ASSIGNMENT
Course Name: Financial Derivatives
Module 1: Introduction
1. Write types of Derivatives?
Derivatives are financial instruments whose value is derived from an underlying asset such as
stocks, commodities, currencies, interest rates, or indices. Based on structure and trading
methods, derivatives are broadly classified into the following types:
a) Forwards Contracts
A forward contract is a customized, over-the-counter (OTC) agreement between two parties to
buy or sell an asset at a predetermined price on a future date. These are not traded on exchanges
and have higher counterparty risk.
b) Futures Contracts
Futures are standardized contracts traded on exchanges that obligate the buyer to purchase, and
the seller to sell, the underlying asset at a set price on a specified future date. These are marked-
to-market daily, reducing credit risk.
c) Options Contracts
Options give the holder the right, but not the obligation, to buy (call option) or sell (put option)
an asset at a predetermined price before or on a specific date. The seller of the option, however,
has the obligation to fulfill the contract if exercised.
d) Swaps
Swaps are OTC contracts in which two parties exchange cash flows or financial instruments. The
most common types are interest rate swaps and currency swaps. These are typically used for
hedging interest rate or currency exposure.
e) Credit Derivatives
These are contracts that transfer credit risk from one party to another without transferring the
underlying asset. The most common type is the Credit Default Swap (CDS), used to hedge
against or speculate on the creditworthiness of a borrower.
2. Explain Popular Derivative Instruments?
Several derivative instruments have gained prominence in financial markets due to their
effectiveness in hedging and speculation. Some of the most widely used instruments include:
a) Index Futures and Options
These derivatives derive value from a stock market index like the Nifty 50 or S&P 500. They
allow investors to hedge against or speculate on the movements of the entire market rather than
individual stocks.
b) Stock Futures and Options
These are contracts on individual stocks where investors bet on price movements. They’re
popular among retail and institutional investors for both speculation and risk management.
c) Currency Futures and Options
These instruments are used to hedge or speculate on currency exchange rate fluctuations. They
are particularly useful for exporters, importers, and investors with foreign currency exposure.
d) Commodity Derivatives
These include futures and options contracts on physical commodities like gold, crude oil, natural
gas, or agricultural products. They are used by producers and consumers to hedge price risks and
by traders to profit from price movements.
e) Interest Rate Derivatives
These are based on interest rate movements. Products like interest rate swaps help businesses and
governments manage fluctuations in borrowing costs.
3. Describe Evolution of derivatives?
The history and development of derivatives can be traced through several stages:
Ancient Period
• The concept of derivatives is not new. It dates back to ancient civilizations
like Mesopotamia (around 2000 BC), where farmers and merchants would agree on
future prices for commodities.
• Aristotle mentioned options-like contracts in his writings around 350 BC.
Middle Ages
• In Europe, especially in Holland and Italy, forward contracts were used for
trade in commodities such as spices and grains.
• Amsterdam became a hub for sophisticated commodity trading using
forward contracts.
Modern Era
• The Chicago Board of Trade (CBOT) was established in 1848 to create
standardized futures contracts, starting with agricultural commodities like corn and
wheat.
• Later in the 20th century, financial derivatives emerged, with instruments
based on interest rates, currencies, and equity indices.
Recent Developments
• The 1970s saw the introduction of options trading on organized
exchanges like the Chicago Board Options Exchange (CBOE).
• The Black-Scholes model (1973) provided a theoretical framework for
pricing options, boosting the growth of the options market.
• In the 1990s and 2000s, the market expanded globally with the
introduction of electronic trading platforms.
• The 2008 financial crisis highlighted the risks associated with unregulated
derivative trading, leading to global regulatory reforms.
4. Explain Derivatives in India?
The Indian derivatives market has undergone a major transformation over the past two decades.
Here's a detailed look at its development:
a) Initial Phase (Before 2000)
• Derivatives trading in India was largely informal and occurred through
forward contracts in the OTC markets.
• There was no legal or regulatory framework in place, and such contracts
were not recognized by law.
b) Regulatory Framework
• The Securities Contracts (Regulation) Act, 1956 was amended in 1999
to recognize derivatives as legal financial instruments.
• The Securities and Exchange Board of India (SEBI) was made the
regulator for derivatives markets.
c) Launch of Derivative Trading
• In June 2000, NSE introduced index futures on Nifty 50, marking the
beginning of derivatives trading in India.
• It was soon followed by index options, stock options (2001), and stock
futures (2001).
• The Bombay Stock Exchange (BSE) also began offering derivatives
trading in 2001.
d) Growth and Popularity
• Over the years, India has become one of the largest markets for derivatives
globally, particularly in terms of equity derivatives volume.
• Currency derivatives and commodity derivatives (under MCX and
NCDEX) have also seen robust growth.
e) Recent Trends
• Introduction of weekly options, long-dated options, and F&O contracts
on more stocks.
• Increased participation from retail investors, foreign portfolio investors
(FPIs), and domestic institutions.
• SEBI has introduced stricter regulations to curb excessive speculation and
protect investors.
5. Write Features of financial derivatives?
Financial derivatives have several defining characteristics that make them essential tools in
modern finance. Key features include:
a) Underlying Asset
• All derivatives derive their value from an underlying asset, such as a stock,
index, commodity, interest rate, or currency.
b) Leverage
• Derivatives allow investors to gain large exposure with a relatively small
initial investment (margin). This leverage magnifies both gains and losses.
c) Risk Management
• Derivatives are widely used for hedging against various types of risks—
price risk, interest rate risk, currency risk, and credit risk.
d) Speculation
• Apart from hedging, derivatives are also used for speculative purposes,
where traders try to profit from anticipated price movements.
e) Liquidity
• Many derivatives, especially exchange-traded ones like futures and
options, are highly liquid and offer easy entry and exit.
f) Standardization
• Exchange-traded derivatives are standardized in terms of contract size,
expiration, and settlement procedures, which enhances transparency.
g) Regulation
• Derivative markets are regulated by entities like SEBI (India), CFTC
(USA), etc., to ensure fairness, transparency, and to minimize systemic risk.
h) Margin Requirements
• Trading in derivatives often requires maintaining a margin (initial and
maintenance), which is monitored daily through mark-to-market processes.
i) Settlement Mechanisms
• Derivatives can be settled through physical delivery or cash settlement,
depending on the contract specifications.