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The history of derivatives is surprisingly longer than what most people think. Some texts even
find the existence of the characteristics of derivative contracts in incidents of Mahabharata.
Traces of derivative contracts can even be found in incidents that date back to the ages before
Jesus Christ.

However, the advent of modern day derivative contracts is attributed to the need for farmers to
protect themselves from any decline in the price of their crops due to delayed monsoon, or

The first 'futures' contracts can be traced to the Yodoya rice market in Osaka, Japan around 1650.
These were evidently standardized contracts, which made them much like today's futures.

The Chicago Board of Trade (CBOT), the largest derivative exchange in the world, was
established in 1848 where forward contracts on various commodities were standardized around
1865. From then on, futures contracts have remained more or less in the same form, as we know
them today.

In finance, a derivative is a financial instrument whose value depends on other, more basic,
underlying variables. Such variables can be the price of another financial instrument
(the underlying asset, interest rates, volatilities, indices, etc. There are many kinds of derivatives,
with the most common being swaps, futures, and options. Derivatives are a form of alternative
A derivative is not a stand-alone asset, since it has no value of its own. However, more common
types of derivatives have been traded on markets before their expiration date as if they were
assets. Among the oldest of these are rice futures, which have been traded on the Dojima Rice
Exchange since the eighteenth century.

Derivatives are becoming increasingly important in world markets as a tool for risk management.
Derivatives instruments can be used to minimize risk. Derivatives are used to separate the risks
and transfer them to parties willing to bear these risks. The kind of hedging that can be obtained
by using derivatives in cheaper and more convenient than what could be obtained by using cash
instruments. It is so because, when we use derivatives for hedging, actual delivery of the
underlying asset is not at all essential for settlement purposes. The profit or loss on derivatives
deal alone is adjusted in the derivative market.

Moreover, derivatives do not create any new risk. They simply manipulate risks and transfer
them to those who are willing to bear these risks. To cite a common example, let us assume that
Mr. X owns a car. If he does not take an insurance, he runs a big risk. Suppose he buys an
insurance, (a derivative instrument on the car) he reduces his risk. Thus, having an insurance
policy reduces the risk of owing a car. Similarly, hedging through derivatives reduces the risk of
owning a specified asset which may be a share, currency etc.

Hedging risk through derivatives is not similar to speculation. The gain or loss on a derivative
deal is likely to be offset by an equivalent loss or gain in the values of underlying assets.
µOffsetting of risk¶ in an important property of hedging transactions. But, in speculation one
deliberately takes up a risk openly. When companies know well that they have to face risk in
possessing assets, it is better to transfer these risks to those who are ready to bear them. So, they
have to necessarily go for derivative instruments.
All derivative instruments are very simple to operate. Treasury managers and portfolio managers
can hedge all risks without going through the tedious process of hedging each day and
amount/share separately.

Till recently, it may not have been possible for companies to hedge their long term risk, say 10-
15 year risk. But with the rapid development of the derivative markets, now, it is possible to
cover such risks through derivative instruments like swap. Thus, the availability of advanced
derivatives market enables companies to concentrate on those management decisions other than
funding decisions.

Further, all derivative products are low cost products. Companies can hedge a substantial portion
of their balance sheet exposure, with a low margin requirement.
Derivatives also offer high liquidity. Just as derivatives can be contracted easily, it is also
possible for companies to get out of position in case that market reacts otherwise. This also does
not involve much cost.

Thus, derivatives are not only desirable but also necessary to hedge the complex exposures and
volatilities that the companies generally face in the financial markets today.


The amount of outstanding derivatives worldwide as of December 2007 crossed USD 1,144
Trillion. The main categories of derivatives market were the following:

1.‘ *isted credit derivatives stood at USD 548 trillion;

2.‘ The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596
trillion and included:
a.‘ Interest Rate Derivatives at about USD 393+ trillion;
b.‘ Credit Default Swaps at about USD 58+ trillion;
c.‘ Foreign Exchange Derivatives at about USD 56+ trillion;
d.‘ Commodity Derivatives at about USD 9 trillion;
e.‘ Equity *inked Derivatives at about USD 8.5 trillion; and
f.‘ Unallocated Derivatives at about USD 71+ trillion.

When the first Credit Default Swap was created by a group of JP Morgan bankers in 1997, the
intention was to remove the credit risk from a balance sheet without touching the actual asset.
Derivatives made this very easy as it involved only two parties ± the "protection" seller and
buyer ± dealing directly with each other. But given this "over-the-counter" nature, the market
naturally grew as more market participants started to trade these CDS contracts outright.
The US market grew to about $57tn but the growth was largely due to the ability to trade CDS
contracts without actually owning the underlying asset they were "protecting". Even Warren
Buffett, who once referred to derivatives as "financial weapons of mass destruction" in a 2003
letter to shareholders, has been an active user of derivatives. According to his Q3 2008 earnings
statement, he reported losses in excess of $2bn seemingly on CDS contracts

Over-the-counter derivative contracts were only effective for so long as the two parties
themselves are operational. Buffett argued that unless these contracts were fully collateralized,
the ultimate value of these derivatives depended on the creditworthiness of the parties involved.
The worse the creditworthiness, the lower the value of the derivative. Not only does this explain
the enormous loss in value we have seen in derivative contracts today but it also shows how a
vicious cycle has formed. *osses all around lead to a deterioration in creditworthiness for
everyone, which leads to a further devaluation of derivatives contracts and more losses.
As financial engineering improved in the 1990s the individual loans were gathered into bundles,
for example 10,000 home loans of $100,000 each. It turned into a $1 billion security that could
be traded in ways the individual mortgages never could. But that wasn't enough. The financiers
realized they could boost their profits by carving the $1 billion package into different slices, with
different risk levels. In that way, a pool of B-rated mortgage assets could generate a slice that
was rated AAA, because it was judged the slice most likely to be repaid.

But what happened was that the people holding the paper could no longer be sure if or when their
particular slice would be repaid. The traditional accounting approach -- of estimating the
projected cash flow and then discounting for the risk -- didn't work. With 10,000 disparate
mortgages underlying the paper, both the rate of cash payments and the risk of default were
impossible to predict. So the credit pyramid of mortgages began to wobble and finally collapsed
in 2007. However the derivative market emerged almost unscratched from the whole economic
crisis that it caused.

The main problem with derivatives was that they were unregulated, not traded on any public
exchange, without universal standards, dealt with by private agreement, not transparent, have no
open bid/ask market, are unguaranteed, have no central clearing house, and are just not really

Now, the governments have put a control on derivative markets to avoid credit crunch like that
of 2007. Better regulation and oversight of these "over-the-counter" derivatives by creating a
central clearing house which acts as a central counterparty to all market participants. This not
only removes the counterparty risk between the two parties of a derivative trade, but it would
allow regulators to assess very quickly the net market exposure and risk that each and every
institution holds through derivative contracts. Some would go further by arguing all derivatives
should be traded on exchanges, like the main equity cash and futures markets, which would bring
further transparency, clarity and oversight.

Calls to bring an end to the derivatives markets, though, are premature. Ultimately, derivatives
provide a useful means by which market participants can transfer risk to those who are better
able to hold that risk on a micro level. It's the systemic risk that needs to be tackled.

In finance, a forward contract or simply a forward is a non-standardized contract between two
parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast
to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a
forward contract. The party agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes a short position. The price
agreed upon is called the delivery price, which is equal to the forward price at the time the
contract is entered into.

The forward price of such a contract is commonly contrasted with the spot price, which is the
price at which the asset changes hands on the spot date. The difference between the spot and the
forward price is the forward premium or forward discount, generally considered in the form of
a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or
exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality
of the underlying instrument which is time-sensitive.

A forward contract is an agreement between two parties to buy or sell a product at a certain
price, but the purchase is not taking place until a future date. When a product is being sold
immediately it is considered a spot contract. One advantage of a forward contract is that the
current or today price is what the purchaser pays regardless of whether the price increases before
the product changes hands. This can also be a disadvantage if the price happens to drop because
the price cannot be changed once the contract is signed.

- Can be written for any amount and term
- Offers a complete hedge

- Difficult to find a counterparty (no liquidity)
- Requires tying up capital
- Subject to default risk


In finance, a futures contract is a standardized contract between two parties to buy or sell a
specified asset (e.g. oranges, oil, gold) of standardized quantity and quality at a specified future
date at a price agreed today (the futures price or the strike price). The contracts are traded on
a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or
warrants. They are still securities, however, though they are a type of derivative contract. The
party agreeing to buy the underlying asset in the future assumes a long position, and the party
agreeing to sell the asset in the future assumes a short position.

The future date is called the delivery date or final settlement date. The official price of the
futures contract at the end of a day's trading session on the exchange is called the settlement
price for that day of business on the exchange.

A futures contract gives the holder the obligation to make or take delivery under the terms of the
contract, whereas an option grants the buyer the right, but not the obligation, to establish a
position previously held by the seller of the option. In other words, the owner of an options
contract may exercise the contract, but both parties of a "futures contract" must fulfill the
contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a
cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss
to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a
futures position has to offset his/her position by either selling a long position or buying back
(covering) a short position, effectively closing out the futures position and its contract

›‘ Standardization of contracts' parameters on a developed market leads to high liquidity.
›‘ With futures contracts, it is possible to open short as well as long positions in the same manner
and at the same costs.
›‘ If permitted by the respective exchange, there is a choice of several methods for closing a
›‘ Daily settlement of gains and losses provides for regular realization of gains, which the investors
may utilize.
›‘ *ots of liquidity
›‘ Position can be reversed easily
›‘ Doesn't tie up much capital

›‘ The leverage effect works in both directions and, therefore, makes trading in futures contracts
highly risky.

›‘ Daily settlement of gains and losses provides for regular realization of losses, for which reason
an investor must have a sufficient reserve so that his or her position will not be closed
›‘ Futures contracts involve the same risks as may be potentially involved in other investment
instruments, such as market and currency risk
›‘ Written for fixed amounts and terms
›‘ Offers only a partial hedge
›‘ Subject to basis risk (bond issuer can default)

In finance, an option is a derivative financial instrument that establishes a contract between two
parties concerning the buying or selling of an asset at a reference price. The buyer of the option
gains the right, but not the obligation, to engage in some specific transaction on the asset, while
the seller incurs the obligation to fulfill the transaction if so requested by the buyer. The price of
an option derives from the difference between the reference price and the value of
the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium
based on the time remaining until the expiration of the option. Other types of options exist, and
options can in principle be created for any type of valuable asset.
›‘ An option which conveys the right to buy something is called a call;
›‘ an option which conveys the right to sell is called a put.
›‘ The reference price at which the underlying may be traded is called the strike price or
exercise price.
›‘ The process of activating an option and thereby trading the underlying at the agreed-upon
price is referred to as exercising it.
›‘ Most options have an expiration date. If the option is not exercised by the expiration date,
it becomes void and worthless.
An option can usually be sold by its original buyer to another party. Many options are created in
standardized form and traded on an anonymous options exchange among the general public,
while other over-the-counter options are customized ad hoc to the desires of the buyer, usually
by an investment bank.


Flexibility. Options can be used in a wide variety of strategies, from conservative to high-risk,
and can be tailored to more expectations than simply "the stock will go up" or "the stock will go

*everage. An investor can gain leverage in a stock without committing to a trade.

*imited Risk. Risk is limited to the option premium (except when writing options for a security
that is not already owned).

Hedging. Options allow investors to protect their positions against price fluctuations when it is
not desirable to alter the underlying position.

›‘ *everage. Options allow you to employ considerable leverage. This is an advantage to

disciplined traders who know how to use leverage.

›‘ Risk/reward ratio. Some strategies, like buying options, allows you to have unlimited
upside with limited downside.

›‘ Unique Strategies. Options allow you to create unique strategies to take advantage of
different characteristics of the market - like volatility and time decay.

*ow capital requirements. Options allow you to take a position with very low capital
requirements. Someone can do a lot in the options market with $1,000 but not so much with
$1,000 in the stock market


Costs. The costs of trading options (including both commissions and the bid/ask spread) is
significantly higher on a percentage basis than trading the underlying stock, and these costs can
drastically eat into any profits.

*iquidity. With the vast array of different strike prices available, some will suffer from very low
liquidity making trading difficult.

Complexity. Options are very complex and require a great deal of observation and maintenance.

Time decay. The time-sensitive nature of options leads to the result that most options expire
worthless. This only applies to those traders that purchase options - those selling collect the
premium but with:

Unlimited Risk. Some option positions, such as writing uncovered options, are accompanied by
unlimited risk.

Overall Options present a good opportunity to formulate plans which can take advantage of
volatility in underlying markets as well as price direction. However for most traders the
disadvantages are significant and online futures trading is usually a better option.

Tim Welford runs Online Futures Trading, a website that provides information and resources for
traders. Tim also provides a free day trading system, the results of which are updated daily on the

›‘ *ower liquidity. Many individual stock options don't have much volume at all. The fact
that each option able stock will have options trading at different strike prices and
expirations means that the particular option you are trading will be very low volume
unless it is one of the most popular stocks or stock indexes. This lower liquidity won't
matter much to a small trader that is trading just 10 contracts though.

›‘ Higher spreads. Options tend to have higher spreads because of the lack of liquidity. This
means it will cost you more in indirect costs when doing an option trade because you will
be giving up the spread when you trade.

›‘ Higher commissions. Options trades will cost you more in commission per dollar
invested. These commissions may be even higher for spreads where you have to pay
commissions for both sides of the spread.

›‘ Complicated. Options are very complicated to beginners. Most beginners, and even some
advanced investors, think they understand them when they don't.

›‘ Time Decay. When buying options you lose the time value of the options as you hold
them. There are no exceptions to this rule.

›‘ *ess information. Options can be a pain when it is harder to get quotes or other standard
analytical information like the implied volatility.

›‘ Options not available for all stocks. Although options are available on a good number of
stocks, this still limits the number of possibilities available to you.