Derivative management

Unit 1

PARTICIPANTS OF FUNCTIONS

 Derivative management for participants involves various strategies and roles

played by different entities in the derivatives market. Derivatives are
financial contracts that derive their value from an underlying asset or group
of assets.
 Here's a breakdown of derivative management for participants and the
functions of derivatives, with a focus on speculators, hedgers, and
arbitrageurs:

Functions of Derivatives:

Derivatives serve several crucial functions in financial markets:

Risk Management (Hedging):

 This is one of the primary functions. Derivatives allow participants to

manage or mitigate risks associated with price fluctuations in underlying
assets (e.g., commodities, currencies, interest rates, stocks). By taking an
offsetting position in the derivatives market, hedgers can protect their
existing investments from adverse market movements.

Price Discovery:
 Derivative prices reflect the collective expectations of market participants
about future asset prices. The continuous trading of derivatives helps in
determining the fair value of the underlying assets.

Leverage:

 Derivatives often require a smaller initial capital outlay (margin) compared

to directly investing in the underlying asset. This leverage can magnify both
potential profits and losses.

Capital Efficiency:

 Derivatives allow investors to gain exposure to various asset classes without

the need for direct ownership, making them a capital-efficient tool.

Liquidity Enhancement:

 Derivatives contribute to market liquidity by providing avenues for investors

to enter and exit positions swiftly, reducing transaction costs and improving
market efficiency.

Transfer of Risk:
 Derivatives facilitate the transfer of risk from one party (e.g., a hedger who
wants to reduce risk) to another (e.g., a speculator who is willing to take on
that risk for potential profit).

Participants in the Derivatives Market:

 The major participants in the derivatives market are typically categorized

into three groups:

1. Hedgers

Role:

 Hedgers use derivatives to reduce or mitigate risk associated with adverse

price movements in an underlying asset they already own or are planning to
transact in the future. They aim to protect their existing investments or future
cash flows from uncertainty.

Motivation:

 Their primary goal is risk aversion, not profit maximization from price
movements. They are willing to forgo potential gains if it means avoiding
significant losses.

Example (Commodity):

 A farmer expects to harvest wheat in six months and is concerned about a

potential drop in wheat prices. To "lock in" a selling price, the farmer can
sell wheat futures contracts today. If the price of wheat falls by harvest time,
 the loss on the physical sale of wheat is offset by the profit from the futures
contract.

Example (Currency):

 A company expecting to receive payment in a foreign currency in the future

might sell a currency forward contract to hedge against the risk of that
foreign currency depreciating against their domestic currency.

Example (Interest Rate):

 A company with floating-rate debt can enter into an interest rate swap to
exchange its variable interest payments for fixed interest payments, thereby
stabilizing its interest expenses.

2. Speculators

Role:

 Speculators enter the derivatives market with the primary objective of

profiting from anticipated future price movements of the underlying asset.
They are willing to take on significant risk in the hope of generating
substantial gains.
 Motivation:

 Their goal is profit maximization by betting on the direction of market

prices.

Example:

 A speculator believes that a particular stock's price will rise significantly in

the near future. They might buy call options on that stock. If the stock price
indeed rises, the value of their call options will increase, allowing them to
sell them for a profit. Conversely, if they anticipate a price drop, they might
buy put options or short sell futures contracts.
 Speculators often use technical analysis, fundamental analysis, and other
forecasting methods to predict price trends.
 They typically have a shorter time horizon for their trades compared to long-
term investors.

3. Arbitrageurs

Role:

 Arbitrageurs aim to make riskless (or near-riskless) profits by exploiting

temporary price discrepancies or inefficiencies between different markets or
financial instruments.

Motivation:
  Their goal is to achieve guaranteed returns with minimal risk by
simultaneously buying an asset in one market where it's undervalued and
selling it in another where it's overvalued.

Example (Index Arbitrage):

 If a stock index futures contract is trading at a price that deviates from the
theoretical fair value of the underlying basket of stocks, an arbitrageur might
buy the undervalued asset (e.g., the futures contract) and simultaneously sell
the overvalued asset (e.g., the individual stocks in the index), or vice versa.
They then hold these positions until the prices converge, locking in a profit.

Example (Spatial Arbitrage):

 If the same commodity is priced differently in two different geographic

markets, an arbitrageur might buy it in the cheaper market and
simultaneously sell it in the more expensive market.

Example (Convertible Arbitrage):

 Exploiting price differences between a convertible security (like a

convertible bond) and its underlying common stock.

FORWARD CONTRACT

 A Forward contracts is a simple contract between two parties to

buy or sell an asset a certain time in the future for a certain price
 Unlike future contracts
  They are not traded on an exchange
 Rather traded in the over – the counter market
 Usually between two financial institutions or between a financial
institution and one of its client
FOR EXAMPLE

 An Indian company buys Automobile parts from USA with payment of

one million dollar due in 90 days. The importer, thus, is short of dollar
that is, it owes dollars for future delivery. Suppose present price of dollar
is Rs 48. Over the next 90 days, however, dollar might rise against Rs
[Link] importer can hedge this exchange risk by negotiating a 90 days
forward contract with a bank at a price [Link] to forward
contract in 90 days the bank will give importer one million dollar and
importer will give the bank 50 million rupees hedging a future payment
with forward contract. On the due date importer will make a payment of
Rs 50 million to bank and the bank will pay one million dollar to
importer , whatever rate of the dollar is after 90 days. So this is a typical
example of forward contract on currency.
FEATURES

 Forward contracts are bilateral contracts, and hence, they are exposed to
counter-party risk. There is risk of non-performance of obligation either of
the parties, so these are riskier than to futures contracts.
 Each contract is custom designed, and hence, is unique in
terms of contract size, expiration date, the asset type, quality,
etc.
 In forward contract, one of the parties takes a long position by agreeing to
 buy the asset at a certain specified future date. The other party assumes a
short position by agreeing to sell he same asset at the same date for the
same specified price. A party with no obligation offsetting the forward
contract is said to have an open position. A party with a closed position is,
sometimes, called a hedger.

 The specified price in a forward contract is referred to as the

delivery price. The forward price for a particular forward contract
at a particular time is the delivery price that would apply if the
contract were entered into at that time. It is important to
differentiate between the forward price and the delivery price.
Both are equal at the time the contract is entered into. However,
as time passes, the forward price is likely to change whereas the
delivery price remains the same.
 In the forward contract, derivative assets can often be
contracted from the combination of under-lying assets, such
assets are offtenly known as synthetic assets in the forward
market
 In the forward market, the contract has to be settled by delivery
of the asset on expiration date. In case the party wishes to
reverse the contract, it has to compulsory go to the same
counter party, which may dominate and command the price it
wants as being in a monopoly situation.
 In the forward contract, covered parity or cost-of-carry relations are
relation between the prices of forward and underlying assets. Such
relations further assist in determining the arbitrage-based forward asset
 prices.
 Forward contracts are very popular in foreign exchange market as well
as interest rate bearing instruments. Most of the large and international
banks quote the forward rate through their 'forward desk' lying within
their foreign exchange trading room. Forward foreign exchange quotes
by these banks are displayed with the spot rates.
 As per the Indian Forward Contract Act-1952, different kinds of
forward contracts can be done like hedge contracts, transferable
specific delivery (TSD) contracts and non-transferable specify
delivery (NTSD) contracts. Hedge contracts are freely transferable
and do not specific, any particular lot, consignment or variety for
delivery.
 Transferable specific delivery contracts are though freely
transferable from one party to another, but are concerned
with a specific and predetermined consignment. Delivery
is mandatory. Non-transferable specific delivery contracts,
as the name indicates, are not transferable at all, and as
such, they are highly specific.

F U T U R E CONTRACT

A futures contract is an agreement between two parties to buy or sell a specified

quantity of an asset at a specified price and at a specified time and place.
Futures contracts are normally traded on an exchange which sets the certain
standardized norms for trading in the futures

Example:
 A silver manufacturer is concerned about the price of
silver, since he will not be able to plan for profitability.
Given the current level of production, he expects to have
about 20,000 ounces of silver ready in next two
[Link] current price of silver on May 10 is Rs 1052.5
per ounce, and July futures price at FMC is Rs 1068 per
ounce, which he believes to be satisfied price. But he fears
that prices in future may go down. So he will enter into a
futures contract. He will sell four contracts at MCX where
each contract is of 5000 ounces at Rs 1068 for delivery in
July

FEATURES

Standardization:

One of the most important features of futures contract is that the

contract has certain standardized specification, i.e., quantity of the asset,
quality of the asset, the date and month of delivery, the units of price
quotation, location of settlement, etc. For example,

the largest exchange on which futures contracts are traded are the
Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange
(CME).They specify about each term of the futures contract.

Clearing house:

In the futures contract, the exchange clearing house is an adjunct of the

ex-change and acts as an intermediary or middleman in futures. It gives the
guarantee for the performance of the parties to each [Link]
clearing house has a number of members all of which have offices near to
the clearing house. Thus, the clearing house is the counter party to every
contract.

Tick size:

The futures prices are expressed in currency units, with a minimum

price movement called a tick size. This means that the futures prices must
be rounded to the nearest tick. The difference between a futures price and
the cash price of that asset is known as the basis. The details of this
mechanism will be discussed in the forthcoming chapters.

Cash settlement:

Most of the futures contracts are settled in cash by having the short
or long to make a cash payment on the difference between the futures
price at which the contract was entered and the cash price at expiration
date. This is done because it is inconvenient or impossible to deliver
some-times, the underlying asset. This type of settlement is very much
popular in stock indices futures contracts.

Delivery:

The futures contracts are executed on the expiry date. The

counter parties with a short position are obligated to make delivery
to the exchange, whereas the exchange is obligated to make
delivery to the longs. The period during which the delivery will be
made is set by the exchange which varies from contract to contract.

Regulation:

The important difference between futures and forward

markets is that the futures contracts are regulated through a
exchange, but the forward contracts are self regulated by the
counter-parties themselves. The various countries have
established Commissions in their country to regulate futures
markets both in stocks and commodities. Any such new futures
contracts and changes to existing contracts must by approved by
their respective Commission.

O P T I O N S CONTRACT

 Options are the most important group of derivative

securities. Option may be defined as a contract,
between two parties whereby one party obtains the
right, but not the obligation, to buy or sell a particular
asset, at a specified price, on or before a specified
date.
 The person who acquires the right is known as the option
buyer or option holder, while the other person (who
confers the right) is known as option seller or option
writer. The seller of the option for giving such option to
the buyer charges an amount which is known as the option
premium.

Options can be divided into two types:

calls and puts. A call option gives the holder the

 right to buy an asset at a specified date for a specified price
whereas in put option, the holder gets the right to sell an asset
at the specified price and time.

 The specified price in such contract is known as the

exercise price or the strike price and the date in the
contract is known as the expiration date or the
exercise date or the maturity date.
 The asset or security instrument or commodity
covered under the contract is called as the
underlying asset. They include shares, stocks, stock
indices, foreign currencies, bonds, commodities,
futures contracts, etc,

Swap contracts

 There are two most popular forms of swap contracts, i.e.,

interest rate swaps and currency swaps. In the interest
rate swap one party agrees to pay the other party interest at
a fixed rate on a notional principal amount, and in return, it
receives interest at a floating rate on the same principal
notional amount for a specified period.
 The currencies of the two sets of cash flows are the same.
In case of currency swap, it involves in exchanging of
interest flows, in one currency for interest flows in other
currency. In other words, it requires the exchange of cash
flows in two currencies. There are various forms of swaps
 based upon these two, but having different
features in general.

Difference between cash and future market?

CASH MARKET FUTURE MARKET

pay full money Pays margin money

Shares have to be first bought Buy/sell – either can happen first

Shares actually bought Shares are not actually bought

Delivery takes place within T+2 Delivery doesn’t take place within
T+2

Customization possible Customization not possible

No cap on stock holding Cap on stock holding

Dividends accrue Dividends does not accrue

Capital appreciation occurs on the Capital appreciation does not occur

return on the return
Less risky More risky

Investment is through mutual funds, Investment is via forwards, options

buying bonds, T-bills, commercial and swaps etc.
paper etc.

Traders in Derivatives Management :

Traders in derivatives management are individuals or entities that

engage in buying and selling derivative instruments, such as futures,
options, swaps, or forwards. These instruments derive their value
from underlying assets like stocks, commodities, currencies, or
indices. Traders aim to profit from price movements in these
derivatives by taking positions based on market analysis, forecasts, or
hedging needs.

1. Types of Traders in Financial Markets :

Traders can be classified based on their objectives, strategies, and the

markets they operate in:

a. Hedgers:
 Objective: Reduce risk due to price fluctuations.

Example: A farmer uses futures contracts to lock in the price of crops to

avoid loss from falling prices.

b. Speculators :

Objective: Earn profit from price changes.

Example: A trader buys crude oil futures expecting oil prices to rise.

c. Arbitrageurs :

Objective: Exploit price differences of the same asset in different markets

for riskless profit.

Example: Buying a stock in the US market and selling it in the UK

market if there’s a price difference.

d. Margin Traders :

Objective: Trade using borrowed funds to magnify potential returns (or

losses).

Common in: Futures and options markets.

e. Algorithmic Traders (Quant Traders) :

Objective: Use automated systems or algorithms to make rapid trades.

Benefit: Speed, accuracy, and ability to analyze large data sets.

OTC (Over-The-Counter) Securities :

1. Definition:

 Securities traded directly between two parties without a

centralized exchange.
 Often customized to meet specific needs.

2. Characteristics:

 Less transparent than exchange-traded securities.

 Higher counterparty risk.
 Greater flexibility in terms of contract specifications.

3. Examples:

 Certain derivatives, such as swaps or forwards.

 Some types of bonds or structured products.

Exchange-Traded Securities :
 1. Definition:
 Securities traded on a centralized exchange, such as
stocks or options.
 Standardized contracts with transparent pricing.

2. Characteristics:
 Higher liquidity and transparency.
 Lower counterparty risk due to exchange guarantees.
 Standardize contract specifications.
3. Examples:

 Stocks, options, futures, and ETFs.

Types of Settlements in Derivatives Management :

In derivatives management, settlement refers to the process of

fulfilling the obligations of a derivative contract at its expiration or
termination. There are two primary types of settlements: cash
settlement and physical settlement. The type of settlement depends on
the terms of the derivative contract and the underlying asset.

1. Cash Settlement :

Definition: In cash settlement, the derivative contract is settled in cash

based on the difference between the contract price and the market price of
the underlying asset at the time of expiration.
 Characteristics:
 No physical delivery of the underlying asset.
 Settlement amount is calculated based on the price difference.
 Often used in index futures, options, and other derivatives where
physical delivery is impractical.
 Example: If you hold a futures contract for an index and the index
price at expiration is higher than the contract price, you receive the
difference in cash.

2. Physical Settlement :

Definition: In physical settlement, the derivative contract is settled by

delivering the underlying asset according to the terms of the contract.

Characteristics:
 Physical delivery of the underlying asset is required.
 Buyer pays the agreed-upon price, and the seller delivers the asset.
 Commonly used in commodity futures and certain types of options.
 Example: If you hold a futures contract for crude oil, physical
settlement would involve the delivery of the specified quantity of
crude oil to the buyer.

3. Daily Settlement (Mark-to-Market) :

 Definition: Daily settlement, also known as mark-to-market, involves
adjusting the value of a derivative contract daily to reflect changes in the
market price of the underlying asset.

Characteristics:
 Profits and losses are settled daily based on the closing price.
 Used primarily in futures contracts to manage risk and ensure
financial integrity.
 Helps in maintaining margin requirements and reducing
counterparty risk.
 Example: If you hold a futures contract and the market price
moves in your favor, your account will be credited with the gains.
Conversely, if the market moves against you, your account will be
debited.

Importance of Settlement in Derivatives Management :

 Risk Management: Proper settlement mechanisms help manage

counterparty risk and ensure financial stability.
 Contract Fulfillment: Settlement ensures that the obligations of the
derivative contract are fulfilled according to the agreed terms.
 Market Efficiency: Efficient settlement processes contribute to the overall
functioning and liquidity of derivatives markets.

Challenges in Settlement :
  Operational Risk: Ensuring accurate and timely settlement can be
challenging, especially in complex or high-volume markets.
 Counterparty Risk: The risk that one party may fail to fulfill their
obligations can impact settlement.
 Logistical Issues: Physical settlement can involve logistical
challenges, such as storage and transportation of the underlying asset.

By understanding the different types of settlements in derivatives

management, market participants can better navigate the complexities
of derivative contracts and manage their risk exposure effectively.

Uses and advantages of derivatives and Risks in derivatives

Uses of Derivatives

Derivatives are supposed to provide the following services:

1. One of the most important services provided by the derivatives is to
control, avoid, shift and manage efficiently different types of risks
through various strategies like hedging, arbitraging. spreading, etc.
Derivatives assist the holders to shift or modify suitably the risk
characteristics of their portfolios. These are specifically useful in
highly volatile financial market conditions like erratic trading, highly
flexible interest rates, volatile exchange rates and monetary chaos.

2. Derivatives serve as barometers of the future trends in prices which

result in the discovery of new prices both on the spot and futures
markets. Further, they help in disseminating different information
regarding the futures markets trading of various commodities and
securities to the society which enable to discover or form suitable or
correct or true equilibrium prices in the markets. As a result, they
assist in appropriate and superior allocation of resources in the
society.

3. As we see that in derivatives trading no immediate full amount of

the transaction is required since most of them are based on margin
trading. As a result, large number of traders, speculators arbitrageurs
operate in such markets. So, derivatives trading enhance liquidity and
reduce trans-action costs in the markets for underlying assets.

4. The derivatives assist the investors, traders and managers of large

pools of funds to devise such strategies so that they may make proper
 asset allocation increase their yields and achieve other investment
goals.

5. It has been observed from the derivatives trading in the market that
the derivatives have smoothen out price fluctuations, squeeze the
price spread, integrate price structure at different points of time and
remove gluts and shortages in the markets.

6. The derivatives trading encourage the competitive trading in the

markets, different risk taking preference of the market operators like
speculators, hedgers, traders, arbitrageurs, etc, resulting in increase in
trading volume in the country. They also attract young investors,
professionals and other experts who will act as catalysts to the growth
of financial markets.

7. Lastly, it is observed that derivatives trading develop the market

towards 'complete markets". Complete market concept refers to that
situation where no particular investors be better of than others, or
patterns of returns of all additional securities are spanned by the
already existing securities in it, or there is no further scope of
additional security

Critiques of Derivatives
Besides from the important services provided by the derivatives, some
experts have raised doubts and have become critique on the growth of
derivatives. They have warned against them and believe that the
derivatives will cause to destabilization, volatility, financial excesses
and oscillations in financial markets. It is alleged that they assist the
speculators in the market to earn lots of money, and hence, these are
exotic instruments. In this section, a few important arguments of the
critiques against derivatives have been discussed.

Speculative and gambling motives

One of most important arguments against the derivatives is that they

promote speculative activities in the market. It is witnessed from the
financial markets throughout the world that the trading volume in
derivatives have increased in multiples of the value of the underlying
assets and hardly one to two percent derivatives are settled by the
actual delivery of the underlying assets. As such speculation has
become the primary purpose of the birth, existence and growth of
derivatives. Sometimes, these speculative buying and selling by
professionals and amateurs adversely affect the genuine producers
and distributors

Some financial experts and economists believe that speculation brings

about a better allocation of supplies overtime, reduces the fluctuations
in prices, make adjustment between demand and supply, removes
 periodic gluts and shortages, and thus, brings efficiency to the market.
However, in actual practice, above such agreements are not visible.
Most of the speculative activities are 'professional speculation' or
'movement trading' which lead to destabilization in the market.
Sudden and sharp variations in prices have been caused due to
common, frequent and widespread consequence of speculation.

Risk management :

1 Increase in risk

The derivatives are supposed to be efficient tool of risk management

in the market. In fact this is also one-sided argument. It has been
observed that the derivatives market especially OTC markets, as
particu-larly customized, privately managed and negotiated, and thus,
they are highly risky. Empirical studies in this respect have shown
that derivatives used by the banks have not resulted in the reduction in
risk, and rather these have raised of new types of risk. They are
powerful leveraged mechanism used to create risk. It is further argued
that if derivatives are risk management tool, then why 'government
securities, a riskless security, are used for trading interest rate futures
which is one of the most popular financial derivatives in the world.

Instability of the financial system

 It is argued that derivatives have increased risk not only for their users
but also for the whole financial system. The fears of micro and macro
financial crisis have caused to the unchecked growth of derivatives
which have turned many market players into big losers. The
malpractices, desperate behaviour and fraud by the users of
derivatives have threatened the stability of the financial markets and
the financial system.

Price instability

Some experts argue in favour of the derivatives that their major

contribution is toward price stability and price discovery in the market
whereas some others have doubt about this. Rather they argue that

derivatives have caused wild fluctuations in asset prices, and

moreover, they have widened the range of such fluctuations in the
prices. The derivatives may be helpful in price stabilization only if
there exist a properly organized, competitive and well-regulated
market. Further, the traders behave and function in professional
manner and follow standard code of conduct. Unfortunately, all these
are not so frequently practiced in the market, and hence, the
derivatives sometimes cause to price instability rather than stability.

Displacement effect
There is another doubt about the growth of the derivatives that they
will reduce the volume of the business in the primary or new issue
market specifically for the new and small corporate units. It is
apprehension that most of investors will divert to the derivatives
markets, raising fresh capital by such units will be difficult, and
hence, this will create displacement effect in the financial market.
However, it is not so strong argument because there is no such rigid
segmentation of invertors, and investors behave rationally in the
market.

Increased regulatory burden

As pointed earlier that the derivatives create instability in the financial

system as a result, there will be more burden on the government or
regulatory authorities to control the activities of the traders in
financial derivatives. As we see various financial crises and scams in
the market from time to time, most of time and energy of the
regulatory authorities just spent on to find out new regulatory,
supervisory and monitoring tools so that the derivatives do not lead to
the fall of the financial system.

In our fast-changing financial services industry, coercive regulations

intended to restrict banks' activities will be unable to keep up with
financial innovation. As the lines of demarcation between various
types of financial service providers continues to blur, the bureaucratic
leviathan responsible for reforming banking regulation must face the
fact that fears about derivatives have proved unfounded. New
regulations are unnecessary.

Indeed, access to risk-management instruments should not be feared,

but with caution, embraced to help the firms to manage the
vicissitudes of the market.

In this chapter various misconceptions about financial derivatives are

explored. Believing just one or two of the myths could lead one to
advocate tighter legislation and regulatory measures designed to
restrict derivatives activities and market participants. A careful review
of the risks and rewards deriva-tives offer, however, suggests that
regulatory and legislative restrictions are not the answer. To blame
organizational failures solely on derivatives is to miss the point. A
better answer lies in greater reliance on market forces to control
derivative-related risk taking.

Financial derivatives have changed the face of finance by creating

new ways to understand, mea-sure and manage risks. Ultimately,
financial derivatives should be considered part of any firm's risk-
management strategy to ensure that value-enhancing investment
opportunities are pursued. The free-dom to manage risk effectively
must not be taken away