Derivatives Management

Meaning :

Financial derivatives are financial

instruments whose prices or values are
derived from the prices of other underlying
financial instruments or financial assets.
Definition:
The Securities Contracts(Regulation) Act 1956
defines,” derivative “ as under:
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
Characteristics:
★ A derivative instrument relates to the future contract
between 2 parties.
★ Derivative instruments have the value which derived from
the values of other underlying assets.
★ The counter parties have specified obligations under the
derivative contract.
★ The derivative contracts can be undertaken directly
between the 2 parties or through the particular exchange
like financial future contracts.
★ Derivatives are also known as deferred delivery or deferred
payment instrument.
★ Derivatives are mostly secondary market instruments and
have little usefulness in mobilizing fresh capital by the
 Basic Financial Complex Financial
Classification Derivatives Derivatives

Forwards Swaps

Futures

Options

Warrants and
convertibles
Forwards
 It is a simple customised contract between 2 parties to buy
or sell an asset at a certain time in the future for a certain
price.
 They are not traded on the stock exchange, rather traded in
the over-the –counter market, usually between two financial
institutions or between a financial institution and one of its
client.
Futures

 Like a forward 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 contract are normally
traded on an exchange which
sets the certain standardized
norms for trading in the futures
contract.
Options
 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 is known as option seller or option writer.
 The seller of the option for giving such an option to the buyer charges an amount which
is known as the option premium.

Shares
 Put option gives the
Put option holder the right to sell
Two types of an asset.

Options
Call option gives the
Call Option holder the right to buy an
asset.

The specified price in such a contract is

known as the exercise price or strike price.

The specified date in the contract is known

as expiration date or the exercise date or
the maturity date.

Options can be American or European. European

option can be exercised on the expiration date only
whereas an American option can be exercised at any
time before the maturity date.
 Spot
price
CIPLA Share= Rs. 750

Strike
Price

Owns 1000 Put option at Rs.800, in

shares next 2 months delivery
BSE
X
X will exercise the Put
Option premium is Rs. option if the price of
10 per share stock goes down below
Rs.790 and will not
exercise the option if the
price is more than
Rs.800 on the exercise
date.

2 months.
 Swaps

 It is an agreement between 2 counter parties to exchange cash flows in the future.

 Under the swap agreement, various terms like the dates when the cash flows are
to be paid, the currency in which to be paid and the mode of payment are
determined and finalized by the parties.
 Usually the calculations of cashflows involves the future values of one or more
market variables.

An interest rate swap is a type of a derivative contract Currency swap is an agreement between the
through which two counterparties agree to exchange two parties for exchanging notional amounts
one stream of future interest payments for another, in one currency with that of another currency
based on a specified principal amount. In most cases, and its interest rate can be fixed or floating
interest rate swaps include the exchange of a fixed rates denominated in two currencies. Such
interest rate for a floating rate agreements are valid for the specified period
only and could range up to a period of ten
years depending upon the terms and
conditions of the contract.
Warrants and Convertibles
● It gives investors a right to buy the underlying share, bond, or any other
security at a certain future date and at a specific price. However, investors
have no obligation to buy the underlying security at that time and at that
price. Moreover, if an investor decides to exercise the warrant, then they
need to pay the pre-decided money to buy the stock or security, or the
instrument. Many features of a warrant are the same as that of options.
● On the other hand, Convertibles give investors an option to convert bonds
or preferred stocks into common stock in the future again at a specified
date and price. Usually, companies that want to raise quick capital or do
not have access to traditional financing options use this type of security.
Participants or Traders in Derivatives

Hedgers Arbitrageurs
Speculators
Hedgers

● Hedge is a position taken in futures or any other markets for the

purpose of reducing exposure to one or more types of risks.
● A person who undertakes such position is called as hedger.
● In other words, a hedger uses futures markets to reduce risk caused
by the adverse movements in prices of securities, commodities,
exchange rates, interest rates, indices etc.
● The essence of the hedging strategy is the adoption of the future
position that, on average, generates profits when the market value
of the commitment is higher than the expected value.
Speculators

● A speculator may be defined as an investor who is willing to take a

risk by taking futures position with the expectation to earn profits.
● The speculator forecasts the future economic conditions and
decides which position (long or short) to be taken that will yield
profit if the forecast is realised.
● In short, speculators are the traders with clear profit objectives.
● They do not have any business interest, in hope of making gains
that are large enough to offset the risk, they are ready to take
bigger risks by betting on the likelihood of price movements.
Arbitrageurs

● An arbitrageur is a trader who attempts to make profits by locking

in a riskless trading by simultaneously entering into transactions in
two or more markets.
● They seek to earn profit from the difference in the price of security
by buying and selling them quickly in different markets.
● These traders aims to gain from mis-pricing of the instruments/
market mistakes.
● It occurs when the same product has different prices in different
markets.
Functions of Derivatives Market
1) Price discovery
2) Transfer of risk
3) Hedging risk
4) Lower transaction cost
5) Provide access to unavailable
assets and markets.
6) Higher leverage.
 Price discovery: Derivative contract helps in determining the prices of the
underlying assets. Future and forward contracts prices are used in
determining the future spot prices for the commodity. This way it is beneficial
in discovering the prices for underlying assets.
 Transfer of risks: Derivatives are used for transferring the risk from one party
to another that is buyer of a derivative product to the seller. It is an effective
risk management tool that transfers the risk from those having a low risk
appetite to those having a high risk appetite.
 Hedging risk: It helps in hedging risk against unfavourable price movements
of an underlying assets by entering into a forward contract, the buyer and
seller agrees to complete the deal at a pre-decided price at some specific
date in the future. Any unexpected price hikes or drop will not influence the
contract value, thereby providing protection against these types of risks.
 Lower transaction cost: The cost of trading in derivative instruments is
quite low as compared to other segments in financial markets. They act
as risk management tool and thereby lower the transaction costs of the
markets.
 Provide access to unavailable assets and markets: Derivatives enable
business in reaching out to hard to trade assets and markets.
Organizations with applications of interest rate swaps can obtain better
interest rates than available in the current market.
 Higher leverage: Derivatives instruments provide higher leverage than
any other instruments available in the financial market. Capital required
to take positions in derivative instruments is very low as compared to the
stock market. In case of a future contract, only 20-40% of the contract
value is needed whereas, in case of options, only the amount of premium
Evolution
❖ Forward trading has been in existence since 12th century in England and
France.
❖ Forward trading in rice was started in 17th century in Japan, known as Cho-
at-Mai concentrated around Dojima, in 1730 this market got official
recognition and became the first futures market with high degree of
standardization.
❖ The butter eggs dealers of Chicago joined hands in 1898 to form the
Chicago Mercantile Exchange for futures trading.
❖ The international Monetary market was formed as a division of the Chicago
Mercantile Exchange in 1972 for futures trading in foreign currencies .
❖ In 1982, it introduced a futures contract on the S&P 500 stock index.
❖ Many other exchanges throughout the world started trading in futures like
Chicago Rice and Cotton Exchange, New York Futures Exchange, London
International Financial Futures Exchange etc.
 ❖ In the 1980’s market developed for options in foreign exchange, options on stock
indices, and options on future contracts.
❖ The Philadelphia Stock Exchange is the premier exchange for trading foreign
exchange options.

Although financial derivatives have been in operation since long, but they have
become a major force in financial markets in the early 1970s. The basic reason
behind this development was the failure of Brettonwood system and the fixed
exchange rate regime was broken down. As a result, floating rate system based
upon market forces came into existence. But due to pressure of demand and
supply on different currencies, the exchange rates were constantly changing, as
a result, the business firms faced a new risk known as currency or foreign
exchange risk. Accordingly, a new financial instrument was developed to
overcome this risk in the the new financial environment .
Derivatives in India
● Commodities futures trading in India was initiated long back in 1950, however , the 1960s marked
a period of great decline in futures trading.
● Market after market was closed usually because different commodities prices increase were
attributed to speculation on these markets.
● Accordingly, the central government imposed the ban on trading in derivatives in 1969 under a
notification issue.
● The late 1990s showed trend of large scale-revival of futures markets in India, hence the Central
Govt revoked the ban on futures trading in 1995.
● The Civil Supplies Ministry agreed in principle for starting of futures trading in Basmati rice,
further, in 1996 the Government granted permission to the Indian Pepper and Spice Trade
Association to convert its Pepper Futures Exchange into an International Pepper Exchange.
● As such, on November 17, 1997, India’s first international futures exchange at Kochi, known as
the India Pepper and Spice Trade Association –International Commodity Exchange(IPSTA-ICE)
was established.
● Similarly, the Cochin Oil Millers Association, in June 1996, demanded the introduction
of futures trading in coconut oils. The Central Minister for Agriculture announced in
June 1996 that it is in favour of introduction of futures trading both domestic and
international.
● Further, a new coffee futures exchange was started in Bangalore.
● In August 1997, the Central Government proposed that Indian companies with
commodity price exposure should be allowd to use foreign future and option markets.
● RBI set up the Sodhani Expert Group which recommended major liberalization of the
forward exchange market and urged the setting up of a rupee-based derivatives in
financial instruments.
● SEBI appointed a committee named the Dr. L C Gupta Committee(LCGC) by its
resolution in order to develop appropriate regulatory framework for derivatives
trading in India.
● The Board of SEBI accepted the recommendations of the Dr. L C Gupta Committee
and approved the introduction of derivatives trading in India in the phased manner.
● In December 1999, the new framework has been approved and
derivatives have been accorded the status of ‘Securities”.
● In June 2000, the NSE and BSE started stock index based futures
trading in India.
Factors Contributing to the growth of Derivatives

● Price volatility.
● Globalisation of the market.
● Technological advances.
● advances in financial theories.
Price Volatility.

● Prices are generally determined by market forces. In a market, consumers have

‘demand’ and producers or suppliers have ‘supply’, and the collective interaction of
demand and supply in the market determines the price.
● These factors are constantly interacting in the market causing changes in the price
over a short period of time. Such changes in the price are known as ‘price volatility’..
● These price changes expose individuals, producing firms and governments to
significant risks. The break down of the BRETTON WOODS agreement brought an end
to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars.
● Even equity holders are exposed to price risk of corporate share fluctuates rapidly.
This price volatility risk pushed the use of derivatives like futures and options
increasingly as these instruments can be used as hedge to protect against adverse
price changes in commodity, foreign exchange, equity shares and bonds.
Globalisation of the Market

● Now globalization has increased the size of markets and as greatly enhanced
competition .it has benefited consumers who cannot obtain better quality goods at a
lower cost. It has also exposed the modern business to significant risks and, in many
cases, led to cut profit margins
● Steel industry in 1998 suffered its worst set back due to cheap import of steel from
south East Asian countries. Suddenly blue chip companies had turned in to red. The
fear of china devaluing its currency created instability in Indian exports. Thus, it is
evident that globalization of industrial and financial activities necessitates use of
derivatives to guard against future losses. This factor alone has contributed to the
growth of derivatives to a significant extent.
Technological Advance
● A significant growth of derivative instruments has been driven by technological break
through.
● Advances in this area include the development of high speed processors, network
systems and enhanced method of data entry. Closely related to advances in computer
technology are advances in telecommunications. Improvement in communications
allow for instantaneous world wide conferencing, Data transmission by satellite.
● At the same time there were significant advances in software programmed without
which computer and telecommunication advances would be meaningless. These
facilitated the more rapid movement of information and consequently its instantaneous
impact on market price.
● Derivatives can help a firm manage the price risk inherent in a market economy. To the
extent the technological developments increase volatility, derivatives and risk
management products become that much more important.
Advances in Financial Theories

● Advances in financial theories gave birth to derivatives. Initially forward

contracts in its traditional form, was the only hedging tool available.
● Option pricing models developed by Black and Scholes in 1973 were used to
determine prices of call and put options.
● In late 1970’s, work of Lewis Edeington extended the early work of Johnson
and started the hedging of financial price risks with financial futures.
● The work of economic theorists gave rise to new products for risk
management which led to the growth of derivatives in financial markets.
Regulations for Derivatives Trading
 SEBI set up a 24-member committee under the Chairmanship of
Dr L.C. Gupta to develop the appropriate regulatory framework for
derivatives trading in India.
 On May 11, 1998, SEBI accepted the recommendations of the
committee and approved the phased introduction of derivatives
trading in India beginning with stock index futures.
 The provisions in the Securities Contract (Regulation) Act, 1956 –
SC(R)A and the regulatory framework developed thereunder govern
trading in securities.
Derivatives Market in India can be broadly classified into 2 types:

Financial Commodities Futures

Derivatives Market Market

Regulated By
Regulated By

Forward Market
Commission (FMC)

SEBI RBI

Stock Exchange Over-the –

Counter (OTC)
Financial Derivatives Markets

 Financial derivatives markets in India are regulated and

controlled by the Securities and Exchange Board of India (SEBI).
 The SEBI is authorized under the SEBI Act to frame rules and
regulations for financial futures trading on the stock exchanges
with the objective to protect the interest of the investors in the
market.
 Further, carry forward trading (Badla trading) is also regulated by
the SEBI which is traded on the stock exchanges.
 Financial derivatives markets deal with the financial futures
instruments like stock futures, index futures, stock options, index
options, interest rate futures, currency forwards and futures,
financial swaps, etc.
 Some of the other financial derivatives like currency options and futures and interest rate
futures are controlled by the Reserve Bank of India (RBI).
 These are dealt with in Over-the-Counter (OTC) markets.
 Financial futures on interest rate include both the short-term interest rate and long-term
interest rate forwards.
 Since the RBI is the apex body to regulate currencies and interest rates in India, hence,
financial derivatives relating to foreign currencies and interest rates generally come under
the RBI regulation.

Commodities Futures Market

 Commodity Futures markets are regulated in India by the forwarding Market Commission
(FMC).
 The commission is entrusted with regulating commodities futures trading in India.
Products like potatoes, pepper, cotton, etc., are traded on Coimbatore Commodity
Exchange and Calcutta Commodity Exchange.
 Recently the Central Government has allowed futures trading on 54 new commodities of
different categories to be eligible for trading on exchanges .
SEBI Guidelines for Derivative Trading

 Any exchange fulfilling the eligibility criteria as prescribed in the L.C. Gupta committee report
may apply to SEBI for a grant of recognition under Section 4 of the SC(R)A, 1956 to start
trading derivatives.
 The derivatives exchange should have a separate governing council and representation of
trading/clearing members shall be limited to a maximum of 40% of the total members of the
governing council..
 The exchange shall have a minimum of 50 members.
 The members of an existing segment of the exchange will not automatically become members
of the derivative segment. The members of the derivative segment need to fulfill the eligibility
conditions as laid down by the L.C. Gupta committee.
 The clearing and settlement of derivatives trades shall be through a SEBI-
approved clearing corporation/house.
 Derivative brokers/dealers and clearing members are required to seek
registration from SEBI. This is in addition to their registration as brokers of
existing stock exchanges.
 The minimum net worth for clearing members of the derivatives clearing
corporation/house shall be ₹300 lakh.
 The minimum contract value shall not be less than ₹2 lakh. Exchanges should also submit
details of the futures contract they propose to introduce.
 The initial margin requirement, exposure limits linked to capital adequacy, and margin
demands related to the risk of loss on the position shall be prescribed by SEBI/Exchange
from time to time.
 The L.C. Gupta committee report requires strict enforcement of the “Know your customer”
rule and requires that every client shall be registered with the derivatives broker.
 Derivative trading to take place through an online screen-based Trading System.
 The Derivatives Exchange/Segment shall have online surveillance capability to monitor
positions, prices, and volumes on a real-time basis so as to deter market manipulation.
 The Derivatives Exchange/Segment should have a satisfactory system of monitoring
investor complaints and preventing irregularities in trading.
 The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.
Derivatives Market Growth and Development

 Financial derivatives in NSE and BSE in 2000

 Commodity derivatives started in MCX, NMCE and NCDEX in 2003.
 Index futures(2000) and index options(2001) as well as stock
futures and options(2001) are traded.
 Short-long term interest rate futures were introduced in 2003, but
withdrawn in 2006; in 2009 they were re-introduced.
 Currency futures introduced in 2008 and traded in NSE , BSE and
MCX.
 Interest rate swaps, currency swaps, forward rate agreements and
credit derivatives traded in the over-the –counter market.
● In India, derivatives market have been functioning since the 19th
century with organized trading in Cotton through the establishment of
Cotton Trade Association in 1875.
● Derivatives, as exchange traded financial instruments were
introduced in India in June 2000.(Nifty 50 index futures contract).
● First to be traded were futures contract on index.
● After this came, options on individual securities and index
● Futures contract on individual stocks were launched in November
2001.
● In 1999, the Securities Contract (Regulation ) Act of 1956, or SC(R)A,
was amended so that derivatives could be declared as “securities”.
● The Act considers derivatives on equities to be equal and valid, but
only if they are traded on exchanges.