MODULE 5

FINANCIAL DERIVATIVES
MEANING

Financial derivatives are financial instruments that are linked to a

specific financial instrument or indicator or commodity, and through
which specific financial risks can be traded in financial markets in
their own right.

Common examples of derivatives include futures contracts, options

contracts, and credit default swaps. Financial derivatives are contracts
whose value is derived from the underlying asset. Hedgers and speculators
widely use these contracts to take advantage of market volatility. The buyer
of the contract agrees to buy the asset at a specific price on a specific date.
Similarly, the seller also enters into one such contract. The different types
of derivatives include futures and options, forwards and swaps.

Types of Financial Derivatives

Futures
Futures are a type of derivatives contract where the buyer and seller enter into
an agreement to fix the quantity and price of the asset. The agreement has
the quantity, price and date of the transaction mentioned. Upon entering into
the contract, the buyer and seller are obligated to fulfil their duty regardless of
the asset’s current market price. Futures contracts are popular for hedging
risk and speculation. However, the main purpose is to fix the price of the asset
against volatility.
With a futures contract, you can take advantage of the margins. A margin
requirement is a minimum amount that you must deposit in order to trade
futures on an exchange. The higher the leverage, the lower is the margin.
For example, if a commodity’s exchange margin is set at 5%, the leverage is
20 times. This indicates a deposit value of INR 5; you can trade for INR 100.
The trader must repay the entire amount when the contract expires. As a
result, higher leverage indicates high risk.
Options
Options also derive their value from the underlying asset. The option holder is
not obligated to buy or sell the asset on expiry. Following are the two types of
options:
 Call Option: The buyer of a call option has the right, but not the obligation, to
purchase the asset at the stated price on the specified date. For example, if
you buy a call option on Company ABC to buy 100 shares at INR 200 on a
certain date. The share price of Company ABC has plummeted to INR 150 on
the expiration date.

As a result, you are unwilling to execute the contract since it is a loss

proposition. You have the option not to purchase the stock. You will just lose
the premium paid to enter the contract in such a case. As a result, instead of
losing INR 5,000, you will just lose the premium you paid.

 Put Option: A put option holder has the right but not the obligation to sell the
underlying asset at a specific price on a specific date. Suppose you acquire a
put option on a Company ABC to sell 100 shares at INR 200 on a certain
date, for example. The share price of Company ABC has increased to INR
250 on the expiration date, and you are unwilling to execute the contract since
you would lose money. You have the option of not selling the stock and saving
INR 5,000.

Forwards
Forward contracts are similar to futures contracts. The contract holder is
under the obligation to fulfil the contract. However, these contracts are not
standardized and do not trade on the exchange. Forward contracts are over
the counter contracts. As a result, these are customized contracts to suit the
requirements of the buyers and sellers (parties to the contract).
Swaps
Swaps are derivative contracts that help two parties to exchange their
financial obligations. Corporates use swap contracts to minimize and hedge
their uncertainty risk of certain projects. There are four types of swaps.
Namely, interest rate swaps, currency swaps, commodity swaps and credit
default swaps.
The most popular type of swap is a credit default swap. A credit default swap
provides insurance from a debt default. The buyer of the swap gives the seller
the premium payments. In case of a default, the seller will pay the buyer the
face value of the asset. At the same time, the seller will get possession of the
asset.
 CHARACTERISTICS OF DERIVATIVES

[Link] asset Underlying asset are the financial assets upon which a
derivative's price is based.

[Link] independent value ; The value of derivative is derived from the value of
underlying asset such as an equity,foreign currency bond etc.

[Link] defined period: All derivative instruments have a predetermined life at

the end f this fixed period they expire off

[Link] fulfillment : A derivative contract is a contract between two

parties it has to be fulfilled in the future

5. Instruments for hedging risk : They help to transfer risk

[Link] Initial Investment : Derivatives require very low or no initial

investment.

[Link] balance sheet instruments : Derivatives are off balance instruments.

They are not shown in balance sheet.

[Link] market instrument : Derivatives are mostly secondary market

instruments, hence they are not useful in mobilizing fresh capital by the
companies.

CLASSIFICATION OF DERIVATIVES

I ON THE BASIS OF CONTRACT OR NATURE OF PAYOFF

[Link]

2. Futures

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[Link]
ON THE BASIS OF BASIS OF UNDERLYING ASSET

[Link] derivatives: These were first to emerge. In this case underlying

assets are commodities, it may be commodities like agricultural products such
as rice wheat cotton oil soya coffee rubber etc and metals such as cpper tin
gold silver

2. Financial derivatives : In this case the underlying asset are financial

instruments or products. In short financial derivatives derive the value frm
financial assets such as foreign currencies share or security or interest rates
etc.

ON THE BASIS F TRADING MECHANISM

[Link] the counter : Over-the-counter derivatives trading is conducted through dealer

networks, and these derivatives are frequently referred to as unlisted stocks. The
broker/dealer network conducts OTC derivatives trade through direct negotiation in which
the two parties agree upon the terms.

[Link] traded derivatives ; These are traded on the organized or

regulated exchanges. The buyer and seller need not know each other. This
means that the derivatives exchange act as an intermediary to all transactions.
It takes initial margin from both the sides of the trade to act as a guarantee.
Exchange traded are standardized products, In short derivatives which are
traded through derivatives are called exchange traded derivatives

DIFFERENCE BETWEEN EXCHANGE TRADED DERIVATIVES AND

OVER THE COUNTER EXCHANGE DERIVATIVES

ETDS
 OTC

[Link] not have any counter party risk 1, Counter party risk is involved
[Link] on organized exchange [Link] outside anexchange
[Link] cost are less 3. Transaction cost is high
4. The contracts have standardized 4. ntracts are customized t the
terms requirements f thye cunter party
[Link] are publically available 5. Prices are kept confidential
6. Market traders do not know each 6. Market traders know each other
other

Advantages of financial derivatives

1. Risk management: The overall risk related to an underlying asset

is broken down and distributed among the people who are ready
to take risk.
2. Price discovery : It plays an important role in determining correct
price of a commodity,Derivatives markets serve as an important
surce of information about the prices
3. Liquidity: Financial derivatives improve the liquidity of the
underlyinginstruments they provide better avenues for raising
[Link] the capital required is less more participants will
operate in the market . This leads to increased volume of trade
and liquidity.
4. Transaction efficiency: As the financial derivatives increase the
liquidity it lowers the transaction cost the cst of raising capital is
lowered.
5. Portfolio management: Financial derivatives help the investors in
diversifying thei portfolio with a smaller fund at disposal better
diversification can be achieved.

6. Economic development; Derivative markets energise others to

create new business new products and employment opportunities
it helps in increase savings and investment in the long run.

DISADVANTAGES
 1. High volatility:

Since the value of derivatives is based on certain underlying

things such as commodities, metals and stocks etc., they are
exposed to high risk. Most of the derivatives are traded on open
market. And the prices of these commodities metals and stocks
will be continuously changing in nature. So the risk that one
may lose their value is very high.

2. Requires expertise:

In case of mutual funds or shares one can manage with even a

limited knowledge pertaining to his sector of trading. But in
case of derivatives it is very difficult to sustain in the market
without expert knowledge in the field.

3. Contract life:

The main problem with the derivative contracts is their limited

life. As the time passes the value of the derivatives will decline
and so on. So one may even have chances of losing completely
within that agreed time frame.

 [Link] risk

The derivatives can be highly volatile which can incur significant losses.
Hence the risk factor in derivatives is largely high.

 [Link] oriented
Derivative are unpredictable and highly dependent on speculations. This
tool of speculation can bring huge losses if the speculation is unreasonable.

To conclude, we have understood the types of derivatives with examples and

how they are the best hedging instruments. With these instruments, traders
can predict the future after a better analysis of price movements eventually
giving good profit

[Link] of financial system. It is argued that derivatives would increase

risk not only for their users but also for the whole financial system.

RISK INVOLVED WITH DERIVATIVES

 COUNTER PARTY RISK

 MARKET RISK

 BASIS RISK

 INTER CONNECTION RISK

 OPERATION RISK

 LIQUIDITY RISK

FORWARDS OR FORWARD CONTRACTS

This type of derivative is a custom-made contract between two

parties in which the settlement between the parties takes place in
the future on any decided date. The price is decided beforehand
and at the same price, the deal is made in the future. So when
there are such future settlements between two parties to buy or
sell an underlying asset it is called a forward contract.
 Future Contracts

Futures contract is quite self-explanatory and similar to forward

contracts it is a deal made to buy or sell an underlying asset at a
specified price on a future date. In the futures contract, there is no
need for the parties to meet each other to make the agreement.
The counterparty risk factor in future contracts is low as the
settlement is standardized. As it follows a standardized contract,
the regulation is taken care of by the stock exchange, and the size
is also fixed. To sum up, the future contracts being standardized
has the preset size, preset expiry date, and preset format.

 Options Contracts

The features of options contracts are quite dissimilar as compared

to the above two types of derivatives. In the other types of
contracts, there is no mandate to discharge the contract on the
specified or decided date. In this type, the parties can opt to buy
or sell the asset but are not obliged to do so. The option contract is
also divided further into two types namely- call and put. When the
buyer party has the right to purchase the asset at a predetermined
price when the initial deal was made it is called a call option.
Whereas in the put option the buyer party can buy the asset but
not obliged to sell the asset at a pre-decided price.
 Swap Contracts

Out of all the above various types of derivatives contracts

mentioned above, the swap contracts are the most complicated.
These contracts are made between the two parties privately. The
parties decide a predetermined formula and exchange their cash
flow according to the formula in the future. The risk parameter in
swap contracts is high as the underlying security is the interest
rate or currency. As these both are quite volatile the risk factor is
high. However, this type of derivatives protects the buyer and
seller from various risks. These contracts are not regulated by any
exchanges and traded via middlemen.

Equities are generally instruments to make investments while

derivatives means the instruments that are used for speculation or
hedging purposes. Now that you know what is derivative let us
discuss who and why buy the derivative instruments.