Introduction
Chapter 1
The Nature of Derivatives
A derivative is an instrument whose value
depends on the values of other more basic
underlying variables. Or A derivative is an
instrument whose value is a function the
values of other more basic underlying
variables.
The Securities Contracts (Regulation) Act 1956
defines derivatives as under :
Derivative includes
1. 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
Features of Financial Derivatives
•A derivative instrument relates to the future contract between
two parties
•Value derived from the values of the other underlying assets.
•Counter parties have specific obligation under the derivative
contract.
•Derivative contract can either be direct or thru exchange like
options & futures.
•Usually settled by offsetting rather than delivery of the asset.
•Known as deferred delivery or deferred payment instrument,
easier to take long & short positions.
•Mostly secondary market instruments except warrants &
convertibles.
Derivatives Markets
•Exchange traded
–Traditionally exchanges have used the open-outcry system, but
increasingly they have switched to electronic trading
–Contracts are standard there is virtually no credit risk
–Example of default: HKFE in October, 1987
•Over-the-counter (OTC)
–A computer- and telephone-linked network of dealers at financial
institutions, corporations, and fund managers
–Contracts can be non-standard and there is some small amount of
credit risk
–Defaults much bigger than exchanged based
Examples of Derivatives
•Forward Contracts
•Futures Contracts
•Swaps
•Options
Reasons for development of Derivatives
- Increase in growth of International trade & Business
due to Globalization & liberalization
- Increase in volatility in the interest rates, stock prices at
different financial markets
- Increase in the risks associated with business & its
recognition
Ways Derivatives are Used
•To hedge risks
•To speculate (take a view on the future direction of the
market)
•To lock in an arbitrage profit
•To change the nature of a liability
–Interest rate swap to reduce mortgage risk in banks
•To change the nature of an investment without incurring
the costs of selling one portfolio and buying another
Uses of Derivatives
•To control , avoid, shift and manage efficiently different types
of risks.
•Serves as barometer of the future trends in the prices which
results in the discovery of the new prices both in the spot &
future markets.
•Trading on margins ,enhances the liquidity & reduces the
transaction costs.
•Assists the investors to make proper asset allocation to increase
their yields & achieve the other investment objectives.
•Derivatives have smoothened out the price fluctuations, squeeze
the price spread.
•Derivative trading develop the market towards ‘complete
market’