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Management of Financial

Derivatives
Objectives
 To understand the meaning of financial
derivatives;
 To know the various types of financial derivatives
are available;
 To know about background and uses of financial
derivatives;
 To know classification of derivatives markets;
 Difference between Forward & Futures Contract;
 To know important players in the derivatives
market ;
Introduction
A derivative is a financial product which has
been derived from another financial product
or commodity.
Concept of Derivatives:
“ A derivative is instrument whose value is
derived from the value of one or more
underlying assets”. These underlying
assets can be securities, commodities,
bullion, currency, livestocks and so forth.
Legal definition of Derivatives –
Indian Context
In India, the Securities Contracts
(Regulations) Act of 1956, SC(R) A, defines
the word ‘derivatives’ 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.
Legal definition of Derivatives…..

 Derivatives derived from another


financial instrument/contract called the
underlying.
Example;
In the case of Nifty Futures, Nifty Index
is underlying asset. It may be single
stock futures like Infosys stocks are
underlying assets.
Kinds of derivative contracts:

Two kinds of contract:


1. Exchange-traded derivatives : products /
contracts that are traded on the
exchanges ;
2. Over-the-counter-derivatives : contracts
traded outside the exchanges.
Types of Derivatives

One form of classification of derivative:


(a) Commodity derivatives : Derivatives contracts
traded on gold, sugar, jute, pepper, metal,
agricultural products etc.

(a) Financial derivatives: Derivatives contracts


traded on currencies, securities, stock market
indices, interest etc.
Features of derivatives:
(1) Nature of Contract: Three imp. Contracts
- Forward & Futures
- Options
- Swaps
(2) Underlying Asset: Four imp. Types
- Foreign exchange
- Interest bearing financial assets
- Commodities
- Equities
(3) Market Mechanism:
- OTC mechanism – not standardized
- Exchange traded products – more standardized
Definitions : Derivative Instruments

Forward Contract: Is an agreement to buy or


sell an asset on a specified future date for a
specified price.
These are not traded on an exchange; they are
said to trade over the counter (OTC). The quantities
of the underlying asset and the contract terms are
fully negotiable.
Long position – one of the party agrees to buy the
underlying asset
Short Position – the party agrees to sell the asset.
Definitions : Derivative Instruments…..

Futures contract: Is traded on a futures


exchanges as standardized contract,
subject to the rules and regulations of the
exchange. It facilitates the secondary
market trading, it relates to a given quantity
of the underlying assets, for no trading of
fractional contracts is allowed.
Differences: Futures & Forward
Futures Forward
Standardization Std. quality, quantity Tailor made, mutual
place of delivery agreement,
*Liquidity Organized exchange No secondary
more liquidity market
*Conclusion of Offset-before the Delivery of asset on
contract settlement day on maturity date
* Margins By the both parties No margin
*Profit/loss Marked to market On date of maturity
daily profit/loss profit/loss booked
Definitions : Derivative Instruments……..

 Options : Broadly classified as Calls and


Puts.
Calls give the buyer the right but not the
obligation to a buy a given quantity of the
underlying asset, at a given price (exercise 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.
Differences: Futures & Options

Futures Options
- Obligation - both the - Only the seller (writer)
parties of the contract is obliged
- No premium is paid - The buyer pays
- Holder of the contract - The buyer’s loss is
is exposed to the entire restricted to downside
spectrum of downside risk risk to the premium paid.
- Contract must perform at - The buyer can exercise
settlement date. Not option at any time prior
obliged to perform before to the expiry date.
the date.
 Swaps: Swaps re agreements between two
parties to swap the cash flows arising from
particular financial instruments.
Interest rate swaps: which entail swapping
only the interest-related cash flows between the
parties, in the same currency.
Currency swaps: which entail swapping both
principal and interest between the parties, with
the cash flows in one direction being in a
different currency to those in the opposite
direction.
Growth of derivatives market:
(in India)

Derivatives are financial risk management tools,


which have gained a lot of importance today.
Factors, responsible for the growth of financial
derivatives are;
 Increased volatility in financial markets.
 Inter-linkage of national financial markets with
international financial markets.
 Remarkable improvement in the area of
communication and IT.
Growth ……..contd..

 Innovations in financial markets, which present


a combination of risk and return over a number
of financial assets leading to
- higher returns,
- reduced transaction costs but increased
risk.
Growth ……..contd..

Apart from acting as a risk management tool


derivative, markets perform a number of
economic functions like;

Helping in determining current and future


prices of assets.

Facilitating transfer/redistribution of risk from


risk averse to risk takers.
Growth ……..contd..

 Promote entrepreneurial activities.


 Increase market activity and efficiency.
 Direct savings towards investment.
 Improve upon allocation of credit by sharing of
risk.
 To allow investors to leverage relatively small
amounts of funds over a wide class of assets
and thus diversity their portfolios.
Derivatives market in India:

Equity Derivatives:
BSE Derivatives:
 Trading in BSE-30(sensex) index Futures - June 9
2000. It was introduced with three month trading cycle
– the near month (one), the next month (two) and the
far month (three).
 BSE Sensex Options – June 4, 2001
 Individual options – July 2001.
Derivatives market in India……..

 NSE Derivatives:
 NSE launched the S&P CNX Nifty Index
futures – on June 12, 2000.
 Futures contract on Individual Stocks – Nov,
2001
 Index Options – June 4, 2001
 Options on individual securities – July 2, 2001
Derivatives market in India……..
 Commodity Exchange:
 1970 Commodity exchange through OTC
 Cotton was the first trade commodity on
organized exchange in India.
 The Forward Contract Regulation Act (FCRA)
governs commodity exchange in India.
 National Multi Commodity Exchange-NMCE
(Ahmedabad) – First commodity exchange-2002
Derivatives market in India……..

Commodity Exchange…………
 National Commodities and Derivatives Exchange
(NCDEX) & Multi Commodity Exchange (MCE)
started functioning by last quarter of 2003.
 Bullion and Energy products contribute 75-80
percent of MCX business.
 Agri-products which contribute around 80 percent
of NCDEX business.
 Banks, FIs, MFs, PFs, Insurance & FIIs are
allowed in the commodity market.
Derivatives market in India……..

Currency Derivatives:
 India trading forward contracts in currency for the
last 7 years.
 RBI recently allowed options in the over-the-counter
currency.
Interest Rate Derivatives:
NSE introduced trading in cash settled interest rate
Futures in 2003
Uses of Derivatives:
 Derivatives are used to control, avoid, shift and
manage efficiently different risk by using various
strategies like hedging, arbitraging, spreading etc.
 No immediate full amount, enhance liquidity and
reduce transaction cost.
 Attract the investors due to competitive trading in
the market.
 It develops ‘complete markets’, where no particular
investors be better of than others, or there is no
further scope of additional security.
Critics of Derivatives:
 Speculative and gambling motives: more
speculative trading due to more trading volume
increased in multiples & only one or two percent of
derivatives settled by the actual delivery.
 Increase in risk: OTC markets, as customized,
privately managed more credit risk.
 Price instability: due to fluctuations in asset prices.
 Increased regulatory burden
 Displacement effect: increased volume in
secondary market by the investors, reduce the
volume of the business in the primary market.
Players in derivatives market
(a) Hedgers – who wish to eliminate the risk
(price change) to which they are already
exposed. Ex; Forex risk (Forward contract)
Hedgers Example….

Suppose today’s dollar-rupee exchange rate is US


$1=Rs.45.50, while the three month forward rate
is US$1=Rs.46.40.
Indian firm has commitment to pay $100,000, three
months now.
Firm buy a forward contract at US $1=Rs.46.40

At the end of 3 months if the rate is $1=Rs.47.20


firm would gain Rs.80,000 (Rs.0.80 x $100,000)
Without contract, firm needed to pay Rs.47,20,000
(Rs.47.20 x $100,000)
Hedgers Example…..

 Similarly,

If the exchange rate is $1 = Rs.46.10,


firm would regret to having entered into forward
contract, it would have to pay Rs.46,40,000
(Rs.46.40 x $100,000)
Instead of Rs.46,10,000 (Rs.46.10 x $100,000)
Firm stand to loss Rs.0.30 x $100,000 =
Rs.30,000
(b) Speculators: Speculators are those
who are willing to take risk. They
consume information, make forecast
about prices and put their money in
these forecasts.
Ex: If share current quoted price Rs.32
Speculators call option exercise price after one month
Rs.35
Premium - Buying option would be Rs.50 (a call for
100 shares at Rs.0.50 paise)
If price of the share less than or equal to Rs.35
- Call shall not exercised
(loss would be Rs.50 or 100% of investment)
If price of the share at Rs.40 – Call shall exercised
100 x (Rs.40 – Rs.35) = Rs.500
(profit 90% of the investment)
Speculators may :
Day traders – one day trading
Positions traders – positions for
longer position (few days, weeks or even
months)
(c) Arbitrageurs:

Arbitrage involves making risk-less profit by


simultaneously entering into transactions in
two or more markets.
Arbitrage keeps the futures and cash prices in
line with one another. Arbitrage trading helps
to make market liquid, ensure accurate pricing
and enhance price stability. It involves making
profits from relative mis-pricing.
Ex: Suppose that at the expiration of the gold
futures contract, the futures price is Rs.15,500
per 10 grams, but the spot price is Rs.15,480
per 10 grams.
An arbitrageur could purchase the gold for
Rs.15,480 and go short a futures contract that
expires immediately, and make a profit of
Rs.20 per 10 grams by delivering the gold for
Rs.15,500 in the absence of transaction costs.
Functions of derivatives:

- Price Discovery - with the better


information and judgment.
- Risk Transfer
End