SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

INTRODUCTION TO
DERIVATIVES I
T.Y.B .B.

The emergence of the market for

derivative products, most notably
forwards, futures and options, can be
traced back to the willingness of risk-
averse economic agents to guard
themselves against uncertainties arising
out of fluctuations in asset prices. By their
very nature, the financial markets are
marked by a very high degree of volatility.
Through the use of derivative products, it
is possible to partially or fully transfer
price risks by locking–in asset prices. As
instruments of risk management, these
generally do not influence the fluctuations
in the underlying asset prices. However,
by locking-in asset prices, derivative
products minimize the impact of
fluctuations in asset prices on the
profitability and cash flow situation of risk-
averse investors.

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DEFINITION

Derivative is a product whose value is

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derived from the value of one or more

basic variables, called bases (underlying
asset, index, or reference rate), in a
contractual manner. The underlying asset
can be equity, forex, commodity or any
other asset. For example, wheat farmers
may wish to sell their harvest at a future
date to eliminate the risk of a change in
prices by that date. Such a transaction is
an example of a derivative. The price of
this derivative is driven by the spot price
of wheat which is the “underlying”.

In the Indian context the Securities

Contracts (Regulation) Act, 1956 (SC(R)A)
defines “Derivative” to include –
1. A security derived from a debt
instrument, share, loan whether secured
or unsecured, risk instrument or contract
for differences or any other form of
security.
2. A contract which derives its value from
the prices, or index of prices, of
underlying securities.

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Derivatives are securities under the

SC(R)A and hence the trading of
derivatives is governed by the regulatory I

framework under the SC(R)A. The main T.Y.B .B.

types of derivatives are forwards, futures,

options, and swaps.

Derivatives can be used to mitigate

the risk of economic loss arising from
changes in the value of the underlying.
This activity is known as hedging.
Alternatively, derivatives can be used by
investors to take a risk and make a profit
if the value of the underlying moves the
way they expect (e.g. moves in a given
direction, stays in or out of a specified
range, reaches a certain level). This
activity is known as speculation.

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PRODUCTS & PARTICIPANTS

Derivative contracts have several

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variants. The most common variants are

forwards, futures, options and swaps. The
following three broad categories of
participants - hedgers, speculators, and
arbitrageurs trade in the derivatives
market. Hedgers face risk associated with
the price of an asset. They use futures or
options markets to reduce or eliminate
this risk. Speculators wish to bet on future
movements in the price of an asset.
Futures and options contracts can give
them an extra leverage; that is, they can
increase both the potential gains and
potential losses in a speculative venture.
Arbitrageurs are in business to take
advantage of a discrepancy between
prices in two different markets. If, for
example, they see the futures price of an
asset getting out of line with the cash
price, they will take offsetting positions in
the two markets to lock in a profit.
The derivatives market performs a
number of economic functions. First,
prices in an organized derivatives market

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reflect the perception of market

participants about the future and lead the
prices of underlying to the perceived I

future level. The prices of derivatives T.Y.B .B.

converge with the prices of the underlying

at the expiration of the derivative
contract. Thus derivatives help in
discovery of future as well as current
prices.
Second, the derivatives market helps
to transfer risks from those who have
them but may not like them to those who
have an appetite for them.
Third, derivatives, due to their inherent
nature, are linked to the underlying cash
markets.
Fourth, speculative trades shift to a
more controlled environment of
derivatives market.
Fifth, an important incidental benefit
that flows from derivatives trading is that
it acts as a catalyst for new
entrepreneurial activity. The derivatives
have a history of attracting many bright,
creative, well-educated people with an
entrepreneurial attitude. They often
energize others to create new businesses,
new products and new employment
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opportunities, the benefit of which are

immense. Finally, derivatives markets
help increase savings and investment in I

the long run. Transfer of risk enablesT.Y.B .B.

market participants to expand their

volume of activity.

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TYPES OF DERIVATIVES
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Futures Contract
Futures Contract means a legally
binding agreement to buy or sell the
underlying security on a future date.
Future contracts are the
organized/standardized contracts in
terms of quantity, quality (in case of
commodities), delivery time and place
for settlement on any date in future. The
contract expires on a pre-specified date
which is called the expiry date of the
contract. On expiry, futures can be
settled by delivery of the underlying
asset or cash. Cash settlement enables
the settlement of obligations arising out
of the future/option contract in cash.

Option contract
Options Contract is a type of
Derivatives Contract which gives the
buyer/holder of the contract the right
(but not the obligation) to buy/sell the
underlying asset at a predetermined
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price within or at end of a specified

period. The buyer / holder of the option
purchase the right from the seller/writer I

for a consideration which is called the

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premium. The seller/writer of an option

is obligated to settle the option as per
the terms of the contract when the
buyer/holder exercises his right. The
underlying asset could include
securities, an index of prices of
securities etc.
Under Securities Contracts
(Regulations) Act, 1956 options on
securities has been defined as "option in
securities" meaning a contract for the
purchase or sale of a right to buy or sell,
or a right to buy and sell, securities in
future, and includes a teji, a mandi, a
teji mandi, a galli, a put, a call or a put
and call in securities.
An Option to buy is called Call option
and option to sell is called Put option.
Further, if an option that is exercisable
on or before the expiry date is called
American option and one that is
exercisable only on expiry date, is called
European option. The price at which the
option is to be exercised is called Strike
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price or Exercise price.

 Swaps: I
T.Y.B .B.
Swaps are private agreements
between two parties to exchange cash
flows in the future according to a
prearranged formula. They can be
regarded as portfolios of forward
contracts. The two commonly used
swaps are:
• Interest rate swaps: These entail
swapping only the interest related
cash flows between the parties in the
same currency.
• Currency swaps: These entail
swapping both principal and interest
between the parties with the cash
flows in one direction being in a
different currency than those in the
opposite direction.

 Swaptions:
Swaptions are options to buy or sell a
swap that will become operative at the
expiry of the options. Thus a swaption
is an option on a forward swap. Rather
than have calls and puts, the
swaptions market has receiver
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swaptions and payer swaptions. A

receiver swaption is an option to
receive fixed and pay floating. A payer I

swaption is an option to pay fixed and

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receive floating.

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Global Derivatives Markets

The derivatives markets have grown I
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manifold in the last two decades. The total
estimated notional amount of outstanding
over–the–counter (OTC) contracts stood at
US$ 95.2 trillion as at end–December
2000, an increase of 7.9% over end–
December 1999.
Growth in OTC derivatives market is
mainly attributable to the continued rapid
expansion of interest rate contracts, which
reflected growing corporate bond markets
and increased interest rate uncertainty at
the end of 2000. The amount outstanding
in organized exchange markets increased
by 5.8% from US$ 13.5 trillion as at end–
December 1999 to US$ 14.3 trillion as at
end–December 2000.
The turnover data are available only
for exchange–traded derivatives
contracts. The turnover in derivative
contracts traded on exchanges has
increased by 9.8% during 2000 to US$
384 trillion as compared to US$ 350
trillion in 1999(Table 1.2). While interest
rate futures and options accounted for

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nearly 90% of total turnover during 2000,

the popularity of stock market index
futures and options grew modestly during I

the year. According to BIS, the turnover in

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exchange–traded derivative markets rose

by a record amount in the first quarter of
2001, while there was some moderation in
the OTC volume.

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Derivatives Market in India

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Derivatives trading commenced in T.Y.B .B.

India in June 2000 after SEBI granted the

final approval to this effect in May 2000.
SEBI permitted the derivative segments of
two stock exchanges, NSE and BSE, and
their clearing house/corporation to
commence trading and settlement in
approved derivatives contracts. To begin
with, SEBI approved trading in index
futures contracts based on S&P CNX Nifty
and BSE–30(Sensex) index. This was
followed by approval for trading in options
based on these two indexes and options
on individual securities. The trading in
index options commenced in June 2001
and the trading in options on individual
securities commenced in July 2001.
Futures contracts on individual stocks
were launched in November 2001. Trading
and settlement in derivative contracts is
done in accordance with the rules,
byelaws, and regulations of the respective
exchanges and their clearing
house/corporation duly approved by SEBI
and notified in the official gazette.

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Derivatives Market at NSE

The derivatives trading on the I

exchange commenced with S&P CNX Nifty

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Index futures on June 12, 2000. The

trading in index options commenced on
June 4, 2001 and trading in options on
individual securities commenced on July 2,
2001. Single stock futures were launched
on November 9, 2001. The index futures
and options contract on NSE are based on
S&P CNX Nifty Index. Currently, the
futures contracts have a maximum of 3-
month expiration cycles. Three contracts
are available for trading, with 1 month, 2
months and 3 months expiry. A new
contract is introduced on the next trading
day following the expiry of the near month
contract.

Trading mechanism

The futures and options trading system of

NSE, called NEAT-F&O trading system,
provides a fully automated screen–based
trading for Nifty futures & options and stock
futures & options on a nationwide basis and an
online monitoring and surveillance

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mechanism. It supports an anonymous order

driven market which provides complete
transparency of trading operations and
operates on strict price–time priority. It is
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similar to that of trading of equities in the
Cash Market (CM) segment. The NEAT-F&O
trading system is accessed by two types of
users. The Trading Members(TM) have access
to functions such as order entry, order
matching, and order and trade management.
It provides tremendous flexibility to users in
terms of kinds of orders that can be placed on
the system. Various conditions like Good-till-
Day, Good-till-Cancelled, Good till- Date,
Immediate or Cancel, Limit/Market price, Stop
loss, etc. can be built into an order.
The Clearing Members (CM) uses the
trader workstation for the purpose of
monitoring the trading Member for whom they
clear the trades. Additionally, they can enter
and set limits to positions, which a trading
member can take.

Membership criteria

The emergence of the market for

derivative products, most notably forwards,
futures and options, can be traced back to the
willingness of risk-averse economic agents to

1
2
 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

guard themselves against uncertainties arising

out of fluctuations in asset prices. By their
very nature, the financial markets are marked
by a very high degree of volatility. Through the
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T.Y.B .B.
use of derivative products, it is possible to
partially or fully transfer price risks by locking–
in asset prices. As instruments of risk
management, these generally do not influence
the fluctuations in the underlying asset prices.
However, by locking-in asset prices, derivative
products minimize the impact of fluctuations in
asset prices on the profitability and cash flow
situation of risk-averse investors.

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 SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

What is the Structure of

Derivative Markets in India? I
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Derivative trading in India takes can

place either on a separate and
independent Derivative Exchange or on a
separate segment of an existing Stock
Exchange. Derivative Exchange/Segment
function as a Self-Regulatory Organisation
(SRO) and SEBI acts as the oversight
regulator. The clearing & settlement of all
trades on the Derivative
Exchange/Segment would have to be
through a Clearing Corporation/House,
which is independent in governance and
membership from the Derivative
Exchange/Segment.

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Derivatives in a Liberalizing
India I
T.Y.B .B.

{current era}For better or for worse, the

Indian economy has entered an era in
which Indian companies cannot ignore
global markets. In the old era many prices
were controlled. Others, though not
controlled, were largely based on
controlled prices inputs. This meant
limited uncertainty and hence limited
volatility of prices. Deregulation freeing of
the exchange rate and removal of prices
and trade controls are measures that are
increasing the volatility of prices of
various goods and services in India to
producers and consumers alike .gyrations
of stock market prices also create
instability in portfolio values for mutual
fund and unit trusts Hedging through
derivatives can mitigate these risks.
Unfortunately India has very little
relevant research or teaching material
derivatives. Even the research that has
been done some of it high quality has
received little or no publicity this is of

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course only natural given the obscurity of

the subject in the pre liberalization era
this book is an attempt to help fill the void
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by providing market participants

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economists accountants financial analysis

financial journalists policy makers and
students with references work on
derivative in general and futures in
particular from an Indian perspectives. It
covers all facets of derivatives--what they
are, why they exist, how they work as well
as what good they can do:
 An introductory overview of derivative
 A comprehensive theatrical and
empirical treatment of the nature
functions benefits and problems of
forward and futures markets with
specific reference to India
 An analysis of carry forward trading in
the stock market
 An introduction to options swaps an
other derivatives to provide a working
knowledge of their nature and uses
 An analysis of market structures and
the regulatory framework for
derivative

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 An overview of accounting and tax

treatment of derivative
 An introduction to the management of I

derivative risks T.Y.B .B.

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