DERIVATIVES MARKET

Derivatives are most modern financial instruments in hedging risk.

The individuals and firms who wish to avoid or reduce risk can deal
with the others who are willing to accept the risk for a price.

 A common place where such transactions take place is called

Derivative Market.

Derivatives are those assets whose value is determined from the

value of some underlying assets. The underlying asset may be
equity, commodity or currency.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 A derivative is a financial instrument which derives its value from some other
financial price. This “other financial price” is called the underlying.

A wheat farmer may wish to contract to sell his harvest at a future date to eliminate
the risk of a change in prices by that date. The price for such a contract would
obviously depend upon the current spot price of wheat. Such a transaction could take
place on a wheat forward market. Here, the wheat forward is the “derivative” and
wheat on the spot market is “the underlying”.
The terms “derivative contract”, “derivative product”, or “derivative” are used
interchangeably.

The most important derivatives are futures and options.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Types of Derivatives OTC products are :
Customised,
 Forwards, Futures and
Future Rate Agreements Written across the counter or struck on
(FRA’s) telephone, fax, e-mail, etc.
 Swaps By financial institution
 Options Flexible
Expensive
Types of Derivatives –
Based on Limited liquidity
Characteristics

Over the Counter (OTC) Typical OTC

Traded Derivatives Derivatives are
 Exchange Traded Forwards & FRA’s)
Derivatives

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Types of Derivatives Exchange traded products are :
Traded on the floor of physical
 Forwards, Futures and
exchange,
Forward Rate Agreements
(FRA’s) Standardised
 Swaps Participation of large number of players
 Options Less Expensive
High liquidity
Types of Derivatives –
Based on
Characteristics

Over the Counter (OTC) Typical Exchange

Traded Derivatives Traded Derivatives
 Exchange Traded are Futures
Derivatives

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Difference between OTC & Exchange Traded Derivatives
OTC
 Traded on private basis and
bilaterally negotiated
 No standard specifications i.e.
customised to the needs of individual
 Prices are less transparent
Less Liquid
Market players known to each other
and based on creditworthiness
Can not be closed easily
Settlement by physical delivery
Each contract is unique
Typical derivative is Forwards
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Exchange Traded
Traded on the floor of physical
exchange,
Standardised
Prices are transparent
Highly Liquid
 Not known to each other
 Positions can be easily closed out
 settlement on cash basis
The contracts are standardised
Typical derivative is Futures
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 Hedging
Hedging is a mechanism
to reduce price risk
inherent in open position.
Its purpose is to reduce the
volatility of a portfolio, by
reducing the risk.
Not maximisation of
return. Only reduction in
variation of return.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Spot Market
Cash Market where the sale and purchase of
commodity takes place for immediate
delivery.
The price at which the exchange takes place
is called Cash or Spot Price.
On the spot or immediate transfer of
ownership and delivery of
commodity/instrument.
Forward Contract
 An agreement made today
Between buyer & Seller
To exchange the instrument for cash
(at forward price)
At a predetermined future date
At a price agreed upon today (forward
price) 6
 Forward Contract

In a forward contract, two parties irrevocably agree to settle a trade at a future

date, for a stated price and quantity. No money changes hands at the time the
trade is agreed upon.

Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec
2005 at Rs.5,000/tola. Here, Rs.5,000/tola is the “forward price of 31 Dec 2005
Gold”.

The buyer L is said to be long and the seller S is said to be short. Once the contract
has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2005, and take
delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept
Rs.500,000 on 31 Dec 2005, and give 100 tolas of gold in exchange

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Futures Contract
A future contract is a financial security,
issued by an organised exchange to buy
or sell a commodity, security or
currency at a predetermined future
date at a price agreed upon today.
The agreed upon price is called the future price.
In other words “ Futures are exchange traded
contracts to sell or buy financial
instruments /physical commodities for
future delivery at an agreed price.
Characteristics:
v) Contract is standardised
vi) Trading is centralised – Exchange traded
vii) Highly liquid
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Standarised items in Futures :
 Quantity of the underlying
Quality of the underlying (not
required in financial financial
futures)
The date and month of delivery
The units of price quotation (Not
the price itself) and minimum
change in price
Location of settlement
 For the easy and convenient
access by a large number of market
participants.
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 Types of Futures Contract
 Commodity Futures : Where the
underlying is a commodity or physical
asset such as wheat, cotton, butter, eggs,
etc.. In India futures on soyabean, black
pepper and spices have been trading for
long.
 Financial Futures : Where the
underlying is a financial asset such as
foreign exchange, interest rates, Shares,
treasury bills or stock index
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Mechanism in Future Contracts :
In the commodities market the following
conventions apply :
 Buy a future to agree to take delivery
of a commodity. This will protect
against a rise in price in the spot market
as it produces a gain if spot prices rise.
Buying a future is said to be going long.
Sell a future to agree to make delivery
of a commodity. This will protect
against a fall in price in the spot market
as it produces a gain if spot prices fall.
Selling a future is said to be going short.
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 Future Contract : Future Price

Future Price = Spot Price + Cost of Carrying

 The Spot Price is the current price of a commodity/asset.
 The cost of carrying of a commodity / asset will be the aggregate of the
following :
- Storage
- Insurance
- Transportation
- interest payments
- Finance cost – interest forgone on funds used for purchase of the
commodity/ asset.

Apart from the theoretical value, the actual value may vary depending on demand
and supply of the underlying at present and expectations about the future.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Functions of Future Markets Participants in Future Markets

 Hedgers : Hedgers wish to eliminate

or reduce the price risk to which they are
already exposed. The hedging function
solely focuses on the role of transferring
 Price Discovery the risk of price changes to other holders
 Hedging in the future markets.
 Speculators :These class of investors
willingly take price risks to profit from
price changes in the underlying.
 Arbitrageurs : Making profit from
price differential existing in two markets
by simultaneously operating in two
different markets.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Simple Strategies in Future Markets

Commodities Future Markets

 Buy a future to agree to take delivery of a commodity to protect against a rise in price in
the spot market as it produces a gain if spot prices rise. Buying a future is said to be going
long.
 Sell a future to agree to make delivery of a commodity to protect against a fall in price in
the spot market as it produces a gain if spot prices fall. Selling a future is said to be going
short.

Currency Futures
 Buying long a currency future protects against a rise in currency value.
 Selling short a currency future protects against a fall in currency value.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Settlement / Closing Out of
Futures Contract :
A futures position can be closed out at any
time. This is done by entering a reverse
trade.
In other words a buy contract is closed out
by a sale and vice-versa.
Long position in futures – by selling
futures
Short position in futures – by buying
futures on the exchange.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Stock Index Futures
 A Stock Index is a composition of
selected securities traded on an
exchange. e.g. sensex
 The value of stock index futures
derives its value from a stock index
value.
 Buyers & sellers agree to buy / sell
the entire stock index.
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 Options : Terminology in Options

An option contract gives the holder of the  Buyer / Holder / Owner – Who buys
contracts the option to buy or sell shares at the option
a specified price on or before a specific  Seller/ Writer – Who sells the option
date in the future.
 Option Premium – Amount paid by
a Buyer to Seller for acquiring the right
Right Obligation to buy or sell an underlying or price
received by Seller for surrendering his
Buyer YES NO rights in an option contract.
Option  Strike Price – The agreed / exercise
Seller NO YES price at which the right to buy or sell the
underlying is exercisable.
 Expiry Date – The date on which the
option contract expires or becomes
invalid.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Terminology in Options

Call Options : An option acquired

to obtain the right to buy/call an
underlying in the market.

Buyer Seller
Holder Writer
Long Short

Has the right but not Is obligated on

the obligation to buy demand to sell
underlying at the strike underlying at the strike
price price when the holder
exercises

Pays the total premium Receives the total

premium

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Terminology in Options
Call Options : Expectation,
Rewards and Risk of Buyer & Seller
Buyer
Holder
Long
• Expectation : Wants the market price of
the underlying stock to rise.
• Reward : Potential unlimited gain when
the price of the underlying stock
appreciates
• Risk : Losses only the total premium
paid for the call when the market price
of underlying stock declines.
Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
Seller
Writer
Short
• Expectation : Wants the
market price of the
underlying stock to stay flat.
• Reward : Limited gain as
premium
• Risk : Potential unlimited
loss when the price of the
underlying stock rises.
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 Terminology in Options Put Option : Expectation,
Rewards and Risk of Buyer & Seller
Put Option : An option acquired
to obtain the right to sell/put an Buyer Holder Seller Writer
underlying in the market. Long Short

• Expectation : Wants • Expectation :

the market price of Wants the market
Buyer Seller the underlying stock price of the
Holder Writer to decline. underlying stock
Long Short to stay flat or rise.
• Reward : Maximum
profit when the price • Reward : Limited
Has the right but the Is obligated on of the underlying gain as premium
obligation to sell demand to buy stock declines to
underlying at the underlying at the zero. • Risk : More
strike price strike price when losses when the
• Risk : Losses only price of the
the holder exercises
the total premium underlying stock
paid for the call declines lower
Pays the total Receives the total when the market and lower.
premium premium price of underlying
stock rises.
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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Features of Options

 The option is exercisable only by

the owner namely the buyer of the
option.
 The owner has limited liability
 Options have high degree of risk to
the option writers.
 Options are popular because they
allow the buyer profits from favourable
movements in exchange rate.
 Flexibility in investors need.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18
 Difference between Futures & Options

Futures Options
 Both the parties are obliged to Only the seller (writer) is obligated to
perform the contract. perform the contract.
 No premium is paid by either parties The buyer pays the seller (writer) a
premium.

 The holder of the contract is exposed
to the entire spectrum of downside risk
and has potential for all the up side
return.
The parties of the contract must
perform at the settlement date. They are
not obliged to perform before the date.
The buyer’s loss is restricted to downside
risk to the premium paid, but retains
upward indefinite potentials.
The buyer can exercise option any time
prior to the expiry date.

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Dr. Ratnesh Chaturvedi, FMS, Session – 17-18