and Puts. A call option gives a buyer/holder a right but not an obligation to buy the underlying on or before specified time at
a specified price (usually called strike/exercise price) and quantity. A put option gives a holder of that option a right but not
an obligation to sell the underlying on or before specified time at a specified price and quantity.
4. Warrants: Warrants are long term options with three to seven years of expiration. In contrast, stock options have a
maximum life of nine months. Warrants are issued by companies as a means of raising finance with no initial servicing costs,
such as divided or interest. They are like a call option on the stock of the issuing firm. A warrant is a security with a market
price of its own that can be converted into a specific share which leads at a predetermined price and date. If warrants are
exercised, the issuing firm has to create a new share which leads to a dilution of ownership. Warrants are sweeteners attached
to bonds to make these bonds more attractive to the investor. Most of the warrants are detachable and can be traded in their
own right or separately. Warrants are also available on stock indices and currencies.
5. Swaps: Swaps are generally customized arrangements between counterparties to exchange one set of financial obligations
for another as per the terms of agreement. The major types of swaps are currency swaps, and interest rate swaps, bond
swaps, coupon swaps, debt equity swaps.
6. Swaptions: Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and
puts, swaptions have receiver swaption (an option to receive fixed and pay floating) and a payer swaption (an option to pay
fixed and receive floating).

Exchange Traded versus OTC Derivatives Markets:

There has been a sharp growth of around 40 percent a year in the OTC derivatives markets globally. In the OTC markets
transactions take place via telephone, fax, and other elections means of communication as opposed to the trading floor of an
exchange. Information technology (IT) has enabled this fast growth in OTC derivatives markets. OTC derivatives contracts
are more flexible than exchange traded contracts. However, OTC derivatives markets are characterized by the absence of
formal rules for risk (a prerequisite for market stability and integrity), the absence of formal centralized limits or individual
positions, leverage or margining and the absence of a regulatory authority.
What are the various types of derivatives?
Derivatives can be classified into four types:

Forwards

Futures

Options

Swaps

Who are the operators in the derivatives market?

Hedgers - Operators, who want to transfer a risk component of their portfolio. Hedgers are the end users
or producers of the particular asset or commodity who hedge against the price rise/fall risk.

Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit. Speculators are
the risk takers who want to benefit from the risk they take.

Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and
eliminate mis-pricing. Arbitrageurs usually earn profit by trading in two different markets
simultaneously or two instruments related to each other.

Derivatives are risky instruments

Derivatives help to improve market efficiencies i.e. by reducing the risk for farmers, oil companies, interest rate
risk for banks, etc. But they can turn out to be the cause of the massive destruction in economy. They work as a
dependent instrument so if one of the underlying variables goes bankrupt that will lead to fall of whole chain
which in turn may wipe out entire financial system.