Chapter-2

Concept of Derivatives
 Chapter-2 Concept of Derivatives

2.1 Definition of Derivatives

A derivative is an instrument whose payoffs depend on a more primitive or
fundamental good. It is a contractual relationship between parties where payoffs are
derived from some agreed upon benchmark. These do not have independent existence
without underlying product or commodity. Even, derivatives do not have their own value
and rather they derive their value li'om some underlying product or commodity.
A financial derivative is a financial instrument, whose payoffs depend on another
financial instrument or we can say a financial derivative is a financial instrument, whose
value is linked in some way to the value of another instrumcnt, underlying the
transaction. The underlying instrument could be securities, currencies or indices. For
example an option on a share of stock depends on the value of the underlying share.

To quote
"A derivative can be defined as a financial instrument whose value depends on (or
derives from) the values of other, more basic underlying variables." - John C. Hull

"A derivative is simply a financial instrument (or evcn morc simply an agreement
between two people) which has a value determined by the price of something
else." - Robert L. McDonald

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, J 956 (SC(R)A) defines
"Derivative" to include-
•

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 • A security derived from a debt instrument, share, loan whether secured or
unsccured, risk instrument or contract for differences or any other form of
security.
• A contract, which derives its value from the pnccs, or index of pnces, of
underlying securities.
Derivatives are securities under the SC(RJA and hence the trading of derivatives
is governed by thc regulatory framework under the SC(RJA.
There is no definitive list of derivative products and the types of derivative
products that can be developed are limited by human imagination only. However the
most common financial derivatives can be classified as forwards. futures, options and
swaps.
A derivative is defined as a "financial instrument"

• Whose value changes in response to the change in a specified interest rate,

security price, commodity price, foreign exchange rate, index (if prices or rates,
a credit rating or credit index, or similar variable (sometimes called the
"underlying "),
• That reqllires no initial net investment or lillie initial net investmelll relative to
other types of contracts that have a similar response to changes in market
conditions, and
• That is sellied at aflltllre date.
"A 'derivative contract' is-
(a) An option, a future, a warrant or a contract for differences,
(b) An option to enter into a contract falling within paragraph (a), or
(c) A future relating to the sale of slich a contract."
The following factors have generally been identified as the major driving force behind
growth of financial derivatives:
• Increased volatility in asset priccs in financial markets.
• Increased integration of national financial markets with the international
markets.
• Marked improvcment in communication facilities and sharp decline in their
costs.

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 • Development of more sophisticated risk management tools, providing
economic agents a wider choice of risk management strategies.
• Innovations in the dcrivatives markets, which optimally combine the risks and
returns over a large number of financial assets, leading to higher returns,
reduced risk as well as transaction costs as compared to individual financial
assets.
A futures contract ,s an agreement between two parties to sell or buy a given
commodity or security that will be delivered at a certain time in the future for a
predetermined price.
Futures contracts involving industrial commodities, imported foodslUffs, or
agricultural commodities are called 'commodity' futures. Futures contracts that are based
on financial instruments or financial indexes are called 'financial' futures. Financial
futures can be classified into three groups: stock index futures or contracts based on stock
indexes, interest rate futures or contracts concerning an asset whose price is solely
dependent on the level of interest rates, and currency futures or contracts on foreign
currencies.'
Futures contracts are traded on exchanges, and they are standardized according to
the rules and the regulations of the exchange in question. The exchange determines the
exact quality and the quantity of the goods to be delivered per contract, when the contract
terminates, and the location of the delivery. This standardization facilitates secondary
market trading and enhances the liquidity of the market. The parties involved need not
concern themselves with the creditworthiness of other players because the exchange itself
guarantees the performance of all par1ies. 2
The seller of a futures contract is said to be in the 'short' position and the buyer is
said to be in the 'long' position. The date at which the parties must complete the
transaction is the settlement or delivery date. The price agreed to by two parties is known
as the futures price.

I Frank Fabozzi & Franco Modigiiani, Capital J\1arkels, Prentice l1all, New Jersey, 1996, p. 216.
?
- Fred D. Arditti, DeriHlfi\'cs. Harvard Business School Press, Boston, 1996, p. ISO.

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 2.2 History of Futures & Options Markets

2.2.1 History of Futures Markets

futures markets exist as a result of the need to reduce price risk in commodity
markets. The earliest type of futures contracts known to have developed was the
agricultural futures contracts on rice in Osaka in the 1730s3 The U.S. Chicago Board of
Trade (CBOT) was established in 1848. Within a few years, the first future type contract
was developed, known as a "to-arrive" contract, which soon became an alternative to the
trading of grain itself. In 1874, The Chicago Produce Exchange was established to
provide a market for certain agricultural products. In 1898, butter and egg dealers
withdrew from the market and formed the Chicago Buttcr and Egg Board. It was later
reorganized for futures trading and was renamed the Chicago Mercantile Exchange
(CME) in 1919-1.
The first financial futures contracts were currency futures contracts introduced by
the International Monetary Market (IMM), which was originally formed as a division of
the Chicago Mercantile Exchange in 1972. Later, in 1976, the IMM began trading
treasury bill futures 5 . The first interest-rate futures contracts and futures on mortgage-
backed securities bega\l to be traded by the Chicago Board of Trade in 1975. The Kansas
City Board of Trade introduced a futures contract on Standard & Poor's 500 stock index
in 19826 . By the 1980s, the rapid growth in financial futures markets was spreading
overseas: the London International Financial Futures Market (LIFFE) was established in
1982, the Sydney Futures Market in 1980, The Singapore International Monetary
Exchange in 1984, the Tokyo International Financial Futures Exchange in 1989, the

3 Terry J. Watsham, Futures and Opfiolls in Risk MwwMcmenl, Intemational Thomson Business Press,
Lonoon, 199&, p, 7,

.tJohn C. Hull, Introduction to Futures lind Options Markets, Prentice-Hall International, New Jersey,
1998. pp. 2-3.

5
Mark J. Powers & Mark G. Castelino, Inside the Financial Futures Markets, John Wiley & Sons Inc.,
New York, 1991,p.14.

.. 6 Walsh"lI11, op.ciL, p. 7.

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Swiss Options and Financial Futures Exchange in 1988, the Matif in Paris in 1986 and
the Deutsche Tenninbtirse in 1990.

2.2.2 History of Options Markets

In the early 1900s, a group of firms set up what was known as the Put and Call
Brokers and Dealers Association. It, however, did not allow the buyer of an option the
right to sell it to another party prior to expiration and there was no mechanism to
guarantee that the writer of the option would honour the contract. In April 1973, the
Chicago Board of Trade set up a new exchange, the Chicago Board of Options Exchange,
specilically for thc purpose of trading stock options. Since then options markets have
become increasingl y popular with investors.
The American Stock Exchange and the Philadelphia Stock Exchange began
trading options in 1975. By the early 1980's, the volumc of trading had grown so rapidly
that thc number of shares underlying the option contracts sold each day exceeded the
daily volume of shares traded on the New York Stock Exchange.
In the 1980's, markets developed for options in foreign exchange, options on
stock indices, and options on futures contracts. The Philadelphia Stock Exchange is the
premier exchange for trading foreign exchange options. The Chicago Board Options
Exchange trades options on the S&P 100 and the S&P SOO stock indices while the
American Stock Exchange trades options on the Major Market Stock Index, and the New
York Stock Exchange trades options on the NYSE Index. Most exchanges offering
futures contracts now also offer options on these futures contracts. Thus, the Chicago
Board of Trades offers options on corn futures, the Chicago Mercantile Exchange otTers
options on live cattle futures, and the International Monetary Market offers options on
foreign currency futures, and so on.

2.3 Emergence of Financial Derivative Products

The emergence of the market for derivative products, notably Futures and
Options, can be traced back to the willingness of risk-averse investors to guard
themselves against uncertainties arising out of Ouctuations in asset prices. Through the
lise of derivative products, it is possible to partially or fully transfer price lisks by locking

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III asset pnces. Derivative products initially emerged as hedging devices against
tluctuations in commodity prices. Commodity-linked derivatives remained the sole fonn
of such products for almost three hundred years. The advent of modern day derivative
contracts can be attributed to the need for farmers to protect thcir produce from any
decline in the price of their crops.
For example if a farmer wanted to save his produce against any decline in prices
due to natural calamities or any loss or production, he can enter into a future agreement
with the buyer wherein he can fix the price at which he is going to sell the produce at a
future date. In this way, the farmer is hedged against any risk that he could have been
exposed to in the future. In the same way options arc similar to insurance products
whereby the insured pays a premium to insure his assets. The option buyer pays a small
price, which is the premium, to insure his stock prices against any fall in the underlying
by buying a put option.
The financial derivatives came into spotlight post-1970 due to growing instability
in the financial markets. The first stock index futures contract introduced in the world
was the Value line contract, introduced by the Kansas City Board of Trade in 1982 in the
USA. Since then we have seen numerous markets all over the world launching new
derivative contracts every year. In recent years, the market for financial derivatives has
grown tremendously both in terms of variety of instruments available, their complexity
and also turnover.
The advent of stock index futures and options has profoundly changed the nature
of trading on stock exchanges. The concern over how trading in futures contracts affects
the spot market for underlying assets has been an interesting subject for investors, market
makers, academicians, exchanges and regulators alike. These markets offer investors
flexibility in altering the composition of their portfolios and in timing their transactions.
Futures markets also provide opportunities to hedge the risks involved with holding
diversified equity portfolios. As a consequence, significant portion of cash market equity
transactions are tied to futures and options market activity.
Derivative products initially emerged as hedging devices against fluctuations in
commodity prices, and commodity-linked derivatives remained the sole form of such
products for almost three hundred years. Financial derivatives came into spotlight in the

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 post-I970 period due to growing instability in the financial markets. However, since their
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emergence, these products have become very popular and by 1990s, they accounted for
about two-thirds of total transactions in derivative products. In recent years, the market
fm financial derivatives has grown tremendously in terms of variety of instruments
available, their complexity and also turnover. In the class of equity derivatives the world
over. futures and options on stock indices have gained more popularity than on individual
stocks, especially among institutional invcstms, who are major users of index-linked
derivatives. Even small investors find these useful due to high cOlTelation of the popular
indexes with various portfolios and ease of use. The lower costs associated with index
derivatives vis-a-vis derivative products based on individual securities is another reason
for their growing usc.

2.4 Scope & Purpose of Derivatives Markets

Derivntives exist on almost all traded financial and commodity markets, and even
on instruments which are not publicly traded. The underlying market or instrument may
be oil or copper or a rate of interest for a particular period, such as the rate on a three-
month Treasury bill. Alternatively the derivative contract may relate to the likelihood of a
corporation defaulting on its borrowings or the amount of rainfall in Cape Town during
Deccmber. There are also derivatives on other derivative instlUments, for example,
options to buy or sell other options, and options on futures and swaps.
Whilst the principal influences on prices in cash markets are supply and demand
and perceptions of future value, derivatives often require fairly complex mathematical
computations in order to arrive at a COlTect, or at least, non-arbitrageable price, i.e. a price
whieh is in line with the market prices of similar instlUments and which does not present
an immediate mispricing opportunity to more astute market participants.
The derivatives markets can be seen as supplementary markets, existing side by
side with the underlying markets to which they relate, and from which they derive a
significant portion of their value. To these markets, in turn, derivatives bring significantly
greater dimension and flexibility, as well as a host of new participants with alternative
risk profiles .
•

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 The global derivatives markets have witnessed explosive growth over the last
couple of decades due to a variety of factors. These include,

• The globalization and liberalization of world trade giving rise to new and different
risk profiles of economic agents.
• The relaxation of capital controls permitting a huge increase in global investment
opportunities and risks.
• The technology and communications "revolution" especially the advent of the
mIcroprocessor.
• The development of risk management as a strategic focus of organizations.
• The generally acknowledged success of the theoretic of derivatives pricing and
hedging in the real world over this period.

Purpose of futures and options markets

Fluctuating interest rates. commodity and share prices, and exchange rates present
~ uncertainty and financial risk to individuals and businesses alike. Those with significant
exposure to these l1uctuations, such as investment banks, fund managers and corporations
use the futures market to insure or protect themselves from this price uncertainty. Futures
and options markets provide buyers with a means of locking in the price at which they
will purchase a commodity or financial instrument in the future. Conversely, sellers are
able to establish ahead of time, the price they will receive for their commodity or
security.
As buyers and sellers are exchanging contracts rather than the underlying
commodity or financial instrument itself, it is possible to deal on the futures and options
exchange without ever seeing or handling the assets concerned. The majority of
transactions are closed out by market palticipants taking a position in the market opposite
to that originally held. Futures and options contracts to buy are cancelled by contracts to
sell, while futures and options contracts to sell are cancelled by contracts to buy. In this
way, most market participants use the market primarily as a price setting mechanism
rather than a means of making or receiving delivery.

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2.5 Economic Benefits and Risks of Derivative Securities

2.5.1 Economic Benefits of Derivatives Securities

Futures markets are of critical importance for the global economy and its financial
markets. Instability of interest rates. currency values, and stock index prices represent
great headaches for financial planners and forecasters. Futures trading serves as a tool
that helps minimize the risk of this market turbulence. Financial managers use futures as
risk management tools. which are generally successful in significantly reducing the
potential for drastic losses in cash positions. In addition, the degree of leverage provided
by futures is not available with any other financial instruments, underlining their singular
importance. With futures, speculators are able to creatively develop portfolios for which
the level of risk is minimized.
The central purpose of futures trading is to sUpp0l1 healthy competition, capital
formation, and new product development. By reducing barriers to competition, futures
help to safeguard and improve the general competitiveness of the economy. Futures
exchanges are institutions that represent great equality of oppo!1unity through access to
improved forms of information flow they are highly efficient markets. Futures trading
enhance investment levels and saving flows by providing well-built, secure, and stable
commercial banking, investment banking, and brokerage industries. Finally, by creating a
wide collection of new savings instruments, futures markets encourage the mobilization
of savings and provide a rich variety of risk repackaging services, increasing the now of
funds between savers and investors, and simulating the growth of financial inter-
mediation services. Nevertheless, the central economic functions perfom1ed by futures
are still in the fields of competitive price discovery and the hedging of price risks.
Futures markets provide infonnation about the prices of underlying markets and
serve as an accurate reflection of market expectations. The role of price discovery has
been assigned to futures markets. Futures prices arc established through open and
competiti ve trading on the 1100r of the exchange. Prices reflect what is estimated to be the
underlying supply and demand of an asset at some specific future date. These prices are
public, global information. This process makes prices visible and available to everyone
and establishes equilibrium between current and anticipated cash prices.

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 Another important function of futures markets is the shifting of risk through
hedging. Futures markets separate priee risk from other business risks and allow for
transferring the price risk from traders who wish to avoid it to speculators who are
willing to assume it. Thus. futures help traders to reduce or control risk exposure, the
results of adverse price fluctuations.
At first glance. the economic benefits of derivatives might not be apparent. since
derivatives are zero-sum monetary games: the amount paid by one side of the contract is
the amount received by the other side. When the contract expires or is cxercised. the
gains and losses completely offset each other. But even though derivatives represent
zero-sum monetary gamcs, they need not represent zero-sum cconomic games.
Individuals and firms that use derivative instruments can do so to hedge, to speculate, or
to engage in arbitrage. When individuals or firms hedge risks with derivatives, they are
attempting to use these contracts as a kind of insurance against a bad future outcome.
In addition to efficient allocation of risk, derivatives offer another important
benefit: they can provide investors with opportunities that would otherwise be
unavailable to them at any price. That is, derivatives can provide payoffs that simply
cannot be obtained with other, existing assets.

2.5.2 Risks associated with the use of derivative instruments

Derivative products are specialized instrumcnts that require investment techniques
and risk analyses differcnt from those associated with stocks and bonds. The use of a
derivative requires an understanding not only of the underlying instrument but also of the
derivative itself. Derivatives require maintenance of adequate controls to monitor the
transactions cntered into, the ability to assess the risk that a derivative adds to the
portfolio. Understanding the various risks that are associated with derivatives is necessary
in order to apply control over the risk. The following are the risks associated with the
derivative segment.

2.5.2.1 Basis risk

Basis is the difference between the price of the futures and the price of the
underlying asset. The futures contract either trades at a discount or at a premium to the

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spot. The difference in the prices between the spot and the futures can create a risk to the
investors, which can be termed as Basis Risk. For example an investor takes a short
position in Nifty futures expecting a downfall of 20 points from the current level. Let us
assume that Nifty futures are trading at a discount of l'i points to the spot. It is possible
that Nifty spot might shed 20 points but Nifty fUlUres might not lose 20 points
simultaneously.
This could be on account of short covering in the index. So even though Nifty
spot might fall by 20 points, the fall in Nifty futures could be limited to only around 5
points. In this case, the trader was right in judging the 20-point fall in Nifty but could not
factor it in the fall in Nifty futures on account of basis risk. Basis risk gets enhanced
during expiry since there is rapid short covering or profit booking around that time. Basis
risk can also be caused in stocks, which are not very liquid.
In such stocks, the difference between the bid and ask are so high that it can result
in huge difference between the spot and the futures. It is advisable to avoid such stocks
where there is a considerable difference between the bid ask spread as this would enhance
the basis risk in that stock.

2.5.2.2 Time risk

The risk arising due to the timely specifications in the F&O segment can be taken
as the time risk. The time risk is known as theta in the technical language of options.
Options carry a lot of time risk as the value of the options decrease as we move towards
the expiry. At the start of a fresh contract the options are valued by their intrinsic value
plus the time value of the contract. As the expiry approaches, the total value of the option
keeps declining due to the decrease in its time value. In the same manner if an investor
seeks to take a position in the mid or far month contracts then he will have to buy at a
premiulll to the market price due to higher cost of carry which is again the basis risk
translating into time risk. If an investor takes a long position in the ncar month contract
and his anticipated target is not achieved. Hence, he will be forced to close the position
before the expiry or has to rollover the position to the next month contract. The extra cost
that the investor incurs is termed as rollover cost, which can attribute to the time risk.

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f 2.5.2.3 Volatility risk
The risk arising In the value of options due to the unpredictable
changes/movement in the volatility of the underlying asset. The higher the volatility of
the stock then higher is the premium paid for buying the stock options. For example. a
stock like Sat yam computers which has a high volatility and is trauing at 880. the price of
the 900 call option is arounu Rs. 25 whieh is only the high premiulll paid for the stock
option. If the investor intends to buy a stock with high volatility then the premium paid
over the fair value of the option becomes his risk in Illonetary terms.

2.5.2.4 Leverage risk

Leverage is regarded as one of the biggest advantage of the derivatives over
equity. This advantage can also be considered a high-risk situation. In equity we pay the
entire value of the investment whereas in futures we pay only 20% of the total value of
the contract as upfront margin. Hence a gain ur loss of every Re. I becomes 5 times in the
futures. But just as the upside return is amplified to an extent of 5 times. in the same
manner the downside risk is also equally amplified.
For example. if an investor has taken a long position in Reliance futures which
has a margin of around Rs. 80000 and in equity the total value of 6 lacs for owning 600
shares. Suppose, Reliance dips by 30 rupees in a single uay effectively the investor is
loosing Rs. 18000. In terms of percentage the same loss is amplified to 23% loss in
futures versus a meager 3% loss of the capital in equity.

2.5.2.5 Liquidity risk

Liquidity risk arises when it becomes difficult to sell the stocks that one has
purchased. This risk exists in the stocks where the bid-ask spread is wide and the investor
is not able to sell the stock at his anticipated price. Liquidity Risk can be partly
compensated by diversification of the portfolio and the investments into illiquid stock has
to backed with strong market news and expectations.
Stop loss is an effective tool to minimize losses, but yet another disadvantage in the
case of illiquid stocks is there are high chances that the stop-loss is triggered and the

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 stock price bounces back, In the widely spread bid-ask levels of a stock price, the stop
(
loss has to be maintained at such a juncture where the stock has a very strong support.

2,6 Uses of Derivatives

• Derivatives can be used as a convenient substitute for other investments, leaving

Risks and rewards unchanged

For example, instead of buying each of the stocks in Nifty Index of the 50 largest
Indian Capital Market stocks, a pension fund might buy a Nifty 50 futures contract of
the same face value and set aside the full value in cash reserves, This strategy is no
more or less risky than buying the stocks themselves, but uses futures as an efficient
medium for investments,

• Derivatives can be used to hedge other instruments and thereby reduce risks and
rewards or can help manage the risks inherent in a business -
For example, a pension fund that owns $ I billion of large Indian stocks, but
realizes that a temporary market decline is imminent may sell $ I billion of futures
contract or buy $ I billion of put options, to protect its portfolio against the risk of a
general market decline, In the context of currency fluctuations, exporters face losses
if the rupee appreciates and importers face losses if the rupee depreciates, By forward
contracting in the dollar-rupee forward market, they supply insurance to each other
and reduce the risk,

• Derivatives can be used speculatively to increase risk and reward through

leverage-
For example, an investor with $ I million could buy futures contracts with a face
value equal to $ 10 million of stock, This investor is taking a big risk in the hope of a
gain, leveraging the investmcnt approximately 10: I, if the stock market goes up 10
percent, increasing the value of the stock up to $ II million, then the investor has
made a $ I million profit, doubling his initial $ I million investment. If the stock
market goes down 10 percent, decreasing the value of the stock to $ 9 million, then all
of the investor's money is lost.

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, • Derivatives are also the hasis for modern financial engineering
For example. mortgage derivatives may be used to create a repackaged asset,
which is only part of an underlying bundle of mortgages financially engineered into a
variety of sub-divided forms. One derivative might pass on only the interest payments
of the underlying mortgages while another may pass on only the principal. These new
instruments would be an additional attraction for the investors with varying needs.
In audition. inuex based derivatives are very useful in minimizing risks. An
investor who buys stocks may like to enjoy peace of mind by capping his downside
loss. Put options on the index are the ideal form of insurance here. Regardless of the
composition of a person's portfolio, index put options will protect him from exposure
to a fall in the index. To illustrate, suppose a person has a portfolio worth Rs I
million and suppose the Nifty (NSE 50 Index) is at toOO. This investor decides that
he does not want to suffer a loss worse than 10 percent. He can purchase a Nifty put
option with the strike price set to 900. If the Nifty falls below 900 his put option
reimburses him for the full loss. Portfolio insurance is thus possible through index-
based derivatives.
Derivatives markets serve two important economIC purposes: risk shifting and
price discovery. Risk shifting more commonly called hedging is the transfer of risk
from one entity who does not want it to another entity that is more willing or able to
bear it. Derivatives trading can help determine or 'discover' the price of certain
assets, commodities or types of risk that would not otherwise occur because of
transactions costs, dispersion of markets for the underlying item or the
conglomeration of many risks into one whole asset. One of the most important price
discovery functions is the determination of the price of the underlying item, e.g. an
exchange rate, over time. Derivatives markets can serve to determine not just spot
prices but also future prices (and in the ease of options the price of the risk is
determined).

2S
(
2.7 Application of Derivatives
• Risk IVlanagement
Risk management IS not about the elimination of risk rather it is about the
management of risk. Financial derivatives provide a powerful tool for limiting risks
that individuals and organizations face in the ordinary conduct of their businesses.
Successful risk management with derivativcs requires a thorough understanding of
the principles that govern the pricing of financial derivatives. Used con·eclly.
derivatives can save costs and increase returns.

• Trading Efficiency
Derivatives allow for the free trading of individual risk components. thereby
improving market efficiency. Traders can use a position in one or more financial
derivatives as a substitute for a position in the underlying instruments. In many
instances tradcrs find financial derivatives to be a more attractive instrumcnt than the
underlying sccurity. Reason being, the greater amount of liquidity in the market
offered by the financial derivatives ami lower transaction costs associated with
trading a financial derivative as compared to the costs of trading the underlying
instrument.

• Speculation
Serving as a speCUlative tool is not the only use, and probably not the most
important use, of financial derivatives. Financial derivatives are considered to be
risky. However, these instruments act as a powerful instrument for knowledgeable
traders to expose themselves to properly calculated and well understood risks in
pursuit of a reward i.e. profit.

2.8 Types of Derivative Instruments

In the exchange-traded market, the biggest success story has been derivatives on
equity products. In India Index futures were introduced in June 2000, followed by index
options in June 2001, and options and futures on individual securities in July 2001 and
November 2001, respectively. As of June 2007. the NSE trades futures and options on

26
(
213 individual stocks and 3 stock indices. All these derivative contracts are settled by
cash payment and do not involve physical delivery of the underlying product (which may
be costly).
Derivatives on stock indexes and individual stocks have grown rapidly since
inception. Tn particular, single stock futures have become hugely popular; accounting for
ahout 60% of NSE's lr<lded value in June 2007. In fact, NSE has the highest volume (i.e.
number of contracts traded) in the single stock futures globally; enabling it to rank 4
among world exchanges in the first half of 2007. Single stock options are less popular
than futures. Index futures arc increasingly popular, and accounted for closc to 27 % of
traded value in June 2007.
NSE launched interest rate futures in June 2003 but, in contrast to equity
derivatives, there has been little trading in them. One problem with these instruments was
faulty contract specifications, resulting in the underlying interest rate deviating erratically
from the reference rate used by market participants. Institutional investors have prefcITed
to trade in the OTC (Over the Counter) markets, where instruments such as interest rate
swaps and forward rate agreements are thriving. As interest rates in India have fallen,
companies have swapped their fixed rate borrowings into noating rates to reduee funding
costs. Activity in OTC markets dwarfs that of the entire exchange-traded markets, with
daily value of trading estimated to be Rs.30 billion in 2004 (Source: Fitch Ratings, 2004).
Foreign exchange derivatives are less active than interest rate derivatives in India,
even though they have been around for longer. OTC instruments in currency forwards
and swaps are the most popular. Importers, exporters and banks use the rupee forward
market to hedge their foreign currency exposure. Turnover and liquidity in this market
has been increasing, although trading is mainly in shorter maturity contracts of one year
or less (Gambhir and Goel, 2003). In a currency swap, banks and corporations may swap
its rupee denominated debt into another cUITeney (typically the US dollar or Japanese
yen), or vice versa. Trading in OTC currency options is still muted. There are no
exchange-traded currency derivatives in India.
Exchange-traded commodity derivatives have been trading only since 2000, and
the growth in this market has becn uneven. The number of commodities eligible for
futures trading has increased from 8 in 2000 to 110 in 2007, while the value of trading

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 has increased almost four times in the same period (Nair. 2(04). However. many
(

contracts barely trade and. of those that are active. trading is fragmented over multiple
market venues, including central and regional exchanges, brokerages, and unregulated
forwards markets. Total volume of commodity derivatives is still small, less than half the
size of equity derivatives (Gorham et a1. 2005).
Details of different types of derivatives contracts traded in India are as below.

2.8.1 Forwarcl contracts

A forward contract is an agreement to buy or sell an asset on a specifIed date for a
specified price. One of the parties to the contract assumes a long position and agrees to
buy the underlying asset on a certain specified future date for a certain specified price.
The other party assumes a short position and agrees to sell the asset on the same date for
the samc price. Other contract details like delivery date, price and quantity are negotiated
bilaterally by the parties to the contract. The forward contracts are normally traded
outside the cxchanges.

r The salient features of forward contracts arc:

'r They arc bilateral contracts and hence exposed to counter-party risk.
'r Each contract is custom designed, and hence is unique in terms of contract
size, expiration date and the asset type and quality.
'r The contract price is generally not available in public domain.
>- On the expiration date, the contract has to be settled by deli very of the
asset.
>- If the party wishes to reverse the contract, it has to compulsorily go to the
same counterparty, which often results in high prices being charged.
However forward contracts in certain markets have become very standardized, as
In the case of foreign exchange, thereby reducing transaction costs and increasing
transactions volume. This process of standardization rcaches its limit in the organized
futures market. Forward contracts are very useful in hedging and speculation. The classic
hedging application would be that of an exporter who expects to receive payment in
dollars three months later. He is exposed to the risk of exchange rate fluctuations. By
r, using the ClllTency forward market to sell dollars forward, he can lock on to a rate today and

28
reduce his uncertainty. Similarly an importer who is required to make a payment in dollars
two months hence can reduce his exposure to exchange rate tluctuations by buying dollars
forward.
If a speculator has information or analysis, which forecasts an upturn in a price, then
he can go long on the forward market insteacl of the cash market. The speculator would go
long on the forward, wait for the price to rise, and then take a reversing transaction to book
profits. Speculators may well be requirecl to c1eposit a margin upfront. However, this is
generally a relatively small proportion of the value of the assets underlying the forward
contract. The use of forward markets here supplies leverage to the speculator.

Illustration: On 1st April, Mr. 'L' enters into a forward contract with Mr. 's' and
agrees to purchase 1000 shares of 'X Ltd.' for a pre-determined price of Rs. 10
three months forward. Here on the fixed future date, Mr. 'L' will get the 1000
shares and will pay the price i.e. Rs. 10.000 and Mr. 's' will deliver the shares
and will receive the moncy.
Fig-2.t Forward contract example

f.\
~_""_
Specified Price
..
0 S
Specified ,\sset

The contract is settled at maturity date. The holder of the short position
delivers the asset to the holder of the long position in return for a cash amount
equivalent to the delivery price. Forwards contracts arc traded over the counter
and are not dealt with on an exchange. These have certain tlexibility and are self-
regulatory. Forwards markets afford privacy that is not there in the exchange
trading. Lack of liquidity and counter party default risks are the main drawbacks
of a forward contract.
Limitations of forward markets
, Lack of centralization of trading,
., Illiquidity, and
,. Counter-party risk

29
 In the first two of these, the basic problem is that of too much Ilexibility
(
and generality. The forward market is like a real estate market in that any two
consenting adults can form contracts against each other. This often makes them
design terms of the deal, which are very convenient in that specific situation. but
makes the contracts non-tradable. Counter-party risk arises from the possibility of
default by anyone party to the transaction. When one of the two sides to the
transaction declares bankruptcy, the other suffers. Even when forward markets
trade standardized contracts, and hence avoid the problem of illiquidity, still the
counter-party risk remains a very serious issue.

2.8.2 Futures Contracts

Futures markets were designed to solve the problems that exist 111 forward
markets. 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. But unlike forward contracts, the futures
contracts arc standardized and exchange traded. To facilitate liquidity in the futures
contracts, the exchange specifies certain standard features of the contract. It is a
standardized contract with standard underlying instrument, a standard quantity and
quality of the underlying instrument that can be delivered, (or which can be used for
reference purposes in settlement) and a standard timing of such settlement. A futures
contract may be offset prior to maturity by entering into an equal and opposite
transaction. More than 99% of futures transactions are offset this way.
Futures contracts can be characterized by:

• An organized exchange,
• Standardized contract terms viz. the underlying asset, the time of maturity
and the manner of maturity etc.,
• Associated clearinghouse to ensure smooth functioning of the market,
• Margin requirements and daily settlement to act as further safeguard, and
• Existence of a regulatory authority.
Futures contracts being traded on organized exchanges impart liquidity to a
transaction. The clearinghouse, being the counter party to both sides of a transaction,

30
 provides a mechanism that guarantees the honouring of the contract and ensuring very
r
low level of default.
The standardized items in a futures contract are:
, Quantity of the underlying
,. Quality of the underlying
,. The date and the month of delivery
,. The units of price quotation and minin1uln price change
, Location of scttlement

Futures tem1inology

,. Spot price: The price at which an asset trades in the spot market.
,. Futures price: The price at which the futures contract trades in the futures
market.
>- Contract cycle: The period over which a contract trades. The index futures
contracts on the NSE have one-month, two-month and three-month expiry
cycles, which expire on the last Thursday of the month.
, Expil)' date: It is the date specified in the futures contract. This is the last
day on which the contract will be traded, at the end of which it will cease
to exist.
>- Contract size: The amount of asset that has to be delivered under one
contract. For instance, the contract size on NSE's futures market is SO
Nifties.
>- Basis: In the context of financial futures, basis can be defined as the
futures price minus the spot price. There will be a different basis for each
delivery month for each contract. In a normal market, basis will be
positive. This rcf1ects that futures prices normally exceed spot prices.
>- Cost of carry: The relationship between futures prices and spot prices can
be summarized in terms of what is known as the cost of carry. This
measures the storage cost plus the interest that is paid to finance the asset
less the income earned on the asset.

31
 >- Initial margin: The amount that must be deposited in the margin account
at the time a futures contract is first entered into is known as initial
margIn.

i' Marking-ta-market: In the futures market, at the end of each trading day,
the margin account is adjusted to renect the investor's gain or loss
depending upon the futures closing price. This is called marking-to-
market.
>- Maintenance margin: This is somewhat lower than the initial margin. This
is set to ensure that the balance in the margin account never becomes
negative. If the balance in the margin account falls below the maintenance
margin, the investor receives a margin call and is expected to top up the
margin account to the initial margin level before trading commences on
the next day.

Illustration: On 1st September, Mr. 'L' enters into a futures contract to purchase
100 equity shares of 'X Ltd.' at an agreed price of Rs. 100 in December. If on the
maturity date (as determined by the rules of the exchange for the month of
December) the price of the equity stock rises to Rs. 120 Mr. 'L' will receive Rs.
20 per share and otherwise if the price of the share falls to Rs. 90 Mr. 'L' will pay
Rs. 10 per share.
Fig-2.2 Futures contract example

Tf market price falls to Rs. <)()

Rs. 10 per share

~~.~--------------~- o
If market p11ce riscs to Rs. 12()
Rs. 20 per share
As compared to a forward contract the futures are normally settled only by the
difference between the strike price and the market price as on maturity date.

32
I Table- 2.1 Features of Forward and Futures markets
r
Fe'lture
C"h Flows
Sccurity dcposits
onsets of long'
and shorts
Credit exposure
Settlement dates
Value of the minimulll
price increment
Daily price limit
Accounting, regulation.
and taxes
l3t!st suited for
Fon'llrd market
Cash changes hands only
l)n the t,"ward date
R1lrclv required
Purchases and sales
remain on the books
The credit risk ofe:Jch
trading rartner
Custom
Depends on the i,,,tn,nlCnt
None
rvlorc desirable accolillting
treatment, less r~glliation.
s imp ieI' tax nt les
Corporations
Futures markd
(3.lins and losses settkd
daily in the fnrlll,1fvariation
1l'K1J"l2ill pavll'l\."n1s
Sccurit:, dt:Pl)~jlS in the f'Hlll
"finitial and maintenance
Il'kHgin arc standard
Purchase, and sales ofiset
one another(ifdonc through
the same clearing bmkcr)
Credit risk of clearing house.
not of trading panner
Standardized
Fixed (the "tick" size)
Futures ~:\Challgc rnay set
a daily price limit
ACl'Ollllting. is 11)1)~t
convenient for tirms that
IH1rk on a tmrk-to-'mrk,:t
basis for c,,"crvthinl!
Traders and Iar.~c hedgers
33
 Table- 2.2 Comparison between Forward and Futures Contracts

Forward Contract Futures Contract

Nature of Tramaction Buyer Elnd seller IllClke a custornwi!ored Buyer and seller agree to buy or sell i1

8CJreernent to buy/sell .;1 qiven amount of iJ standmdized Cllllount of a standardiled

commodity at a ~ price on 8 future date. quality of a commodity at CJ set price on,
a future dilte.

Size of Contract Negoti"bfe StDIl dor eli led

Delivery Date Ncgotidble Stmdardiled

Pricing rricES me naJotioted in priv"te by FTices are determined publicly 111 opell,
buyer and seller, ilnd (]re normally competrtive, auclrolltype market at a
not made public. registered exchange. PncES me oontinuDusl
made public.
-.-..•.. -.~--- ..•. _-_ .•_-_.. _ - _ . _ - -
Security Deposit Dependent on era!it relationship Both buyer md sellB" post i1 performance
bet'lJeen buyer [Jnd seller. May be lB"O. bond (funds) with the exchonge. Daily prb
changes may require one pmty to post
additional funds ,md allCMI the other pmty
to withdraw such lunds.

Getting Out of Deals Difficult to do, so mmtforwards result Easy to do by entering into an opposite
in a physical defivery of goods. transaction from that initially taken
(ie .. buy if you originally sold sell If you
originally bought).

Regulation 5ta te or FedB" a I laws 0 f co m merce 3 tiers: Commodity futures Trading

Commission. National Futures Association,
and self ·regulation by tile exchanges.

Issuer a nd Gun rant or None Exchange clearing house

2.S.3 Options Contracts

The literal meaning of the word 'option' is 'choice· or we can say 'an alternative
for choice', In derivatives market also, the idea remains the same. An option contract
gives the buyer of the option a right (but not the obligation) to buy I sell the underlying

34
 asset at a specified price on or before a specified future date. As compared to forwards
and futures, the option holder is not under an obligation to exercise the right.
Another distinguishing feature is that, while it does not cost anything to cnter into
a forward contract or a futures contract, an investor must pay to the option writcr to
purchase an option contract. The amount paid by the buyer of the option to the scller of
the option is referred to as the premium. For this reward i.e. the option premium, the
option seller is under an obligation to sell / buy the underlying asset at the specificd price
whenever the buyer of the option chooses to exercise the right.
Option contracts having simple standard features are usually called plain vanilla
contracts. Contracts having non-standard features are also available that havc been
created by financial engineers. These arc callcd exotic derivative contracts. These are
generally not traded on exchanges and are structured bctwccn parties on their own. The
relevance of exotic options can be understood jj'om thcse lincs:
"Exotic products come about for a number of reasons. Sometimes they meet a
genuine hedging need in the market; sometimes there are tax, accounting, legal, or
i
\ regulatory reasons why corporate treasures find exotic products attractive;
sometimes the products are designed to renect a cOlvorate treasurer's view on
potential future movemcnts in particular market variables; occasionally an exotie
product is designed by an investment bank to appear more attractive than it is to
an unwary cOlvoratc treasurer."
John C. Hull
Illustration: Mr. 'L' pays $ 2,000 to buy a 'December 103' call option on a $
100,000 US Treasury bond at an exercise price of $ 103. If the price rises above $
103, Mr. 'L' will gain from the difference and if the price falls below $ 103, the
maximum amount which Mr. 'L' may lose is the amount of premium paid.
Fig-2.3 Options contract example

Plymcnts depending
..
on the I)rice at maturity. date

Premium $ 2,OOf)

35
Call Option and Put Option
Basically there are two types of options viz. Call Option and Put Option. A call
option gives the buyer of the option the right (but not the obligation) to buy the
underlying asset on or before a certain future date for a specified price whereas a put
option gives the buyer of the option the right (but not the obligation) to sell the
underlying asset on or before a certain future date for a specified price. As stated earlier.
the option writer is under an obligation to sell / buy the underlying asset at the specified
price whenever the buyer of the option chooses to exercise the right. The specified price
is known as the strike price or the exercise price and the specified date is known as the
exercise date, maturity date or the expiration date.

Table-2.3 Different types of call and put options

Calls Puts
Share price>cxercise price Share price<cxercisc price
In-The-Money (ITM)

At-The-Monev (A TM) Share price=exercise price Share price=exercise price

Out-The-Money (OTM) Share pricc<cxcrcisc price Sh.uc pricc>cxcrcise price

In words, the moneyness of the option for the buyer of the option can be stated as:

• In- the- money options (ITM) - An in-the-money option is an option that would
lead to positive cash flow to the holder if it were exercised immediately. A Call
option is said to be in-the-money when the current price stands at a level higher
than the strike price. If the Spot price is much higher than the strike price, a Call
is said to be deep in-the-money option. In the case of a Put, the put is in-the-
money if the Spot plice is below the strike price.
• At-the-money-option (A TM) - An at-the money option is an option that would
lead to zero cash now if it were exercised immediately. An option on the index is
said to be "at-the-money" when the current price equals the strike price.
• Out-of-the-money-option (OTM) - An out-of- the-money Option is an option
that would lead to negative cash flow if it were exercised immediately. A Call
option is out-of-the-money when the CUITent price stands at a level, which is less

36
than the strike price. If the current price is much lower than the strike price the
call is said to be deep out-of-the money. In case of a Put, the Put is said to be out-
of-money if cunent price is above the strike price.

Option terminology
,. Index opTions: These options have the index as the underlying. Some
options are European while others are American. Like index futures
contracts, index options contracts are also cash settled.
,. STock opTions: Stock options are options on individual stocks. Options
currently trade on over 500 stocks in the United States. A contract gives
the holder the right to buy or sell shares at the specified price.
,. Buyer oj an opTion: The buyer of an option is the one who by paying the
option premium buys the right but not the obligation to exercise his option
on the seller/writer.
,. WriTer oj WI opTion: The writer of a call/put option is the one who receives
the option premium and is thereby obliged to sell/buy the asset if the buyer
exercises on him.
,. Call opTion: A call option gives the holder the right but not the obligation
to buy an asset by a certain date for a certain price.
,. PuT opTion: A put option gives the holder the right but not the obligation to
sell an asset by a certain date for a certain price.
,. Option price: Option price is the price which the option buyer pays to the
option seller. It is also referred to as the option premium.
,. Expiration date: The date specified in the options contract is known as the
expiration date, the exercise date, the strike date or the maturity.
,. Strike price: The price specified in the options contract is known as the
strike price or the exercise price.
>- American op/ions: American options are options that can be exercised at
any time up to the expiration date. Most exchange-traded options arc
American.

37
 r European oprions: European options are options that can be exercised only
r
on the expiration date itself. European options are easier to analyze than
American options, and properties of an American option are frequently
deduced from those of its European counterpart.
r In-rhe-money oprion: An in-the-money (ITM) option IS an option that
would lead to a positive cash flow to the holder if it were exercised
immediately. A call option on the index is said to be in-the-money when
the cun-ent index stands at a levd higher than the strike price (i.e. spot
price >strike price). If the index is much higher than the strike price, the
call is said to be decp ITM. In the case of a put, the put is ITM if the index
is below the strike price.
r Ar-rhe-money oprion: An at-the-money (ATM) option IS an option that
would lead to zero cash flow if it were exerciscd immediately. An option
on the index is at-the-money when the current index equals the strike price
(i.e. spot price = strike price).
r Our-oj-rhe-money apr ion: An out-of-the-money (OTM) option is an option
that would lead to a negative cash now it were exercised immediately. A
call option on the index is out-of-the-money when the current index stands
at a level, which is less than the strike price (i.e. spot price < strike price).
If the index is much lower than the strike price, the call is said to be deep
OTM. In the case of a put, the pul is OTM if the index is above the strike
pnce.
r Inrrinsic vallie of an apr ion: The option premium can be broken down into
two components - intrinsic value and time value. The intrinsic value of a
call is the amount the option is ITM, if it is ITM. If the call is OTM, its
intrinsic value is zero.
" Time mlue of an oprion: The time value of an option is the difference
between its premium and its intrinsic value. Both calls and puts have time
value. An option that is OTM or A TM has only time value. Usually, the
maximum time value exists when the option is ATM. The longer the time

38
 to expiration. the greater is an option's time value, all else equaL At
expiration, an option should have no time value.

Distinction between Futures and Options

An interesting question to ask at this stage is - when would one use options
instead of futures? Options are different from futures in several interesting senses. At a
practical level, the option buyer faces an interesting situation. lIe pays for the option in
full at the time it is purchased. After this, he only has an upside. There is no possibility of
the options position generating any further losses to him (other than the funds already
paid for the option). This is different from futures, which is free to enter into. but can
generate very large losses. This characteristic makes options attractive to many
occasional market participants. who cannot put in the time to closely monitor their futures
positions.
Buying put options is buying insurance. To buy a put option on Nifty is to buy
insurance, which reimburses the full extent to which Nifty drops below the strike price of
the put option. This is attractive to many people. and to mutual funds creating
"guaranteed return products".

Tahle-2,4 Distinction between futures and options

Futures Options
Exchange trad.:d. "ith novation Same as futures.
Exchange ddines the product Same as futures.
Price is zero. strike price tllO\'es Strike price is fixed. price 1I10\'es.
Price is zero Price is always positive.
Linear payofr :\onlinear payoff.
Both long and short at risk Only short at risk.

39
2.8.4 Swaps Contracts
;\ swap can be defined as a barter or exchange. A swap is a contract whereby
parties agrce to exchange obligations that each of them have under their respective
underlying contracts or we can say a swap is an agreement between two or more parties
to exchange scquences of cash flows over a period in the future. The parties that agree to
the swap arc known as counter parties.
Types of Swaps
There are two basic kinds of swaps:

• Interest rate swaps

• Currency swaps
Today, interest rate swaps account for the majority of banks' swap activity
and the fixed-far-floating rate swap is the most common interest rate swap. In
such a swap, one party agrees to make fixed-rate interest payments in return for
lloating-rate interest payments from the counterp~u"ly, with the interest rate
payment calculations bascd on a hypothetical amount of principal called the
notional amount. Notional amount typically docs not change hands and it is
simply used to calculate payments. Currency swaps involve exchange of
currencies at specified exchange rates and to make a series of interest payments
for the cUITency that is received at specified intervals.

IIluslI'ation: Mr. ';\' has borrowed from Mr. 'X' at UBOR (London Interbank
Offered Rate) + 2%. Mr. 'A' to cover the transaction from unanticipated
Iluctuations in the intcrest rate, agrees to pay a fixed rate of 9% to Mr. 'B' and in
return Mr. 'B' agrees to pay a floating rate i.e. UBOR + 2% to Mr. 'A'. Although
the actual payments betwecn Mr. 'A' and Mr. 'B' will take place only on a net
basis. The net result of the transaction for each of the parties will be as follows:

• Mr. 'x" will receivc the amount at UBOR + 2%.

• Mr.·;\'s liability is fixed at 9%.

• Mr. 'B's liability depends on the Iluctuating rate i.e.UBOR.

40
Let us take two cases:
I. LISOR = 10% In this ease lVIr. 'A' will pay to Mr. 'X' at the
rate of 12%. !VIr. 'B' will pay to Mr. '/\' at the rate of 3%.
Hence the net liability of :\Ir. '/\' is 9% only.
2. LIBOR = 5'70 In this case tvlr. '/\' will pay to Mr. 'X' at the
rate of 7'7r and Mr. '/\' will pay to :VIr. 'S' at the rate of 2'7c.
Hence the net liability of :VIr. 'A' remains the same at 9'70.
Fig 2.4 Swaps contract example

F L
L I
0 B
A ( )

T R
I +
N ?1I/u
_,

G
I:U );\TIN C; LIB( ) R + ;";',

.. FIXED 9%
Swaps are not traded on organized exchanges and have an informal market among
the dealers. As distinguished from futures and options, swaps market affords
privacy that may not be there in exchange trading. The inherent limitations of a
swaps market may be summarized as follows; first. a parly has to find a counter
party willing to take the opposite side of the transaction. second, a swap
agreement, being between two counter panics cannot be altered or terminated
early without the agreement of both the parlies, third. parties to the swap must be
certain of the creditworthiness of the counter parly as the risk of counter parly
default is always there.

41
Micro-economic results about derivatives can be summed up also looking at the
single instrument:
• FlItlire COil tracts II1crease market efficiency (by lowering trading costs and
information asymmetry) and liquiJity (given all expiration dates anJ daily setting
of margins). Transparency Jepends on the intemational and national laws anJ is
generally very high. Futures are widely useJ to heJge and speculate. both on
financial and commodity markets. Notional value of future contract does not
represent the exposure of the two counterparts. as long as they settle their position
each day through margi ns.

• Optioll co/llraC!S have the same effects of futures on markets. The only drawback

can be the unclear effect on volatility of the underlying, because futures tend to
lower underlying asset's volatility, whereas option does not give unique empirical
results. The option notional value is not a proxy of the exposure, but the premium
paid to open/close the position represents resources invested.

• Swaps are generally OTC contracts with a longer duration than futures and
options. and satisfy the need of a single client of the bank (a rim1 or financial
institution). They tend to create new investment opportunities in order to hedge
against any type of risk or speculate (currency, interest rate, hearth-quake. credit
default, and so on). In these contracts the notional value of the contract does not
represent the risk taken by the two (or more) counterparts, but periodical
payments.

• Fo/wards are OTC jWlIre COII!mC!S not standardized and created on the client

needs. They showed to have almost the same properties of futures.

• Rel'os are time financing operations between the ECB and the European inter-
bank system; they are used to finance liquidity and not to speculate or hedge. so
that the inclusion of them is given only to their structure of time operations, but
not to their linancial function.

42
2.9 Myths of Derivatives Markets
Myth-I: Derivatives are new, complex and high tech financial products
Reality: Financial Derivatives are not new and have been prevalent in India since
many years. Derivatives as the name implies are the contracts derived from some
underlying assets or index. Most common derivatives instruments are futures,
options, swaps and forwards. Most financial derivatives instruments are like
"plain vanilla", the simplest form of financial instrument. RBI allows forward
trading in rupee-dollar forward contracts, which has become a liquid market.
Meanwhile commodities futures in India are available in commodity like jaggery,
Pepper, castor seed, oil etc. Similarly in the equities market also derivatives have
been in existence for a long time.

Myth-2: Huge investment is required to trade in derivatives

Reality: Derivatives docs not require huge amount to enter in to futures trading
except for margin deposit. Coming to options trading it requires only up-front
payment called options premium, which is a very small investment. Moreover, no
margin has to be paid in buying options and traders can enjoy immense profits
with limited risk which is known in advance i.e. only to the extent of premium
paid. So retail investors who participate in cash can effortlessly opt for options
with very less investment and maximum profits.

Myth-3: Only risk seeking organizations like MNCs, Banks & FIls have a
purpose of trading in derivatives
Reality: There is a false notion among the investors that derivatives trading is
meant only for MNCs, large Banks and Fils. But the fact is that retail investors
can also trade in derivatives to the maximum extent given the number of benefits
it ofFers. So the benefits of trading in derivatives are not restricted only to big
investors but even the retail investor can reap the benefits. Hence it is not true that
only risk-seeking institutions should trade in derivatives. Not only institutions,
banks or large organizations even a common retail investor can take the advantage
of derivatives as part of their overall risk management.

43
 Myth-4: Making profits in cash market is much easier than F &0 market.
r
Reality: This is the most common misconception that hassle many investors. But
one thing they have to realize is it is possible to make huge profits in F&O also.
They have to use different strategies in derivatives in different market trends i.e.
bullish, bearish, range bound and volatile market. But where as it is not easy to
make profits in cash market in different market trends. Only when market is
bullish, investors can make profits and get stuck if they take positions in mid eap
or Small cap stocks, which are highly volatile. Where as in futures, even if it is
volatile, we can take advantage of averaging 4 times in futures with the same
money in comparison to only once in cash (due to 20%margin paid in futures).
As a retail investor one can just have numerous opp0I1unities as
derivatives offers without any misapprehension. What is really attractive 111

derivatives trading is that investors can play high games with small amount of
margin in this segment compared to cash market.

Myth-S: It is not possible to protect the investment in the falling market.

Reality: Derivatives have become important tools to help investors to manage
risk in falling markets. In fact the concept of derivatives was brought in to light to
hedge against specific risks. For instance, an investor is holding 600 shares of
Reliance in cash market at market price of Rs. 800. And there is some news
expected that FIls and Institutions may tllrn to be the net sellers this week. So he
can buy a put option at strike price of Rs.760 and pay a premium of Rs.5 (5*600 =
Rs.3000). After fund selling in the market let us assume that Reliance comes
down to Rs.720 and the premium of 760 strike plice Put option increases to
RsAO. Investor can exercise his put option and sell it at RsAO. So he insured his
positions in the underlying stock and minimized the loss to the extent of (40-
5)*600=Rs.21000. Otherwise if had been holding only in cash market the loss
would have been RsA8, 000 (80*600).

44
 Myth-6: Derivatives arc contracts, so cannot be carried forward
Reality: In cash segment investors cannot cany forward shott positions but Il1

derivatives, they can cany forward short positions same way like they do with
long positions.

Myth-7: Derivatives are meant only for speculation

Reality: Derivative trading by individuals is generally considered as speculative
business. But derivatives, apart from speculation, provide investors with a
multitude of uses namely hedging and speculation. Hedging is a technique that
involves taking a position in the cash market and simultaneously taking a reverse
position in the futures market as a means to protect against losses. Speculation is
the process by which market players take positions on the belief that the market
will move in a particular direction that they anticipate. Coming to arbitrageurs it is
generally called risk-free profit. Generally arbitrages buy and sell the same
security or derivatives at different prices. Like this, investors can take advantage
of derivatives in a number of ways apart from speculation.

2.10 Hypothesis of Derivatives markets

Ill: Derivatives are new, complex alld high tech financial products
Justification: Financial Derivatives arc not new and have been prevalent in India
since many years. Derivatives as the name implies are the contracts derived from
some underlying assets or index. Most common derivatives instruments are
futures, options, swaps and forwards. Most financial derivatives instruments are
like "plain vanilla", the simplest form of financial instrument.
H2: Huge investment is required to trade ill derivatives
Justification: Derivatives does not require huge amount to enter in to futures
trading except for margin deposit. Coming to options trading it requires only up-
front payment called options premium, which is a very small investment.
Moreover, no margin has to be paid in buying options and traders can enjoy
immense profits with limited risk which is known in advance i.e. only to the
extent of premium paid. So retail investors who participate in cash can effortlessly
opt for options with very less investment and maximum protits.

45
lI3: Only risk seeking organizations like MNCs, Banks & FIls have a purpose
of trading in derivatives.
Justification: There is a false notion among the investors that derivatives trading
are meant only for MNCs, large Banks and Fils. But the fact is that retail
investors can also trade in derivatives to the maximum extent givcn the number of
benefits it offers. Derivatives help you in managing your cash flows in a better
fashion.

1I4: Making profits in cash market is mllch easier than F&O market
Justification: This is the most common misconception that hassle many
investors. But one thing they have to realize is it is possible to make huge profits
in F&O also. They have to use different strategies in derivatives in different
market trends i.e. bullish, bearish, range bound and volatile market.

1I5: It is not possible to protect the investment in the falling market.

Justification: Derivatives have become important tools to help investors to
manage risk in falling markets. Infact the concept of derivatives was brought in to
light to hedge against specific risks.

H6: Derivatives are contracts, so canllot be carried forward

Justification: In cash segment investors cannot carry forward short positions but
in derivatives, they can carry forward short positions same way like they do with
long positions.

Il7: Derivatives are meant only for speculation

Justification: Derivative trading by individuals IS generally considered as
speculative business. But derivatives, apart from speCUlation. provide investors
with a multitude of uses namely hedging and speculation. Hedging is a technique
that involves taking a position in the cash market and simultaneously taking a
reverse position in the futures market as a means to protect against losses.
Speculation is the process by which market players take positions on the belief
that the market will move in a particular direction that they anticipate. Corning to
arbitrageurs it is generally called risk-free profit. Generally arbitrages buy and sell
the same security or derivatives at different prices.

46
r
2. II Global Derivative Markets
Modern derivative markets have their intellectual roots in the research of Black,
Scholes, and Merton in the early 1970s which then spun'cd rapid growth as the IT
revolution progressed and when two major futures exchanges in Chicago were
established. The World Bank and IBM were among the first institutions that in 1981
developed derivatives and swapped loans of different cun·encies. The development of
derivative instruments then followed two tracks: highly customized interest rate and
foreign exchange products were developed by leading financial institutions which created
the so-called over-the-counter (OTC) derivatives market. Innovation led to the rapid
development of new products, encouraged by minimum regulation and rich profit
margins in oligopolistic markets dominated by US banks. In 1993, the Group of Thirty
called for the establishment of independent risk oversight, which triggered various
legislative initiatives. On the second track, institutional investors were pursuing more
standardized equity and commodity products that were traded in more organized and
transparent exchanges, starting in Chicago, London, and Tokyo. These exchanges had to
be more regulated, as retail investors became active market participants.
The BIS reports that over-the-counter (OTC) derivative markets have grown ten-
fold over the past decade and in 2006 reached $248 trillion, with an average annual
growth rate that exceeds 30% since 1990. The market value of these OTC derivatives is
about $9 trillion (as compared to US GOP of $12 trillion and US treasury bonds of $4
trillion), but after netting arrangements the actual net market value is estimated to be
around $2 trillion. About 40% of this market is currently traded in the US (half of it at a
single financial institution, lP Morgan Chase), another 40% in Europe (mostly London
and Frankfurt) and 20% in Asia (mostly Tokyo). The large majority of OTC derivatives
(75%) are interest rate products (mostly swaps), and a smaller proportion (12%) are
foreign exchange products (Fig-2.51. The fastest growth has been recorded in credit
derivatives, which now account for about $6 trillion. This market remains dominated by a
few large financial institutions as well as inter-dealers. and only 10% of activity is
currently attributed to non-financial institutions. The main functions of the OTC market
are to provide cost-effective financing, enable cross-currency and interest rate hedging, as
well as the transfer of credit risk.

47
 Fig-2.S Global OTe Derivatives Markets & Exchange Traded Derivatives
OTe Derivatives Markets Exchange Traded Derivatives

• FX
II Interest
• Gov-Debt
o Equ-Index
II Stocks
$53 trn notional
• Comm $10 trn mkt value;
o Credit

On the other hand. the futures Industry Association and BIS arc reporting that
exchange-traded derivative markets (ETD) have grown to notional $53 trillion in 2004,
which have a market value of $10 trillion (larger than the OTe market value). The
exchange-traded products arc equity futures and options (65%, both on the index and
individual stocks). interest rate derivatives (26%, both on short-term interest rates and
long-term government bonds), as well as commodity futures ('!%). The main function of
these markets is to hedge commodity price risks and to redistribute equity market and
interest rate risks from issucrs to investors. About half of the market is driven by
institutional investors (with a strong international participation), and the other half is
shared by retail investors, trading and securities firms, as well as some non-financial
institutions. Major ETD markets report that about half of their volumes are trading
oriented, and the other half is hedging or arbitrage-related. The fastest growth in equity
derivative markets has been recorded in Asia, which currently accounts for over one third
of worldwide volumes. The Korean Stock Exchange has become the largest derivatives
exchange in the world, and extremely rapid growth rates in Brazil, Mexico, China, and
India have propellcd their exchanges to the world's top-20. While many of them arc
focusing on equity derivatives (Korea. India, Hong Kong), others are specializing in
fixed-income products (Brazil, Mexico, Singapore) and there are also a few remaining
commodity specialist exchanges (Dalian, Tokyo, and Zhengzhou).

48
 Fig-2.6 Growth of Global Derivatives Markets

Growth of Global Derivatives Markets

(International Swaps and Derivatives Association)

~ 140.000
c
~ 120.000

-",
:a
.S
100.000
80.000
m
>
60.000
m
c 40.000
0
~ 20.000
z 0

,,0,
~'I ~o,
,,0,
p,"
,,0,
p,">
,,0,
p,"
,,0, ,,0,
~

Year

Table-2.5 Global Participation in Derivatives Markets in year 2006

Hedging Speculation Arbitrage Intermediation
Equity 21.27% 25.53% 19.15% 29.79%
Currency 6.38% 2.12% 4.26% 2.12%
Interest rate [7.02% 2.[2% [7.02% 4.26%
Commodities 2.12% 0.00% 0.00% 2.12%

Fig-2.7 Global OTC derivatives by asset class during year 2006

Other
13%
CO";~:";W~

Equity-
linked-
2%

Interest r<:lte
71°(b

49
 Table-2.6 Equity cash turnover and cquity derivative notional value turnover
r
ycar-2006

Equity derivative
Cash equity Ratio
Market notional val.
($bn) DerivlCash
($bn)

US exchanges 17.322,982 24,177,848 1,40

Deutsche Borse+SWX 1,909689 9,993,959 5.23
Euronext+London exchanqes 5,546,291 5,549080 1.00
Japanese exchanges 2.221,254 3,254,854 1,47
Korean exchanges 459,035 2,265,169 4.93
Italian Exchanqe 820,642 980,627 1,19
Honq Kong Exchanqes & Clearing 296,156 636,243 2,15
Singapore Exchanqe 91,928 525.729 5,72
Brazilian exchanges 66,428 505.73 7,61
~ustralian exchanqes 371,97 445,907 1,20
Spanisll Exchanges (BME) 933,06 367,026 0.39
Indian exchanges 291,975 315,626 108
Iraiwanese exchanqes 591.718 274,783 0,46
Tel-Aviv Stock Exchange 19,115 271,847 14,22
Stockholmsboersen 303.291 190,727 0,63
Canadian exchanges 471,544 125,895 0.27
JSE South Africa 101,127 116,838 1,16
Greek exchanqes 39,672 26,38 0,66
Narsaw Stock Exchange 9,663 15,542 1,61
Wiener Borse 11,135 6,893 0,62
Budapest Stock Exchanqe 8.27 4,838 0.59
FUTOP 67,959 2,755 0,04
MEXDER 25,868 1,451 0,06
HEX 165,622 1,351 0,01
Oslo Bors 78.202 910 0.01

Total 32,224,596 50,058,008 1.55

,

50
Details of various Derivatives Instruments in terms of its share during year 2006 are
given in following figures.

l<'ig-2.8 Global Futures Exchange Volumes

Fig-2.9 Trading volume by derivative product type in 2006

Non-pl"t'(iOLlS
11'11.:1 al

Prer.:"lom metll AgriClIJLLlre

Illdi"jdLUI equi[y 1.21It. Ellerg~'

.)2.J4 Il
"
5.1(1'\,

Eqllit~, index
Illlt"rt"~t r~He
29.(, I(!'fI

Chller)
0.019;',

51
 Fig-2.10 Trading volume by options product type in 2006

N~! 11- PI'<:.'..:i ,:OilS

0.18" ..
Cllil<.:fS
Ilk'l~l[ [Lon" . , Agri..:uhllft'

IUIl'f!.',,' l:ltc:
_
____ '~J.~-'~-'~"'~'::;;:=-~:::::"lI~<7;;;;~~::::_:_~-I-I-')-"-'" EIl~:rgy
1.02''''-.

....... ~_Eqllj[\, ill~k'x

27.91 '}"

Ill~iiYi~ilt.ll t'qll'Il~'
Fort:"I~11 (UITer]!..:y
b2.20""
lJ.2')",,,

Fig-2.ll Trading volume by futures product type in 2006

otl,ers
O.09 '}i-,
Non-~'rt'(iolJs
lllt'tl1
Energy
1).62(~:i,

[quit y in,Jl'x
I [Iteresl r;lle 17.~~ ') '~~.-:_,
5~LOY}rt

--____________---....L""'l-- Foreign2.99'.~:-, (U ITt'nq

J Ildi'.·idLl~d t'l]l1i Iy'

0.1 8r~,;:,

52
 Table-2.7 World leader by derivative product type in 2006

)'I'o(iu(.( lypt.' \V4.lfhl le-ad('l" 2nd .hd :ilh Sih

Agrinlhurt' Chicago Bo.lrd of Tol..:yoGrain New York Board 01 ClllCago J\·'len:aullle Kallillon Lommodity
Tr.ld(' Exdull~e Tr;lde Exch:lne;e Exch~ln«e, J,IP;11l
FrWf~y New York lIILt'rn.uioll;11 rhe -j{),,-yo Central.l.lran Bolsa IVlerc.IIuile de
?\lercJlltile Petroleum COIllllloditv Commodity l-' lIttJ re~. Br:llll
Ex:ch:.llll..le Exchallt!:c, UK Exchange Fxclune.~
l:.quHY luJex Kore;, ~tO(k P'Hls Bn\lrse SA Furex Chi6go Ma.c,li1tit~ Chicago Bo.ud Option
Excklllge E~d1Jnge [xdlaw'e
hJreigli Bob Mercantile <.,.hic:tgo" I Budapest Korea FUlUres New York BOJrd of lea
/ '
currency de futures, BU7jl , ;\'1t~rcamik' COlHmodity Exch;ull!,e
/
+X(h:ll1ge Fxch:IIJl!t', f ItlJl~arv
Illdi"idtl~ll Chicago Board AnH.'riclIl 5WLk Paciti( ~lOck P;tris Bourse ~A tilfex
t'quay Oplinn~ EXlh:lIIt;t' Exchange heh"n"". U~A
Intc.'rt'~( r:tle Eurex ,Chicago B5urd Lhi(a~o !\ ler(,lIlLilt' UHF Balsa MereaIllile de
( ofI"'d. Exdunee [uUlres. Brazil
NUJl-lm;,uous London .\Ieul ~hanghai New York Osaka :Vlerc.lIHiie The ·]okyo Lommodit:
Jlk'lal [xclunge, UK hltilfes ,\'(..-r(3111 i1..' Exchange Ex.change
Exchange Exdlall£;(,
l'r(.'(IOIiS uH'lal lhe Tokyo New York Hols;! ,\krcuuilt' de Kort';.1 hll ures tv1idalTlt'cicl COllllIludi
Commodity Mercamile flUmes, Rr,lzil Exchallg,e Exc!range. U~A
rXdJ:11I~t' ExclulIgl'

2.12 Rise of Derivatives in World Markets

The global deri vati ves markets have witnessed explosive growth over the last couple of
decades due to a variety of factors. These include.

I. Thc globalization and liberalization of world trade - giving nse to new and
different risk profiles of economic agents.
2. The relaxation of capital controls permitting a huge increase in global investment
opportunities and risks.
3. The technology and communications "revolution" - especially the advent of the
nllcroprocessor.
4. The development of risk management as a strategic foclls of organizations.
5. The generally acknowledged success of the thcorctic of derivatives pricing and
hedging in the real world over this period.

53
Worldwide Growth of Listed/OTC Commodities and Futures
Global futures amI options market volume levels exceeded 9.9 billion contracts in
2006 up from 776 million contracts in 1995, a CAGR of 22%. In addition, certain
international markets have experienced volume growth rates in excess of their U.S
counterparts.
This boom can be attributable to a number of factors.
• A Bull Market in commodities, futures and derivatives that shows no signs of
givIng up.

• Significant levels of dircct and indirect investment in the markets, that is invested,
leveraged or hedged with commodity, futures or derivative products.

• A healthy domestic economic environment.

• A relatively high rate of economic growth in the BRIC countries and their need
for risk management and hedging tools.
• High volume/transaction rates and resultant volatility, fueled by professional
traders, hedge funds and a new generation of day traders (e-Iocals).

• Direct access by U.S. market participants to foreign futures exchanges via trading
temlinals in the U.S.

• Widespread availability of cost effective, high performance

hardware/software/networking technologies and trading tools (pre-trade analytics,
order routing, order, risk and portfolio management, multi-media tools, real time
market data, news, position keeping etc.).

2.13 The Mechanics of Futures Trading

2.13.1 Futures Exchange

Futures exchanges represent a physical marketplace for selling and buying futures
contracts. They establish and enforce standards and rules governing futures trading and
promote the business interests of their members 7 • Only the members of futures exchange

7 franklin R. Edwards & Cindy W. Ma. FiliI/res and Options. Me.Graw-Hill, New York, 1992. p.2S.

54
may engage in the actual trading of futures contracts, and membership is limited to a
specified number, Memberships are bought and sold and their price is determined by
supply and demand, Traders buy memberships, or "scats," because they want to take part
in floor trading activities,
Another rcason to buy a seat is so that one can trade in futures without having to
pay commission fees 8, Non-exchange members may rent a seat, as well, thereby attaining
the right to tralk on the exchange for a certain period of time, A board of directors
governs the cxchange but its daily administration is in the hands of a president appointed
by the board,
There are two methods for futures trading, what is referred to as "open outcry"
and electronic trading, Open outcry is a system where the traders gather in a pit and
conduct the trading of futures contracts, The pit is on a circular platfonn in a designated
place on the exchange floor, The price of the contract is determined by the open outcry of
bids or offers, When two traders have agreed to the terms of a deal they complete a deal
ticket and give it to the pit reporters who record the details electronically, At. thf' end of
the day, the exchange matches the tickets, recording sales and purchases, and reconciles
the transactions 9
Locals and noor brokers are the two types of traders running the exchange, Locals
are professional risk takers who buy and sell futures contracts on their own behalf Floor
brokers, like locals, also trade their own accounts but they also execute customer orders
as welL In the USA, for instance, Futures Commission Merchants trade futures for other
,,10
peop Ie an d charge commlSSlOns ,
One fomo of electronic trading of futures is screen-based trading; it tries to copy
the open outcry system on the computer screen, The Automatic Pit Trading (APT)
system, developed by LlFFE, is a good example of screen based trading, A second form
of electronic trading in futures is order matching, which automatically matches orders to

x Powers & Castelino. op.cit., p. 15.

9 \Vatsharn. op.cit.. p. 9.

10 Fabozzi & Modiglialli, Op.CiL, p, 2 t 9.

55
buy and sell. The Deutsche Tenninbiirse in Germany and GLOBEX in the USA utilize
this system.

2.13.2 Clearinghollse
A clearinghouse is an intermediary association, adjunct to an exchange. Once two
parties have agreed upon a price, they cease dealing with each other and continue their
transaction through the clearinghouse. The clearinghouse is the guarantor of the contract,
with respect to both the seller and the buyer. It guarantees that all obligations are met
with respect to any given transaction; it becomes the buyer for every seller and a seller
t·or every buyer II .

The clearinghouse has member firms that are called clearing members; they deal
directly with the clearinghouse. Brokers who are not clearing members must first clear
their trades through a clearing member. In clearing for non-clearing members, clearing
members obtain cel1ain fees; they themselves do not have to pay any clearing fees,
Against these benefits, the clearing members bear the costs of membership.

Fig-2,12 The intermediary role of Clearinghouses in futures transactions

Cu:-;tolllcr

Non-t:learing C1ealing CI.K\ RI7'iGIIOtiSE Clearing

Memher Member Member

The clearinghouse matches trade information and verifies that a trade proceeds
correctly. It is a legal party to all contracts and its net position is always zero. In order to
reduce the possibility of market participants sustaining losses as a result of defaults, the

II Peter Rilchken, Der;\'alil'e Markers, I IarperCollins College Publishers, New York, 1996. p.15-16.

56
clearinghouse collects a certain margin on the initiation of any new position from each
CI · mem ber J'".
earIng

2.13.3 Initiating a Trade

A customer wishing to trade in futures must establish an account with a broker
who is a futures commission merchant. After accomplishing this process. the customer
can place a variety of orders. A proper order must specify whether to buy or sell, under
what terms of contract. the number of contracts, as well as how long and at what price the
order is to remain open. A 'market order' is an instruction requiring the broker to trade at
the best price available at the time that the trade is executed. A 'limit order' specifies a
price limit at which the order must be executed. A 'stop loss order' is not executed until
the market reaches a given price, at which time it becomes a market order. A 'good-until-
canceled order' is an order that remains current until it is canceled. A 'market-if-touched
order' is executed at the best available price after a trade has occurred at a certain
specified price or at a price more favorable than the specified Plice. A 'discretionary
order' allows the broker to delay the execution of an order if he considers that a better
price will be attained later on. A 'day order' is entered for one day only; it is canceled if
not filled by the end of the day. A 'fill-or-kill order' is automatically canceled if it cannot
be executed immediately. A customer's decision of which type of order they will use
generally depends on their trading objectives and their broker's recommendations.
When a customer instructs a broker to execute a trade for him, the broker first
time stamps the order and prepares an office order ticket. Then he sends the order to his
trading post Oil the exchange noor. There, a floor order ticket is prepared and a runner
delivers the order to the floor traders for execution. Once filled, both partics to a trade
record the order. At the end of each day, the clearinghouse assures the accuracy of trades
by ensuring that no discrepancy exists in the matched-trade information.

12 John C. Hull, Options. Full/res and Other Dl'riratil'es, Prentice-Hall International, New Jersey.
t997, p.23.

57
 Fig-2.13 Initiating trades and accompanying order flow for futures contracts.

Buw I' 1 .1 Memher tirm J '\klllhcr tinn

I Seller

! !
Buying Selling
Floor Flo"r
Tr:t(~r Trader

~ ~ TraLling Pil

.
Buying HODI' Broker
Orders executed by "p..'n "utery by
buying anll selling nUllr traders ..
Selling Floor Broker
recorded and placed on ticker
contirms purduse cOnBnll"i sale

! I I
~
Member linn \kll1her firm
J. J.
! Reports
purchase
Reports
sak 1
Confirms purchase Confirms sale
I I
~ ! ! ~
CLEARINGllOUSE
Buyer I I Sellcr
now long ohlig~Hi0n obligation no\v shoI1
I contract long ~hnrt
I conlract

Total open interest

I cuntruet

2.13.4 Closing a Futures Position

Traders have an obligation under the terms of futures contracts to make or take
delivery of the underlying asset. Traders can settle their position, however, before taking
delivery, and not have to do so. The buyer settles his position by selling an identical
futures contract for the same commodity with the same delivery month. Similarly, the
seller liquidates his position by buying an identical contract. This is referred to as
· f ·utures transactIons
o ffsettmg · 1 3.

13 Edwards & Ma. Op.CiL 30-32.

58
 Another way of closing out a futures position is through cash settlement. This is a
general practice with respect to equity index futures. It's difficult, however, to deliver all
of the many individual securities that constitute the index. Cash settlement simply
requires one last variation margin payment between the parties as final settlement i .!.
If futures contracts are not settled by offsetting trade or eash settlement then
delivery takes place. Each futures contract has its own rules for making or taking
delivery. These rules include the time and location of delivery as well as the mode of
transferring funds. The partners to the trade have no obligation other than to the
clearinghouse, which arranges the delivery. When the short position in a futures contract
wants to make delivery, the clearing firm notifies the clearinghouse that this customer
wants to make delivery. The date at which this is done is called the position day.
First, the clearinghouse matches buyers and sellers for delivery, identifying
traders with compatible interests. Second, the buyer and seller communicate appropriate
information regarding the delivery process to each other and to the clearinghouse. The
seller indicates the features of the goods to be delivered and tells the buyer the name of
the bank account to which the funds are to be transmitted. After the funds are transferred,
the seller delivers the title to the goods to the buyer. The date at which this is done is the
delivery date. While the transaction is proceeding, the clearinghouse acts primarily as an
observer and generally plays an insignificant role. If difficulties appear or disagreements
develop, however, the clearinghouse must intervene so as to enforce the rules governing
i5
the exchange •

2.13.5 The Types of Traders

The types of traders who use futures can be classified into three groups:

Hedgers seek to protect themselves against a risk that they have already faced. They are
not trying to increase their profits on their futures positions; rather, they seek to insure
them against the price of cUlTency, interest rates or the risks of falling domestic markets.

14 \Vatsham, op.cit., p.12.

15 Robert W. Kolb, Financial Deril'(flires, New York 111~litllle or Finance, New York. 1993, p.27.

59
Speculators are concerned with changes in expected price levels ovcr1ime. They don't
use or own the commodity in which they deal. Their only motive is to make a profit on
their futures position. They may participate in futures trading by opening their own
account and managing it themselves. Their other alternatives are having their accounts
managed by a Commodity Trading Advisor or joining a commodity limited partnership
l6
organized by a Commodity Pool Operator . There are three types of speculators.
Scalpers look for very short-term trends and try to capitalize on small changes in the
contract price. Day traders hold their position less than a day in order to avoid the risks of
adverse news arising overnight. Position traders hold their positions for much longer
. ds 0 I" tllllC 17 .
peno

Arbitrageurs are in business to take advantage of discrepancies that occur between prices
in two different markets. They seek to minimize risk to their profits by simultaneously
entering into transactions in two or more markets.

16 Powers & Castelino, op.cil.. p.2S-27.

17 Hull. 1998, or.cit., p. 34.

60