Unit 1 Syllabus

• Introduction to Derivatives: forwards,

Futures, options, swaps, trading
mechanisms, Exchanges, Clearing house
(structure and operations, regulatory
framework), Floor brokers, Initiating trade,
Liquidating or Future position, Initial
margins, Variation margins, Types and
orders. future commission merchant.
Introduction to Derivatives

RAVI IBA
 D e ri v a ti v e s – m e a n i n g a n d
de fi n iti o n

• Derivatives are instruments in respect of

which the trading is carried out as a right
on an underlying asset.
• In normal trading, an asset is acquired or
sold.
• When we deal with Derivatives, the asset
itself is not traded, but a right to buy or sell
the asset, is traded.
 Derivatives – contd.
• Thus a derivative instrument does not directly
result in a trade but gives a right to a person
which may ultimately result in trade.
• A buyer of a derivative gets a right over the
asset which after or during a particular period
of time might result in her buying or selling the
asset.
• A derivative is often defined as “ a financial
instrument whose value derives from that
of something else”
 Derivatives contd.
• In abstract, a derivative is a price guarantee.
• Nearly every derivative out there is just an
agreement between a buyer and a future
seller.
• Every derivative specifies a future price at
which some time can or must be sold.
• Thus item is an underlier, which might be
some physical commodity such as corn or
natural gas or some financial security such as
stock or a govt. bond or something abstract
like price index.
 Derivatives contract specifications
• Every derivative must specifies a future
date on or before which the transaction
must occur.
• These are common elements of all
derivatives:
1. buyer and seller,
2. underlier,
3. future price and
4. future date.
• Some derivatives guarantee something
other than a price.
• Credit Derivatives give performance
guarantee not price guarantees.
• Weather derivatives guarantee things like
temperature or rainfall.
• Vast derivatives guarantee price
guarantees.
 Derivatives contd.
• Derivatives are risk transferring
instruments.
• They are called derivatives since they
derive their value from the value of
underlying, which may be either may be
either foreign exchange, index, commodity
or shares or any securities.
• Derivatives can be classified as OTC (over
the counter) and Exchange Traded
Derivatives.
 History of derivatives exchange

• Derivatives exchanges have existed for a long

time. The Chicago Board of Trade (CBOT)
was established in 1848 to bring farmers and
merchants together.
• Initially its main task was to standardize the
quantities and qualities of the grains that were
traded.
• Within a few years the first futures-type
contract was developed
 History of derivatives exchange

• It was known as a to-arrive contract.

Speculators soon became interested in the
contract and found trading the contract to be an
attractive alternative to trading the grain itself.
• A rival futures exchange, the Chicago
Mercantile Exchange (CME), was established
in 1919.
• Now futures exchanges exist all over the world.
 Electronic markets
• Traditionally derivatives exchanges have used
what is known as the open outcry system.
• This involves traders physically meeting on the
floor of the exchange, shouting, and using a
complicated set of hand signals to indicate the
trades they would like to carry out.
 Electronic markets
• Exchanges are increasingly replacing the open
outcry system by electronic trading. This
involves traders entering their desired trades at
a key board and a computer being used to
match buyers and sellers.
• The open outcry system has its advocates, but,
as time passes, it is becoming less and less
common.
 OTC Derivatives
• Over-the-counter (OTC) derivatives are
contracts that are traded (and privately
negotiated) directly between two parties,
without going through an exchange or
other intermediary.
• Products such as swaps, forward rate
agreements, exotic options – and other
exotic derivatives – are almost always
traded in this way.
 OTC Derivatives
• The OTC derivative market is the largest
market for derivatives, and is largely
unregulated with respect to disclosure of
information between the parties, since the
OTC market is made up of banks and other
highly sophisticated parties, such as hedge
funds.
• Reporting of OTC amounts is difficult because
trades can occur in private, without activity
being visible on any exchange.
 Over-the-counter markets
The over-the-counter market is an important
alternative to exchanges and measured in terms
of the total volume of trading, has become
much larger than the exchange-traded market.
It is a telephone- and computer-linked network
of dealers.
Trades are done over the phone and are usually
between two financial institutions or between a
financial institution and one of its clients.
• Trades in the over- the-counter market are
typically much larger than trades in the
exchange-traded market.
• A key advantage of the over-the-counter
market is that the terms of a contract do not
have to be those specified by an exchange.
Market participants are free to negotiate any
mutually attractive deal.
• A disadvantage is that there is usually some
credit risk in an over-the-counter trade.
 Market size
• Both the over-the counter and the exchange-
traded market for derivative are huge.
 Exchange-traded Derivatives
• Exchange-traded derivatives (ETD) are those
derivatives instruments that are traded via
specialized derivatives exchanges or other
exchanges.
• A derivatives exchange is a market where
individuals trade standardized contracts that
have been defined by the exchange.
• A derivatives exchange acts as an
intermediary to all related transactions, and
takes initial margin from both sides of the
trade to act as a guarantee.
 Exchange-traded Derivatives
• The exchange market is sometimes known as
the “Listed Market”
• In the exchange market buyer and seller do
no need to worry about finding each other.
• Futures and most options are traded on
exchange.
• In OTC trade, the two parties have no
fundamental assurance that the other side will
hold up their end of the deal.
• Exchange trade, the exchange itself
guarantees that all counterparties will fulfil
their responsibilities.
 Vanilla and Exotics – Derivatives
Types
• Simple derivatives are known as “Vanilla”
• Some complex derivatives are known as
“Exotics”
• Derivatives are variation or combinations
of four basic types
• Forward contract
• Futures contract
• Swap contract
• Option contract
 How are derivatives used ?
• Derivatives are used primarily for Hedging
(Risk Management) or for Speculation.
• Hedgers used derivatives to reduce
financial risk or the prospect that the price
of things might move against them.
• Speculators use derivatives not to reduce
financial risk but potentially profit from it.
• Other uses of Derivatives : Market-makers
and arbitrageurs.
 How are derivatives used ? Contd.
• Market Maker :a dealer in securities or other assets who
undertakes to buy or sell at specified prices at all times
• 'Market Maker' A broker-dealer firm that accepts the risk of
holding a certain number of shares of a particular security in
order to facilitate trading in that security.
• Each market maker competes for customer order flow by
displaying buy and sell quotations for a guaranteed number of
shares.
• Arbitrageur' A type of investor who attempts to profit from
price inefficiencies in the market by making simultaneous
trades that offset each other and capturing risk-free profits.
• Arbitrageurs search for pricing ‘mistakes’ or ‘inefficiencies’
 Basic Derivatives Types
Forward contract:
• A forward contract is an agreement to buy
something at a specified price on specified
future date.
Futures contract:
• A futures contract is a standardised
forward contract executed at an exchange,
a forum that brings buyers and settlers
together.
 Basic Derivatives Types
Swap contract :
• A swap contract is an agreement to exchange
cash flows. Typically, one cash flow is based
on a variable or floating price and other on a
fixed one.
Option contract :
• An option contract grants the holder the right
but not the obligation to buy or sell
something at a specified price, on or before a
specified future date.
• Most are executed at an exchange.