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Chapter:1 Introduction of derivative

Introduction
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.

Derivatives defined
Derivative is a product whose value is 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.
Derivatives are securities under the SC(R)A and hence the trading of derivatives
is governed by the regulatory framework under the SC(R)A.

Products, participants and functions

Derivative contracts have several 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 reflect the perception of market
participants about the future and lead the prices of underlying to the perceived
future level. The prices of derivatives 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. With the introduction of derivatives, the
underlying market witnesses higher trading volumes because of participation
by more players who would not otherwise participate for lack of an
arrangement to transfer risk. Fourth, speculative trades shift to a more
controlled environment of derivatives market. In the absence of an organized
derivatives market, speculators trade in the underlying cash markets.
Margining, monitoring and surveillance of the activities of various participants
become extremely difficult in these kind of mixed markets. 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 opportunities, the benefit of which are immense. Finally,
derivatives markets help increase savings and investment in the long run.
Transfer of risk enables market participants to expand their volume of activity.
History of derivative

With the opening of the economy to multinationals and the adoption of the
liberalized economic policies, the economy is driven more towards the free
market economy. The complex nature of financial structuring itself involves the
utilization of multi-currency transactions. It exposes the clients, particularly
corporate clients to various risks such as exchange rate risk, interest rate risk,
economic risk and political risk.

With the integration of the financial markets and free mobility of capital, risks
also multiplied. For instance, when countries adopt floating exchange rates,
they have to face risks due to fluctuations in the exchange rates. Deregulation
of interest rate cause interest risks. Again, securitization has brought with it the
risk of default or counter party risk. Apart from it, every asset—whether
commodity or metal or share or currency—is subject to depreciation in its
value. It may be due to certain inherent factors and external factors like the
market condition, Government’s policy, economic and political condition
prevailing in the country and so on.

In the present state of the economy, there is an imperative need of the


corporate clients to protect there operating profits by shifting some of the
uncontrollable financial risks to those who are able to bear and manage them.
Thus, risk management becomes a must for survival since there is a high
volatility in the present financial markets.

In this context, derivatives occupy an important place as risk reducing


machinery. Derivatives are useful to reduce many of the risks discussed above.
In fact, the financial service companies can play a very dynamic role in dealing
with such risks. They can ensure that the above risks are hedged by using
derivatives like forwards, future, options, swaps etc. Derivatives, thus, enable
the clients to transfer their financial risks to he financial service companies.
This really protects the clients from unforeseen risks and helps them to get
there due operating profits or to keep the project well within the budget costs.
To hedge the various risks that one faces in the financial market today,
derivatives are absolutely essential.

SEBI Guidelines:

SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its
Clearing Corporation/House to ensure that Derivative Exchange/Segment and
Clearing Corporation/House provide a transparent trading environment, safety
and integrity and provide facilities for redressed of investor grievances. Some of
the important eligibility conditions are:

1. Derivative trading to take place through an on-line screen based Trading


System.

2. The Derivatives Exchange/Segment shall have on-line surveillance


capability to monitor positions, prices, and volumes on a real time basis
so as to deter market manipulation.

3. The Derivatives Exchange/ Segment should have arrangements for


dissemination of information about trades, quantities and quotes on a
real time basis through at least two information vending networks, which
are easily accessible to investors across the country.

4. The Derivatives Exchange/Segment should have arbitration and investor


grievances redressal mechanism operative from all the four areas/regions
of the country.

5. The Derivatives Exchange/Segment should have satisfactory system of


monitoring investor complaints and preventing irregularities in trading.

6. The Derivative Segment of the Exchange would have a separate Investor


Protection Fund.

7. The Clearing Corporation/House shall perform full novation, i.e., the


Clearing Corporation/House shall interpose itself between both legs of
every trade, becoming the legal counterparty to both or alternatively
should provide an unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the
overall position of Members across both derivatives market and the
underlying securities market for those Members who are participating in
both.

9. The level of initial margin on Index Futures Contracts shall be related to


the risk of loss on the position. The concept of value-at-risk shall be used
in calculating required level of initial margins. The initial margins should
be large enough to cover the one-day loss that can be encountered on
the position on 99 per cent of the days.

10. The Clearing Corporation/House shall establish facilities for


electronic funds transfer (EFT) for swift movement of margin payments.

11. In the event of a Member defaulting in meeting its liabilities, the


Clearing Corporation/House shall transfer client positions and assets to
another solvent Member or close-out all open positions.

12. The Clearing Corporation/House should have capabilities to


segregate initial margins deposited by Clearing Members for trades on
their own account and on account of his client. The Clearing
Corporation/House shall hold the clients’ margin money in trust for the
client purposes only and should not allow its diversion for any other
purpose.

13. The Clearing Corporation/House shall have a separate Trade


Guarantee Fund for the trades executed on Derivative
Exchange/Segment.

SEBI has specified measures to enhance protection of the rights of investors in


the Derivative Market. These measures are as follows:

1. Investor’s money has to be kept separate at all levels and is permitted to


be used only against the liability of the Investor and is not available to
the trading member or clearing member or even any other investor.

2. The Trading Member is required to provide every investor with a risk


disclosure document which will disclose the risks associated with the
derivatives trading so that investors can take a conscious decision to
trade in derivatives.

3. Investor would get the contract note duly time stamped for receipt of the
order and execution of the order. The order will be executed with the
identity of the client and without client ID order will not be accepted by
the system. The investor could also demand the trade confirmation slip
with his ID in support of the contract note. This will protect him from the
risk of price favour, if any, extended by the Member.

4. In the derivative markets all money paid by the Investor towards margins
on all open positions is kept in trust with the Clearing House /Clearing
Corporation and in the event of default of the Trading or Clearing
Member the amounts paid by the client towards margins are segregated
and not utilised towards the default of the member. However, in the
event of a default of a member, losses suffered by the Investor, if any, on
settled/closed out position are compensated from the Investor
Protection Fund, as per the rules, bye-laws and regulations of the
derivative segment of the exchanges.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading
with one another. Forward contracting dates back at least to the 12th century,
and may well have been around before then. Merchants entered into contracts
with one another for future delivery of specified amount of commodities at
specified price. A primary motivation for pre-arranging a buyer or seller for a
stock of commodities in early forward contracts was to lessen the possibility
that large swings would inhibit marketing the commodity after a harvest.
The following factors have been driving the growth of financial derivatives:

1. Increased volatility in asset prices in financial markets,

2. Increased integration of national financial markets with the international


markets,
3. Marked improvement in communication facilities and sharp decline in
their costs,

4. Development of more sophisticated risk management tools, providing


economic agents a wider choice of risk management strategies, and

5. Innovations in the derivatives markets, which optimally combine the risks


and returns over a large number of financial assets leading to higher
returns, reduced risk as well as transactions costs as compared to
individual financial assets.

Derivatives market in India

Approval for derivatives trading

The first step towards introduction of derivatives trading in India was the
promulgation of the Securities Laws(Amendment) Ordinance, 1995, which
withdrew the prohibition on options in securities. The market for derivatives,
however, did not take off, as there was no regulatory framework to govern
trading of derivatives. SEBI set up a 24–member committee under the
Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate
regulatory framework for derivatives trading in India. The committee submitted
its report on March 17 , 1998 prescribing necessary pre–conditions for
introduction of derivatives trading in India. The committee recommended that
derivatives should be declared as ‘securities’ so that regulatory framework
applicable to trading of ‘securities’ could also govern trading of securities. SEBI
also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to
recommend measures for risk containment in derivatives market in India. The
report, which was submitted in October 1998, worked out the operational
details of margining system, methodology for charging initial margins, broker
net worth, deposit requirement and real–time monitoring requirements.
The SCRA was amended in December 1999 to include derivatives within the
ambit of ‘securities’ and the regulatory framework was developed for
governing derivatives trading. The act also made it clear that derivatives shall
be legal and valid only if such contracts are traded on a recognized stock
exchange, thus precluding OTC derivatives. The government also rescinded in
March 2000, the three–decade old notification, which prohibited forward
trading in securities.
Derivatives trading commenced in 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.
Derivatives market at NSE
The derivatives trading on the exchange commenced with S&P CNX Nifty 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 mechanism. It supports an anonymous order
driven market which provides complete transparency of trading operations and
operates on strict price–time priority. It is 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, 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, Goodtill-
Date, Immediate or Cancel, Limit/Market price, Stop loss, etc. can be built into
an order. The Clearing Members(CM) use the trader workstation for the
purpose of monitoring the trading member(s) for whom they clear the trades.
Additionally,they can enter and set limits to positions, which a trading member
can take.

Membership criteria
NSE admits members on its derivatives segment in accordance with the rules
and regulations of the exchange and the norms specified by SEBI. NSE follows
2–tier membership structure stipulated by SEBI to enable wider participation.
Those interested in taking membership on
F&O segment are required to take membership of CM and F&O segment or
CM, WDM and F&O segment. Trading and clearing members are admitted
separately. Essentially, a clearing member(CM) does clearing for all his trading
members(TMs), undertakes risk management and performs actual settlement.
There are three types of CMs:

Self Clearing Member: A SCM clears and settles trades executed by him
only either on his own account or on account of his clients.

Trading Member Clearing Member: TM–CM is a CM who is also a TM. TM–


CM may clear and settle his own proprietary trades and client’s trades as
well as clear and settle for other TMs.
Professional Clearing Member PCM is a CM who is not a TM. Typically,
banks or custodians could become a PCM and clear and settle for TMs.

Table 1.3 Business growth of futures and options market: Turnover(Rs.crore)

Month Index futures Stock futures Index options Stock options Total

Jun-00 35 - - - 35
Jul-00 108 - - - 1
0
8
Aug-00 90 - - - 90
Sep-00 119 - - - 1
1
9
Oct-00 153 - - - 1
5
3
Nov-00 247 - - - 2
4
7
Dec-00 237 - - - 2
3
7
Jan-01 471 - - - 4
7
1
Feb-01 524 - - - 5
2
4
Mar-01 381 - - - 3
8
1
Apr-01 292 - - - 2
9
2
May-01 230 - - - 2
3
0
Jun-01 590 - 196 - 7
8
5
Jul-01 1309 - 326 396 20
31
Aug-01 1305 - 284 1107 26
96
Sep-01 2857 - 559 2012 52
81
Oct-01 2485 - 559 2433 54
77
Nov-01 2484 2811 455 3010 87
60
Dec-01 2339 7515 405 2660 12
91
9
Jan-02 2660 13261 338 5089 21
34
8
Feb-02 2747 13939 430 4499 21
61
6
Mar-02 2185 13989 360 3957 20
49
0

2001-0221482 51516 3766 25163 101925

Details of the eligibility criteria for membership on the F&O segment are
provided in Tables 12.1 and 12.2(Chapter 12). The TM–CM and the PCM are
required to bring in additional security deposit in respect of every TM whose
trades they undertake to clear and settle. Besides this, trading members are
required to have qualified users and sales persons, who have passed a
certification programme approved by SEBI.
Turnover

The trading volumes on NSE’s derivatives market has seen a


steady increase since the launch of the first derivatives
contract, i.e. index futures in June 2000. Table 1.3 gives the
value of contracts traded on the NSE from the inception of the
market to March 2002. The average daily turnover at NSE now
exceeds a 1000 crore. A total of 41,96,873 contracts with a
total turnover of Rs.1,01,926 crore was traded during 2001-
2002.

Clearing and settlement


NSCCL undertakes clearing and settlement of all deals executed on the NSEs
F&O segment. It acts as legal counterparty to all deals on the F&O segment and
guarantees settlement. We take a brief look at the clearing and settlement
mechanism.

Clearing

The first step in clearing process is working out open positions or obligations of
members. A CM’s open position is arrived at by aggregating the open position
of all the TMs and all custodial participants clearing through him, in the
contracts in which they have traded. A TM’s open position is arrived at as the
summation of his proprietary open position and clients open positions, in the
contracts in which they have traded. While entering orders on the trading
system, TMs are required to identify the orders, whether proprietary (if they
are their own trades) or client ( if entered on behalf of clients). Proprietary
positions are calculated on net basis (buy-sell) for each contract. Clients’
positions are arrived at by summing together net (buy-sell) positions of each
individual client for each contract. A TMs open position is the sum of
proprietary open position, client open long position and client open short
position.
Settlement

All futures and options contracts are cash settled, i.e. through exchange of
cash. The underlying for index futures/options of the Nifty index cannot be
delivered. These contracts, therefore, have to be settled in cash. Futures and
options on individual securities can be delivered as in the spot market.
However, it has been currently mandated that stock options and futures would
also be cash settled. The settlement amount for a CM is netted across all their
TMs/clients in respect of MTM, premium and final exercise settlement. For the
purpose of settlement, all CMs are required to open a separate bank account
with NSCCL designated clearing banks for F&O segment.

Risk management system


The salient features of risk containment measures on the F&O segment are:

Anybody interested in taking membership of F&O segment is required to


take membership of“CM and F&O”or “CM,WDM and F&O”. An existing
member of CM segment can also take membership of F&O segment. The
details of the eligibility criteria for membership of F&O segment are given
in the chapter on regulations in this book.

NSCCL charges an upfront initial margin for all the open positions of a CM
upto client level. It follows the VaR based margining system through SPAN
system. NSCCL computes the initial margin percentage for each Nifty index
futures contract on a daily basis and informs the CMs. The CM in turn
collects the initial margin from the TMs and their respective clients.

NSCCL’s on-line position monitoring system monitors a CM’s open


positions on a real-time basis. Limits are set for each CM based on his
base capital and additional capital deposited with NSCCL. The on-line
position monitoring system generates alerts whenever a CM reaches a
position limit set up by NSCCL. NSCCL monitors the CMs and TMs for mark
to market value violation and for contract-wise position limit violation.
CMs are provided with a trading terminal for the purpose of monitoring
the open positions of all the TMs clearing and settling through them. A CM
may set exposure limits for a TM clearing and settling through him. NSCCL
assists the CM to monitor the intra-day exposure limits set up by a CM and
whenever a TM exceeds the limits, it withdraws the trading facility
provided to such TM.

A separate Settlement Guarantee Fund for this segment has been created
out of the capital deposited by the members with NSCCL.

Types of derivatives

The most commonly used derivatives contracts are forwards, futures and
options which we shall discuss in detail later. Here we take a brief look at
various derivatives contracts that have come to be used.

Forwards: Forwards are the oldest of all the derivatives. A forward contract
refers to an agreement between two parties to exchange an agreed quantity
of an asset for cash at certain date in future at a predetermined price specified
in that agreement. The promised asset may be currency, commodity,
instrument etc.

Example: on June 1, x enters into an agreement to buy 50 bales of cotton on


December 1at Rs. 1,000/- per bale from y, a cotton dealer. It is a case of a
forward contract where x has to pay Rs. 50,000 on December 1 to y and y has
to supply 50 bales of cotton.

In a forward contract, a user (holder) who promises to buy the specified asset
at an agreed price at a fixed future date is said to be in the ‘long position’. On
the other hand, the user who promises to sell at an agreed price at a future
date is said to be in ‘short position’. Thus, ‘long position & ‘short position’ take
the form of ‘buy & sell’ in a forward contract.

Futures: A futures contract is an agreement between two parties to buy or


sell an asset at a certain time in the future at a certain price. Futures contracts
are special types of forward contracts in the sense that the former are
standardized exchange-traded contracts.
Clark has defined future trading “as a special type of futures contract bought
and sold under the rules of organized exchanges.” The term ‘future trading’
includes both speculative transactions where futures are bought and sold with
the objective of making profits from the price changes and also the hedging or
protective transactions where futures are bought and sold with view to
avoiding unforeseen losses resulting from price fluctuations.

A future contract is one where there is an agreement between two parties to


exchange any assets or currency or commodity for cash at a certain future
date, at an agreed price. Both the parties to the contract must have mutual
trust in each other. It takes place only in organized futures market and
according to well-established standards.

As in a forward contract, the trader who promises to buy is said to be in ‘long


position’ and the one who promises to sell is said to be in ‘short position’ in
futures also.
Options: Options are of two types - calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset, at a
given price on or before a given future date. Puts give the buyer the right, but
not the obligation to sell a given quantity of the underlying asset at a given
price on or before a given date.

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 swaptions and payer swaptions. A receiver swaption is an option to
receive fixed and pay floating. A payer swaption is an option to pay fixed and
receive floating.
Chapter:2 basic financial derivative

Introduction:
The past decade has witnessed the multiple growths in the volume of
international trade and business due to the wave of globalization and
liberalization all over the world. As a result, the demand for the international
money and financial instruments increased significantly at the global level. In
this respect, changes in the interest rates, exchange rates and stock market
prices at the different financial markets have increased the financial risks to the
corporate world. Adverse changes have even threatened the very survival of
the business world. It is, therefore, to manage such risks; the new financial
instruments have been developed in the financial markets, which are also
popularly known as financial derivatives.
Financial derivatives like futures, forwards options and swaps are important
tools to manage assets, portfolios and financial risks. Thus, it is essential to
know the terminology and conceptual framework of all these financial
derivatives in order to analyze and manage the financial risks. The prices of
these financial derivatives contracts depend upon the spot prices of the
underlying assets, costs of carrying assets into the future and relationship with
spot prices. For example, forward and futures contracts are similar in nature,
but their prices in future may differ. Therefore, before using any financial
derivative instruments for hedging, speculating, or arbitraging purpose, the
trader or investor must carefully examine all the important aspects relating to
them.

Definition of Financial Derivatives


In brief, the term financial market derivative can be defined as a treasury or
capital market instrument which is derived from, or bears a close re1ation to a
cash instrument or another derivative instrument. Hence, financial derivatives are
financial instruments whose prices are derived from the prices of other financial
instruments.
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.7

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 differs
from the payoff that their notional amount might suggest. 8

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.
Types of Financial Derivatives
In the past section, it is observed that financial derivatives are those assets whose values are determined
by the value of some other assets, called as the underlying. Presently, there are complex varieties of
derivatives already in existence, and the markets are innovating newer and newer ones continuously. For
example, various types of financial derivatives based on their different properties like, plain, simple or
straightforward, composite, joint or hybrid, synthetic, leveraged, mildly leveraged, customized or OTC
traded, standardized or organized exchange traded, etc. are available in the market.

Due to complexity in nature, it is very difficult to classify the financial derivatives, so in the
present context, the basic financial derivatives which are popular in the market have been described in
brief. The details of their operations, mechanism and trading, will be discussed in the forthcoming
respective chapters. In simple form, the derivatives can be classified into different categories which are
shown in the Fig.

Derivatives

Financials Commodities

Basic Complex

Forwards Futures Options Warrants Swaps Exotics

& (Nonstandard)
Convertibles
Classification of Derivatives

One form of classification of derivative instruments is between commodity derivatives and financial
derivatives. The basic difference between these is the nature of the underlying instrument or asset. In a
commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton, pepper,
sugar, jute, turmeric, corn, soya beans, crude oil, natural gas, gold, silver, copper and so on. In a financial
derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign exchange, stock index,
gilt-edged securities, cost of living index, etc. It is to be noted that financial derivative is fairly standard
and there are no quality issues whereas in commodity derivative, the quality may be the underlying
matters. However, the distinction between these two from structure and functioning point of view, both
are almost similar in nature.

Basic Financial Derivatives

Forward Contracts
A forward contract is a simple customized contract between two parties to buy or sell an asset at a
certain time in the future for a certain price. Unlike future contracts, they are not traded on an exchange,
rather traded in the over-the-counter market, usually between two financial institutions or between a
financial institution and its client.
Example
An Indian company buys Automobile parts from USA with payment of one million dollar due in 90 days.
The importer, thus, is short of dollar that is, it owes dollars for future delivery. Suppose present price of
dollar is ` 48. Over the next 90 days, however, dollar might rise against ` 48. The importer can hedge this
exchange risk by negotiating a 90 days forward contract with a bank at a price ` 50. According to forward
contract in 90 days the bank will give importer one million dollar and importer will give the bank 50
million rupees hedging a future payment with forward contract. On the due date importer will make a
payment of ` 50 million to bank and the bank will pay one million dollar to importer, whatever rate of the
dollar is after 90 days. So this is a typical example of forward contract on currency.

The basic features of a forward contract are given in brief here as under:

1. Forward contracts are bilateral contracts, and hence, they are exposed to counterparty risk.
There is risk of non-performance of obligation either of the parties, so these are riskier than to
futures contracts.

2. Each contract is custom designed, and hence, is unique in terms of contract size, expiration date,
the asset type, quality, etc.

3. In forward contract, one of the parties takes a long position by agreeing to buy the asset at a
certain specified future date. The other party assumes a short position by agreeing to sell the
same asset at the same date for the same specified price. A party with no obligation offsetting
the forward contract is said to have an open position. A party with a closed position is,
sometimes, called a hedger.

4. The specified price in a forward contract is referred to as the delivery price. The forward price for
a particular forward contract at a particular time is the delivery price that would apply if the
contract were entered into at that time. It is important to differentiate between the forward
price and the delivery price. Both are equal at the time the contract is entered into. However, as
time passes, the forward price is likely to change whereas the delivery price remains the same.

5. In the forward contract, derivative assets can often be contracted from the combination of
underlying assets, such assets are oftenly known as synthetic assets in the forward market.

6. In the forward market, the contract has to be settled by delivery of the asset on expiration date.
In case the party wishes to reverse the contract, it has to compulsory go to the same counter
party, which may dominate and command the price it wants as being in a monopoly situation.
7. In the forward contract, covered parity or cost-of-carry relations are relation between the prices
of forward and underlying assets. Such relations further assist in determining the arbitrage-
based forward asset prices.

8. Forward contracts are very popular in foreign exchange market as well as interest rate bearing
instruments. Most of the large and international banks quote the forward rate through their
‘forward desk’ lying within their foreign exchange trading room. Forward foreign exchange
quotes by these banks are displayed with the spot rates.

9. As per the Indian Forward Contract Act- 1952, different kinds of forward contracts can be done
like hedge contracts, transferable specific delivery (TSD) contracts and non-transferable specify
delivery (NTSD) contracts. Hedge contracts are freely transferable and do not specific, any
particular lot, consignment or variety for delivery. Transferable specific delivery contracts are
though freely transferable from one party to another, but are concerned with a specific and
predetermined consignment. Delivery is mandatory. Non-transferable specific delivery contracts,
as the name indicates, are not transferable at all, and as such, they are highly specific.

In brief, a forward contract is an agreement between the counter parties to buy or sell a specified
quantity of an asset at a specified price, with delivery at a specified time (future) and place. These
contracts are not standardized; each one is usually being customized to its owner’s specifications.

Futures Contracts

Like a forward 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 contracts are
normally traded on an exchange which sets the certain standardized norms for trading in the futures
contracts.

Example

A silver manufacturer is concerned about the price of silver, since he will not be able to plan for
profitability. Given the current level of production, he expects to have about 20.000 ounces of silver
ready in next two months. The current price of silver on May 10 is ` 1052.5 per ounce, and July futures
price at FMC is ` 1068 per ounce, which he believes to be satisfied price. But he fears that prices in future
may go down. So he will enter into a futures contract. He will sell four contracts at MCX where each
contract is of 5000 ounces at ` 1068 for delivery in July.

Perfect Hedging Using Futures


Date Spot Market Futures market
Anticipate the sale of 20,000 ounce in two Sell four contracts, 5000 ounce each
May 10 months and expect to receive ` 1068 per July futures contracts at ` 1068 per
ounce or a total ` 21.36,00.00 ounce.

The spot price of silver is ` 1071 per ounce; Buy four contracts at ` 1071. Total
July 5 Miner sells 20,000 ounces and receives ` cost of 20,000 ounce will be `
21.42,0000. 21,42,0000.

Profit / Loss Profit = ` 60,000 Futures loss = ` 60,000


Net wealth change = 0

In the above example trader has hedged his risk of prices fall and the trading is done through
standardized exchange which has standardized contract of 5000 ounce silver. The futures contracts have
following features in brief:

Standardization

One of the most important features of futures contract is that the contract has certain standardized
specification, i.e., quantity of the asset, quality of the asset, the date and month of delivery, the units of
price quotation, location of settlement, etc. For example, the largest exchanges on which futures
contracts are traded are the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME).
They specify about each term of the futures contract.

Clearing House

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 for the performance of the parties to each
transaction. The clearing house has a number of members all of which have offices near to the clearing
house. Thus, the clearing house is the counter party to every contract.
Settlement Price

Since the futures contracts 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.
Daily Settlement and Margin

Another feature of a futures contract is that when a person enters into a contract, he is required to
deposit funds with the broker, which is 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.

Tick Size
The futures prices are expressed in currency units, with a minimum price movement called a tick size.
This means that the futures prices must be rounded to the nearest tick. The difference between a
futures price and the cash price of that asset is known as the basis. The details of this mechanism will be
discussed in the forthcoming chapters.

Cash Settlement

Most of the futures contracts 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
price at expiration date. This is done because it is inconvenient or impossible to deliver sometimes, the
underlying asset. This type of settlement is very much popular in stock indices futures contracts.

Delivery

The futures contracts 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 delivery to the
longs. The period during which the delivery will be made is set by the exchange which varies from
contract to contract.

Regulation

The important difference between futures and forward markets is that the futures contracts 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 futures
markets both in stocks and commodities. Any such new futures contracts and changes to existing
contracts must by approved by their respective Commission. Further, more details on different issues of
futures market trading will be discussed in forthcoming chapters.

Options Contracts
Options are the most important group of derivative securities. Option may be defined as a contract,
between 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 a specified date. The person who acquires the right is
known as the option buyer or option holder, while the other person (who confers the right) is known as
option seller or option writer. 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 two types: calls and puts. A call option gives the holder the right to
buy an asset at a specified date for a specified price whereas in put option, the holder gets the right to
sell an asset at the specified price and time. The specified price in such contract is known as the 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. They include shares, stocks, stock indices, foreign currencies, bonds, commodities,
futures contracts, etc. Further options can be American or European. A European option can be exercised
on the expiration date only whereas an American option can be exercised at any time before the
maturity date.

Example

Suppose the current price of CIPLA share is ` 750 per share. X owns 1000 shares of CIPLA Ltd. and
apprehends in the decline in price of share. The option (put) contract available at BSE is of ` 800, in next
two-month delivery. Premium cost is ` 10 per share. X will buy a put option at 10 per share at a strike
price of ` 800. In this way X has hedged his risk of price fall of stock. X will exercise the put option if the
price of stock goes down below ` 790 and will not exercise the option if price is more than ` 800, on the
exercise date. In case of options, buyer has a limited loss and unlimited profit potential unlike in case of
forward and futures.

In April 1973, the options on stocks were first traded on an organized exchange, i.e., Chicago
Board Options Exchange. Since then, there has been a dramatic growth in options markets. Options are
now traded on various exchanges in various countries all over the world. Options are now traded both on
organized exchanges and over- the-counter (OTC). The option trading mechanism on both are quite
different and which leads to important differences in market conventions. Recently, options contracts on
OTC are getting popular because they are more liquid. Further, most of the banks and other financial
institutions now prefer the OTC options market because of the ease and customized nature of contract.

It should be emphasized that the option contract gives the holder the right to do something. The
holder may exercise his option or may not. The holder can make a reassessment of the situation and
seek either the execution of the contracts or its nonexecution as be profitable to him. He is not under
obligation to exercise the option. So, this fact distinguishes options from forward contracts and futures
contracts, where the holder is under obligation to buy or sell the underlying asset. Recently in India, the
banks are allowed to write cross-currency options after obtaining the permission from the Reserve Bank
of India.

Warrants and Convertibles

Warrants and convertibles are other important categories of financial derivatives, which are frequently
traded in the market. Warrant is just like an option contract where the holder has the right to buy shares
of a specified company at a certain price during the given time period. In other words, the holder of a
warrant instrument has the right to purchase a specific number of shares at a fixed price in a fixed period
from an issuing company. If the holder exercised the right, it increases the number of shares of the
issuing company, and thus, dilutes the equities of its shareholders. Warrants are usually issued as
sweeteners attached to senior securities like bonds and debentures so that they are successful in their
equity issues in terms of volume and price. Warrants can be detached and traded separately. Warrants
are highly speculative and leverage instruments, so trading in them must be done cautiously.

Convertibles are hybrid securities which combine the basic attributes of fixed interest and
variable return securities. Most popular among these are convertible bonds, convertible debentures and
convertible preference shares. These are also called equity derivative securities. They can be fully or
partially converted into the equity shares of the issuing company at the predetermined specified terms
with regards to the conversion period, conversion ratio and conversion price. These terms may be
different from company to company, as per nature of the instrument and particular equity issue of the
company. The further details of these instruments will be discussed in the respective chapters.

SWAP Contracts

Swaps have become popular derivative instruments in recent years all over the world. A swap 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 payment are determined and finalized by the parties.
Usually the calculation of cash flows involves the future values of one or more market variables.

There are two most popular forms of swap contracts, i.e., interest rate swaps and currency
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. The currencies of the two sets of cash flows are the same. In case
of currency swap, it involves in exchanging of interest flows, in one currency for interest flows in other
currency. In other words, it requires the exchange of cash flows in two currencies. There are various
forms of swaps based upon these two, but having different features in general.

Other Derivatives

As discussed earlier, forwards, futures, options, swaps, etc. are described usually as standard or ‘plain
vanilla’ derivatives. In the early 1980s, some banks and other financial institutions have been very
imaginative and designed some new derivatives to meet the specific needs of their clients. These
derivatives have been described as ‘non-standard’ derivatives. The basis of the structure of these
derivatives was not unique, for example, some non-standard derivatives were formed by combining two
or more ‘plain vanilla’ call and put options whereas some others were far more complex.

In fact, there is no boundary for designing the non-standard financial derivatives, and hence, they are
sometimes termed as ‘exotic options’ or just ‘exotics’. There are various examples of such non-standard
derivatives such as packages, forward start option, compound options, choose options, barrier options,
binary options, look back options, shout options, Asian options, basket options, Standard Oil’s Bond
Issue, Index Currency Option Notes ( ICON), range forward contracts or flexible forwards and so on.

Traditionally, it is evident that important variables underlying the financial derivatives have been
interest rates, exchange rates, commodity prices, stock prices, stock indices, etc. However, recently, some
other underlying variables are also getting popular in the financial derivative markets such as
creditworthiness, weather, insurance, electricity and so on. In fact, there is no limit to the innovations in
the field of derivatives, Suppose that two companies A and B both wish to borrow 1 million rupees for
five- years and rate of interest is:
Company Fixed Floating
Company A 10.00% per annum 6 month LIBOR + 0.30%
Company B 11.20% per annum 6 month LIBOR + 1.00%
A wants to borrow at floating funds and B wants to borrow at fixed interest rate. B has low credit
rating than company A since it pays higher rate of interest than company A in both fixed and floating
markets. They will contract to Financial Institution for swapping their assets and liabilities and make a
swap contract with bank.

Both company will initially raise loans A in fixed and B in floating interest rate and then contract
to bank, which in return pays fixed interest rate to A and receive floating interest rate to A and from B.
Bank will pay floating interest rate and receive. Fixed interest rates and also changes commission from
both A and B have the liability in which both were interested.