INTRODUCTION

Derivatives are tradable products whose price is based upon another market.Derivatives are security
whose value is based upon other more basic underlying variables.In contrast to the market for assets
,derivative markets are markets for contractual instruments whose performance is determined by the
way in which another instrument or asset performs.

For Example:
A rubber cultivator whose rubber is not ready yet ready for sale.He expects to sell in 3 months
time.Since he is uncertain about about the price of rubber at the time of sale in future ,as rubber
prices are fluctuating.HE may incur a loss if the price declines in the future.Thus,he is exposed to
risk on account of the fluctuations in rubber prices.Since he will try to avoid the risk i.e the
possibility of incurring a loss on account of fluctuations in asset prices.This can be done by
“locking in” a specific price for the rubber to be solad in the future,through a suitable
agreement.Such an agreement is a derivative.
Now if the current market price of rubber is Rs.20/kg,the rubber cultivator may enter into an
agreement to sell rubber after 3 months at a price close to the current market price i.e 19 /kg.This is
derivative.The structure of the agreement may vary producing different types of derivatives such as
forwards,futures and options..

From the above example,it can be understood that a derivative is used to hedge the risk involved in
buying and selling a specific asset such as rubber in the above example.Thus derivative has an
underlying asset whose risk is being hedged through the derivative.The agreement used for hedging
the risk of an asset is termed as derivative because it is derived from the underlying asset.A
derivative has no existence without an underlying asset.IT is the need to hedge the risk of an
underlying asset that creates a derivative.

Derivatives are designed to provide protection to participants in commodity markets and financial
markets against adverse movements in the prices of underlying assets.They facilitate the exchange
of physical and financial assets in future at prices determined in the present.Derivatives enable the
participants to “ock in” a particular price for the asset to be exchanged in the future.This effectively
guards against the uncertainities arisisng out of fluctuations in asset prices.

CHARACTERISTICS OF DERIVATIVES

1. Legally binding Agreements or contracts

2.Contracts are structured and operationalized differently
3.Complex Structure
4.Usefool Tools of risk management

FUNCTIONS OF DERIVATIVES

1.Management of risk by hedging

2.Reduce transaction costs as it is easier to buy and sell in the forward market market than in the
cash market.
3.Lower transaction costs often lead to higher liquidity in the derivative market.
4.By reducing transaction costs and increasing liquidity derivatives market improve price discovery
and lead to more accurate prices in the cash market.This leads to better economic decisions.
5.Derivatives increases the attractiveness of the underlying asset by increasing its liquidity and by
allowing its risk to be hedged.
6.In many markets ,it has been found that the existence of derivative markets leads to lower
volatility.This is due to better price discovery as well as a broader investor base.
TYPES OF DERIVATIVES
Based on the type of underlying assets,derivatives are into two major classes namely commodity
derivatives and financial derivatives.Commodity Derivatives have commodities as underlying assets
while financial derivatives have financial assets as underlying assets.Based on the structuring and
operationalizing mode of the agreements,derivatives are classified into different types :

•Forwards
A forward contract is one of the oldest and simplest derivative contracts.''It is an agreement to buy
and sell an asset at a certain future time for a certain price”It is purchase or sale transaction in which
the price and other terms have been agreed upon,but the delievery and payment are postponed to a
later date.

Features of Forward Contracts

1)Bilateral agreement whose terms are negotiated and agreed upon between two parties.
2)Transacted over the counter
3)Both parties know each other
4)The forward contract has to be executed by both the parties on the due date or the specified
maturity date.

•Futures
A futures contract is also an agreement between two parties to buy and sell an asset at a specified
time in the future for a specified price.

Features of Futures Contracts

1)Transacted through a exchange

2)Standardized agreement where the terms of the agreement are specified by the exchange.
3)Exchange guarantees and ensures the execution of the contract by both the parties.
4)The delivery price known as the futures price is determined at the exchange by the demand and
supply forces.
5)Provision of cash settlement through a reverse trade.

•Options
Options are agreements which give the right to buy or sell the underlying asset for a specified price
within a specified date.There are two types of options:
1)A call option gives the holder the right to buy the underlying asset by a certain date for a certain
price.
2)A put option gives the holder the right to sell the underlying asset by a certain date for a certain
price.

Features of Options Contracts

1)Options are purchased by paying option premium.

2)Options are used to make short term profits.
3)Used as a tool for hedging

•Swaps
A swap is an agreement to the future exchange of cash flows.''Swaps are private agreements
between two companies to exchange cash flows in the future “.

Features of Swaps
1)Flexible Instrument
2)Over the Counter Derivatives
3)Used for hedging the risk arising from fluctuations in interest rates as well as for reducing the
interest cost of borrowing.
4)Currency swaps are used to hedge the exchange rate risk involved in foreign currency
borrowings.
5)Coupan swaps help in converting fixed interest loans into floating interest rate loans.

Types of Traders

1)Hedgers
Hedgers are market partcipants who are exposed to risk on acccount of fluctuations in the prices of
certain assets.Hedgers trade in derivatives to hedge their exposure and eliminate the loss likely to
arise from adverse movements in prices of the underlying asset.
2)Speculators
Speculators are market participants who have no economic interest in the underlying asset but in
their price movements.Speculators try to book profit by creating short position and long position in
the underlying asset by buying or selling a futures contract.
3)Arbitrageurs
Arbitrageurs are profit seekers.They attempt to derive profit from differences in prices of an asset in
two different markets.They operate in the derivatives market to exploit discrepancies in the prices
of derivative securities.

EVOLUTION OF DERIVATIVES

1)The first modern organized futures exchange was chicago board of trade(CBOT) established in
North America in 1848.
2)This exchange was started to facilitate futures trading in grains.
3)New York cotton Exchange was established in 1870.
4)New york Coffe Exchange was set up in 1885.
5)After Chicago Board of trade other organized derivatives markets were established in U.S
including Chicago Mercantile Exchange(CME) and The New York Mercantile Exchange and the
chicago board options exchange.
6)Agricultural futures dominated the first 100 years of derivatives trading.
7)Financial derivatives were introduced in 1970s
8)In 1972 ,the chicago Mercantile exchange created International Monetary Market and started
trading in Currency futures.
9)In 1975,Chicago Board of Trade created first interest rate futures contract.
10)In April 1973,the chicago Board options exchange was set for options trading
11)In 1982 ,the Kansas city board of trade launched the first stock index futures
12)IN 1983 CBOE 100(Currently known as S& P 100) was created on Chicago Board options
Exchange.

EVOLUTION OF DERIVATIVES IN INDIA

1)The first organised market was established in 1875 by Bombay Cotton Trade Association to trade
in cotton contracts.
2)IN 1900 trading was started in oilseeds by gujrat vyapari mandali in Mumbai
3)In 1919 futures trading in raw jute was started in calcutta hessian exchange ltd.
4)Nationwide Multi commodity exchange of India limited started futures trading in 24 commodities
on November 26,2002
5)Multi Commodity Exchange of India ltd was established in November 2003.
6)Nationbal commodity and derivatives exchange limited ( COMMENCED OPERATIONS IN
DECEMBER 2003NCDEX)
7)Exchange traded financial derivatives started in June 2000
8)Trading in index options atarted in june 2001
9)Trading in stock futures july 2001
10)Trading in currency futures in 2008