BASICS OF DERIVATIVES:

A derivative is a contract or a product whose value is derived from the value of

some other asset known as the underlying. Derivatives are based on a wide range
of underlying assets.
These include:
 Metals such as Gold, Silver, Aluminium, Copper, Zinc, Nickel, Tin, Lead,
etc.
 Energy resources such as Oil (crude oil, products, cracks), Coal,
Electricity, Natural Gas, etc.
 Agri commodities such as Wheat, Sugar, Coffee, Cotton, Pulses etc., and
 Financial assets such as Shares, Bonds and Foreign Exchange.
DERIVATIVES MARKET – HISTORY & EVOLUTION

The history of derivatives may be mapped back to several centuries. Some of the
specific milestones in evolution of the derivatives market worldwide are given
below:

 12th Century – In European trade fairs, sellers signed contracts promising

future delivery of the items they sold.

 13th Century – There are many examples of contracts entered into by

English Cistercian Monasteries, who frequently sold their wool up to 20
years in advance, to foreign merchants.

 1634-1637 – Tulip Mania in Holland: Fortunes were lost after a speculative

boom in tulip futures burst.

 Late 17th Century – In Japan at Dojima, near Osaka, a futures market in

rice was developed to protect rice producers from bad weather or warfare.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
  In 1848, The Chicago Board of Trade (CBOT) facilitated trading of
forward contracts on various commodities.

 In 1865, the CBOT went a step further and listed the first “exchange
traded” derivative contract in the US. These contracts were called “futures
contracts”.

 In 1919, Chicago Butter and Egg Board, a spin-off of CBOT, was

reorganized to allow futures trading. Later its name was changed to
Chicago Mercantile Exchange (CME).

 In 1972, Chicago Mercantile Exchange introduced International Monetary

Market (IMM), which allowed trading in currency futures.

 In 1973, Chicago Board Options Exchange (CBOE) became the first

marketplace for trading listed options.

 In 1975, CBOT introduced Treasury bill futures contract. It was the first
successful pure interest rate future.

 In 1977, CBOT introduced T-bond futures contract. In 1982, CME

introduced Eurodollar futures contract.

 In 1982, the Kansas City Board of Trade launched the first stock index
futures.

 In 1983, Chicago Board Options Exchange (CBOE) introduced options on

stock indices with the S&P 100® (OEX) and S&P 500® (SPXSM) Indices.

Factors influencing the growth of the derivative market globally

Over the last five decades, the derivatives market has seen phenomenal growth.
Many derivative contracts were launched at exchanges across the world. Some of
the factors driving the growth of financial derivatives are:

 Increased fluctuations in underlying asset prices in financial markets.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
  Integration of financial markets globally.

 Use of latest technology in communications has helped in the reduction of

transaction costs.

 Enhanced understanding of market participants on sophisticated risk

management tools to manage risk.

 Frequent innovations in the derivatives market and newer applications of

products.

INDIAN DERIVATIVES MARKET

As the initial step towards introduction of derivatives trading in India, SEBI set
up a 24–member committee under the Chairmanship of Dr. L. C. Gupta on
November 18, 1996, to develop appropriate regulatory framework for derivatives
trading in India. The committee submitted its report on March 17, 1998
recommending that derivatives should be declared as ‘securities’ so that
regulatory framework applicable to trading of ‘securities’ could also govern
trading of derivatives. Subsequently, SEBI set up a group in June 1998 under the
Chairmanship of Prof. J.R. Varma, to recommend measures for risk containment
in derivatives market in India. The committee submitted its report in October
1998. It worked out the operational details of margining system, methodology for
charging initial margins, membership details and net-worth criterion, deposit
requirements and real time monitoring of positions requirements.

In 1999, The Securities Contracts (Regulation) Act (SCRA) was amended to

include “derivatives” within the domain of ‘securities’ and a regulatory
framework was developed for governing derivatives trading. In March 2000, the
government repealed a three-decade-old notification, which prohibited forward
trading in securities.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
The exchange traded derivatives started in India in June 2000 with SEBI
permitting BSE and NSE to introduce the equity derivatives segment. To begin
with, SEBI approved trading in index futures contracts based on Nifty and
Sensex, which commenced trading in June 2000. Later, trading in Index options
commenced in June 2001 and trading in options on individual stocks commenced
in July 2001. Futures contracts on individual stocks started in November 2001.
Metropolitan Stock Exchange of India Limited (MSEI) started trading in
derivative products in February 2013.

EXAMPLES OF DERIVATIVES
Suppose an Indian exporter expects to receive payment of $1,00,000 in three
months for goods exported to the United States. The exporter is concerned about
the risk of exchange rate fluctuations and wants to lock in the current exchange
rate to protect against potential losses. The current Exchange rate is 1 USD = 80
INR.
The exporter decides to enter into a currency futures contract to sell USD and buy
INR at the current exchange rate for the future date. Each futures contract
represents a specific amount of foreign currency. Let us say one futures contract
represents $10,000. The exporter needs to hedge $100,000, so they will enter into
10 currency futures contracts. The agreed-upon futures price is the same as the
current exchange rate, 1 USD = 80 INR.
If the exchange rate in three months is favorable (say, 1 USD = 70 INR), the
exporter would still exchange $100,000 at the agreed-upon rate of 1 USD = 80
INR through the futures contract. The exporter gains from the favorable exchange
rate, as the actual market rate is better.
If the exchange rate in three months is unfavorable (say, 1 USD = 85 INR), the
exporter would still exchange $100,000 at the agreed-upon rate of 1 USD = 80
INR through the futures contract. The exporter is protected from the adverse
exchange rate movement as they receive the agreed-upon rate.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
The profit or loss depends on the difference between the agreed-upon futures rate
and the actual exchange rate at the time of the currency conversion.
FEATURES OF FINANCIAL DERIVATIVES

1. It is a contract: Derivative is defined as the future contract between two

parties. It means there must be a contract-binding on the underlying parties and
the same to be fulfilled in future. The future period may be short or long
depending upon the nature of contract, for example, short term interest rate
futures and long-term interest rate futures contract.

2. Derives value from underlying asset: Normally, the derivative instruments

have the value which is derived from the values of other underlying assets, such
as agricultural commodities, metals, financial assets, intangible assets, etc. Value
of derivatives depends upon the value of underlying instrument and which
changes as per the changes in the underlying assets, and sometimes, it may be nil
or zero. Hence, they are closely related.

3. Specified obligation: In general, the counter parties have specified obligation

under the derivative contract. Obviously, the nature of the obligation would be
different as per the type of the instrument of a derivative. For example, the
obligation of the counter parties, under the different derivatives, such as forward
contract, future contract, option contract and swap contract would be different.

4. Direct or exchange traded: The derivatives contracts can be undertaken

directly between the two parties or through the particular exchange like financial
futures contracts. The exchange-traded derivatives are quite liquid and have low
transaction costs in comparison to tailor-made contracts. Example of exchange
traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior
that are traded on New York Stock Exchange, Tokyo Stock Exchange, National
Stock Exchange, Bombay Stock Exchange and so on.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
5. Related to notional amount: In general, the financial derivatives are carried off-
balance sheet. The size of the derivative contract depends upon its notional
amount. The notional amount is the amount used to calculate the payoff. For
instance, in the option contract, the potential loss and potential payoff, both may
be different from the value of underlying shares, because the payoff of derivative
products differ from the payoff that their notional amount might suggest.

6. Delivery of underlying asset not involved: Usually, in derivatives trading,

the taking or making of delivery of underlying assets is not involved, rather
underlying transactions are mostly settled by taking offsetting positions in the
derivatives themselves. There is, therefore, no effective limit on the quantity of
claims, which can be traded in respect of underlying assets.

7. May be used as deferred delivery: Derivatives are also known as deferred

delivery or deferred payment instrument. It means that it is easier to take short or
long position in derivatives in comparison to other assets or securities. Further, it
is possible to combine them to match specific, i.e., they are more easily amenable
to financial engineering.

8. Secondary market instruments: Derivatives are mostly secondary market

instruments and have little usefulness in mobilizing fresh capital by the corporate
world, however, warrants and convertibles are exception in this respect.

9. Exposure to risk: Although in the market, the standardized, general and

exchange-traded derivatives are being increasingly evolved, however, still there
are so many privately negotiated customized, over the counter (OTC) traded
derivatives are in existence. They expose the trading parties to operational risk,
counter-party risk and legal risk. Further, there may also be uncertainty about the
regulatory status of such derivatives.

[Link] balance sheet item: Finally, the derivative instruments, sometimes,

because of their off-balance sheet nature, can be used to clear up the balance

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
sheet. For example, a fund manager who is restricted from taking particular
School of Distance Education Financial Derivatives Page 10 currency can buy a
structured note whose coupon is tied to the performance of a particular currency
pair.

TYPES OF FINANCIAL DERIVATIVES

One form of classification of derivative instruments is between commodity

derivatives and financial derivatives. The basic difference between these is the
nature of the underlying instrument or asset. In a commodity derivative, the
underlying instrument is a commodity which may be wheat, cotton, pepper, sugar,
jute, turmeric, corn, soyabeans, crude oil, natural gas, gold, silver, copper and so
on. In a financial derivative, the underlying instrument may be treasury bills,
stocks, bonds, foreign exchange, stock index, gilt-edged securities, cost of living
index, etc. It is to be noted that financial derivative is fairly standard and there are
no quality issues whereas in commodity derivative, the quality may be the
underlying matter. However, despite the distinction between these two from
structure and functioning point of view, both are almost similar in nature. The
most commonly used derivatives contracts are forwards, futures and options.

Forwards: A forward contract is a customised contract between two entities,

where settlement takes place on a specific date in the future at today’s pre-agreed
price. For Derivatives Financial Commodity Basic Complex Forward Futures
Option Warrants & Convertibles Swaps Exotics School of Distance Education
Financial Derivatives Page 11 example, an Indian car manufacturer buys auto
parts from a Japanese car maker with payment of one million yen due in 60 days.
The importer in India is short of yen and suppose present price of yen is Rs. 68.
Over the next 60 days, yen may rise to Rs. 70. The importer can hedge this
exchange risk by negotiating a 60 days forward contract with a bank at a price of
Rs. 70. According to forward contract, in 60 days the bank will give the importer
one million yen and importer will give the banks 70 million rupees to bank.
Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,
Amrita Vishwa Vidyapeetham.
Futures: A futures contract is an agreement between two parties to buy or sell an
asset at a certain time in the future at a certain price. Futures contracts are special
types of forward contracts in the sense that the former are standardised exchange-
traded contracts. A speculator expects an increase in price of gold from current
future prices of Rs. 9000 per 10 gm. The market lot is 1 kg and he buys one lot
of future gold (9000 × 100) Rs. 9,00,000. Assuming that there is 10% margin
money requirement and 10%increase occur in price of gold. the value of
transaction will also increase i.e. Rs. 9900 per 10 gm and total value will be Rs.
9,90,000. In other words, the speculator earns Rs. 90,000.

Options: Options are of two types– calls and puts. Calls give the buyer the right
but not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date. Puts give the buyer the right, but not the
obligation to sell a given quantity of the underlying asset at a given price on or
before a given date.

Warrants: Options generally have lives of upto one year, the majority of options
traded on options exchanges having maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
Leaps: The acronym LEAPS means long term equity anticipation securities.
These are options having a maturity of upto three years.

Baskets: Basket options are options on portfolios of underlying assets. The index
options are a form of basket options.

Swaps: Swaps are private agreements between two parties to exchange cash
flows in the future according to a prearranged formula. They can be regarded as
portfolios of forward contracts. The two commonly used swaps are:

•Interest rate swaps: These entail swapping only the interest related cash flows
between the parties in the same currency

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
•Currency Swaps: These entail swapping both principal and interest on different
currency than those in the opposite direction.

Swaptions: Swaptions are options to buy or sell a swap that will become
operative at the expiry of the options. Thus a swaptions is an option on a forward
swap. Rather than have calls and puts, the swaptions market has receiver
swaptions and payer swaptions. A receiver swaption is an option to receive fixed
and pay floating. A payer swaption is an option to pay fixed and receive floating.-

USES OF DERIVATIVES

Derivatives are supposed to provide the following services:

1. Risk aversion tools: 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. Prediction of future prices: 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. Enhance liquidity: 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

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
such markets. So, derivatives trading enhance liquidity and reduce transaction
costs in the markets for underlying assets.

4. Assist investors: 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. Integration of price structure: 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. Catalyse growth of financial markets: 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. Brings perfection in market: Lastly, it is observed that derivatives trading

develops the market towards ‘complete markets’. Complete market concept refers
to that situation where no particular investors can be better off 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.

COMMON MYTHS ABOUT DERIVATIVES

Several misconceptions surround derivatives, including:

 "Derivatives are Gambling": While derivatives can be used for

speculative purposes, they are primarily risk management tools. Many
businesses use derivatives responsibly to hedge against risks and protect
their cash flows.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
  "Derivatives Are Only for Large Corporations": While derivatives
have traditionally been associated with large corporations and financial
institutions, they are also accessible to individual investors. Exchanges
have introduced retail-oriented products, like options on individual stocks.

 "Derivatives Caused the Financial Crisis": Derivatives like mortgage-

backed securities (MBS) and collateralized debt obligations (CDOs)
played a role in the 2008 crisis, but it was the misuse and lack of regulation,
rather than the existence of derivatives themselves, that led to systemic
risks.

 "Derivatives Always Increase Risk": When used properly, derivatives

reduce risk. For instance, they can stabilize prices for raw materials or
currencies and help balance the financial exposure of businesses.

CRITICS AND CRITICISMS OF DERIVATIVES

Despite their benefits, derivatives face significant criticism:

 Complexity and Lack of Transparency: Many derivatives are highly

complex, and pricing models are intricate, leading to difficulty in
understanding and evaluating these products. This complexity increases
the risk of misuse and mispricing.

 Counterparty Risk: In OTC (over-the-counter) derivatives, there is a risk

that one party might default, as transactions are not standardized or cleared
through an exchange.

 Systemic Risk: The use of derivatives on a massive scale and the

interconnection of global financial institutions can lead to systemic risk.
The 2008 financial crisis illustrated this, where default on mortgage-
backed securities led to widespread economic fallout.

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.
  Speculation Leading to Market Instability: Speculative activities,
especially those involving highly leveraged derivatives, can lead to price
volatility and market instability.

 Lack of Regulation: In unregulated or poorly regulated markets, such as

certain OTC derivatives, the lack of oversight can lead to fraud and other
malpractices.

REFERENCES:

[Link]

[Link]
derivative

[Link]
%20Financial%20Derivatives_0.pdf

Tanushree A, Faculty Associate, AHEAD-Online, Department of Commerce,

Amrita Vishwa Vidyapeetham.