Financial Derivative

Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right. Transactions in financial derivatives should be treated as separate transactions rather than as integral parts of the value of underlying transactions to which they may be linked. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt instruments, no principal amount is advanced to be repaid and no investment income accrues. Financial derivatives are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation. Financial derivatives enable parties to trade specific financial risks (such as interest rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other entities who are more willing, or better suited, to take or manage these riskstypically, but not always, without trading in a primary asset or commodity. The risk embodied in a derivatives contract can be traded either by trading the contract itself, such as with options, or by creating a new Financial derivatives are financial instruments that are linked to a specific financial instrument or indicator or commodity, and through which specific financial risks can be traded in financial markets in their own right. Transactions in financial derivatives should be treated as separate transactions rather than as integral parts of the value of underlying transactions to which they may be linked. The value of a financial derivative derives from the price of an underlying item, such as an asset or index. Unlike debt instruments, no principal amount is advanced to be repaid and no investment income accrues. Financial derivatives are used for a number of purposes including risk management, hedging, arbitrage between markets, and speculation.

Contract which embodies risk characteristics that match, in a countervailing manner, those of the existing contract owned. This latter is termed offsetability, and occurs in forward markets. Offsetability means that it will often be possible to eliminate the risk associated with the derivative by creating a new, but "reverse", contract that has characteristics that countervail the risk of the first derivative. Buying the new derivative is the functional equivalent of selling the first derivative, as the result is the elimination of risk. The ability to replace the risk on the market is therefore considered the equivalent of tradability in demonstrating value. The outlay that would be required to replace the existing derivative contract represents its valueactual offsetting is not required to demonstrate value. Financial derivatives contracts are usually settled by net payments of cash. This often occurs before maturity for exchange traded contracts such as commodity futures. Cash settlement is a logical consequence of the use of financial derivatives to trade risk independently of ownership of an underlying item. However, some financial derivative contracts, particularly involving foreign currency, are associated with transactions in the underlying item.

Advantages of Derivatives: 1. They help in transferring risks from risk adverse people to risk oriented people. 2. They help in the discovery of future as well as current prices. 3. They catalyze entrepreneurial activity. 4. They increase the volume traded in markets because of participation of risk adverse people in greater numbers. 5. They increase savings and investment in the long run.

Types of Derivative Instruments

Derivative contracts are of several types. The most common types are forwards, futures, options and swap.

Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to purchase or sell something at a later date at a price agreed upon today. Forward contracts, sometimes called forward commitments , are very common in everyone life. Any type of contractual agreement that calls for the future purchase of a good or service at a price agreed upon today and without the right of cancellation is a forward contract.

Future Contracts
A futures contract is an agreement between two parties a buyer and a seller to buy or sell something at a future date. The contact trades on a futures exchange and is subject to a daily settlement procedure. Future contracts evolved out of forward contracts and possess many of the same characteristics. Unlike forward contracts, futures contracts trade on organized exchanges, called future markets. Future contacts also differ from forward contacts in that they are subject to a daily settlement procedure. In the daily settlement, investors who incur losses pay them every day to investors who make profits.

There are different types of futures: 1. Index futures - underlying financial instruments are well-known indices. Index futures were first created in the U.S. 1982. They are useful for investors who prefer to work with trend movement of market and not to analyze every stock particular - they bet on the market. 2. Stock futures - give the owner the right to buy or sell a single stock on a particular day in the future on predefined price. 3. Interest rate futures - are effective for protection against the risk of interest rates. Owner usually waits for the delivery of physical assets (bonds). Interest rate futures are basically a fixed-yield instruments such as short-term government bonds (known as T-bills), long-term bonds, eurodollar deposit certificates. 4. Currency futures - are contracts to buy the world's currencies in the future in standardized volumes. Their most important function is protection from non wanted currency fluctuations (hedging), but speculators also often use them.

Options Contracts
Options are contracts that give the owner the right, but not the obligation to buy or sell specific assets (underlying securities) at predefined price - strike price on the expiration date of contract. The buyer is obliged to pay the seller the amount of money that represents the cost of options (known as option price), which is also called a premium. If the option gives the owner the opportunity to buy assets, this option is called "call", otherwise it is a called "put" option.

According to the date of expiration, there are two types of options: American type and European type. These two types of options have nothing to do with geographical use, but with the way how they are traded. American type option allows the holder to execute option on any day until the date of expiration, while European type allows execution strictly on the day of expiration. With the American type option, if the holder does not execute option until the expiration date (including expiration date), the option becomes void. Each option contract must contain the following elements: - Type of contract (sales or buy) - Type of option (American or European) - Underlying security - Unit of trading - Strike price - Expiration date of the contract There are three prices essential for options: the price of underlying security, premium and strike price. The premium is the price that the buyer pays to the option holder. In case of call option premium price represents the maximum amount that the buyer can lose if he does not use the option, or the maximum profit that the seller can achieve. If the buyer executes the call option, the seller is obliged to deliver to him the underlying security at the strike price.

Strike price is the price of the contract used for buying or selling underlying security at the date of maturity. It is a constant and does not change the whole period of validity of an option contract. If the strike price of the call option is less than market price, or greater in case of put option, the option is said to be "in the money", otherwise it is "out of the money". In special case when strike price and market price are the same, option is "at the money".

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 and currency swaps. 1. Interest rate swaps: These involve swapping only the interest related cash flows between the parties in the same currency. 2. Currency swaps: These entail swapping both principal and interest between the parties, with the cash flows in one direction being in a different currency than those in the opposite direction.

Warrants
Warrants are long term options with three to seven years of expiration. In contrast, stock options have a maximum life of nine months. Warrants are issued by companies as a means of raising finance with no initial servicing costs, such as divided or interest. They are like a call option on the stock of the issuing firm. A warrant is a security with a market price of its own that can be converted into a specific share which leads at a predetermined price and date. If warrants are exercised, the issuing firm has to create a new share which leads to a dilution of ownership. Warrants are sweeteners attached to bonds to

make these bonds more attractive to the investor. Most of the warrants are detachable and can be traded in their own right or separately. Warrants are also available on stock indices and currencies.

Distinctive Features of Derivatives Market

1. The derivatives market is like any other market. 2. It is a highly leveraged market in the sense that loss/profit can be magnified compared to the initial margin. The investor pays only a fraction of the investment amount to take an exposure. The investor can take large positions even when he does not hold the underlying security. 3. Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the market view. Derivatives are double edged swords. 4. Derivatives contracts have a definite lifespan or a fixed expiration date. 5. The derivatives market is the only market where an investor can go long and short on the same asset at the same time. 6. Derivatives carry risks that stocks do not. A stock loses its value in extreme circumstances, whole an option loses its entire value if it is not exercised.

SEBI Guidelines
SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House to ensure that Derivative Exchange/Segment and Clearing Corporation/House provide a transparent trading environment, safety and integrity and provide facilities for redressal of investor grievances. Some of the important eligibility conditions are: 1. Derivative trading to take place through an on-line screen based Trading System. 2. The Derivatives Exchange/Segment shall have on-line surveillance capability to monitor positions, prices, and volumes on a real time basis so as to deter market manipulation. 3. The Derivatives Exchange/ Segment should have arrangements for dissemination of information about trades, quantities and quotes on a real time basis through at least two information vending networks, which are easily accessible to investors across the country. 4. The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country. 5. The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.

6. The Derivative Segment of the Exchange would have a separate Investor Protection Fund. 7. The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counterparty to both or alternatively should provide an unconditional guarantee for settlement of all trades. 8. The Clearing Corporation/House shall have the capacity to monitor the overall position of Members across both derivatives market and the underlying securities market for those Members who are participating in both. 9. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the position. The concept of value-at-risk shall be used in calculating required level of initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99 per cent of the days. 10. 11. The Clearing Corporation/House shall establish facilities for electronic In the event of a Member defaulting in meeting its liabilities, the Clearing funds transfer (EFT) for swift movement of margin payments. Corporation/House shall transfer client positions and assets to another solvent Member or close-out all open positions. 12. The Clearing Corporation/House should have capabilities to segregate initial margins deposited by Clearing Members for trades on their own account and on account of his client. The Clearing Corporation/House shall hold the clients margin money in trust for the client purposes only and should not allow its diversion for any other purpose. 13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivative Exchange/Segment.

SEBI has specified measures to enhance protection of the rights of investors in the Derivative Market. These measures are as follows: 1. Investors money has to be kept separate at all levels and is permitted to be used only against the liability of the Investor and is not available to the trading member or clearing member or even any other investor. 2. The Trading Member is required to provide every investor with a risk disclosure document which will disclose the risks associated with the derivatives trading so that investors can take a conscious decision to trade in derivatives. 3. Investor would get the contract note duly time stamped for receipt of the order and execution of the order. The order will be executed with the identity of the client and without client ID order will not be accepted by the system. The investor could also demand the trade confirmation slip with his ID in support of the contract note. This will protect him from the risk of price favour, if any, extended by the Member. 4. In the derivative markets all money paid by the Investor towards margins on all open positions is kept in trust with the Clearing House /Clearing Corporation and in the event of default of the Trading or Clearing Member the amounts paid by the client towards margins are segregated and not utilised towards the default of the member. However, in the event of a default of a member, losses suffered by the Investor, if any, on settled/closed out position are compensated from the Investor Protection Fund, as per the rules, bye-laws and regulations of the derivative segment of the exchanges.