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HISTORY OF DERIVATIVES Derivatives trading began in 1865 when Chicago Board Of Trade (CBOT) listed the first exchange

traded derivatives contract in USA. These contracts are called future contracts. In 1991 the first stock index future contract was trade at Kansas City Board Of Trade With the opening of the economy to multinationals and the adoption of the liberalized economic policies, the economy is driven more towards the free market economy. The complex nature of financial structuring itself involves the utilization of multi currency transactions. It exposes the clients, particularly corporate clients to various risks such as exchange rate risk, interest rate risk, economic risk and political risk. With the integration of the financial markets and free mobility of capital, risks also multiplied. For instance, when countries adopt floating exchange rates, they have to face risks due to fluctuations in the exchange rates. Deregulation of interest rate cause interest risks. Again, securitization has brought with it the risk of default or counter party risk. Apart from it, every assetwhether commodity or metal or share or currencyis subject to depreciation in its value. It may be due to certain inherent factors and external factors like the market condition, Governments policy, economic and political condition prevailing in the country and so on. In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial markets.

DERIVATIVES IN INDIA

In India, all attempts are being made to introduce derivative instruments in the capital market. The National Stock Exchange has been planning to introduce index-based futures. A stiff net worth criteria of Rs.7 to 10 corers cover is proposed for members who wish to enroll for such trading. But, it has not yet received the necessary permission from the securities and Exchange Board of India.

In the forex market, there are brighter chances of introducing derivatives on a large scale. In fact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a high-level expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committees report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible. These are always between two parties and one among them is always a financial intermediary.

However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivative-transactions.

Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools. Since derivates are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market.

Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the

portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products.

There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users.

RECENT DEVELOPMENTS

At present Derivative Trading has been permitted by the SEBI on derivative segment of the BSE and the F&0 segment of the NSE. The natures of derivative contracts permitted are:

Index Futures contracts introduced in June, 2000, Index options introduced in June, 2001, and Stock options introduced in July 2001.

The minimum contract size of a derivative contract is Rs.2 lakhs. Besides the minimum contract size, there is a stipulation for the lot size of a derivative contract. The lot size refers to number of underlying securities in one contract. The lot size of the underlying individual security should be in multiples of 100 and tractions, if any should be rounded of to next higher multiple of 100. This requirement along with the requirement of minimum contract size from the basis for arriving at the lot size of contract.

Apart from the above, there are market wide limits also. The market wide limit for index products in NIL. For stock specific products it is of open positions. But, for option and futures the following wide limits have been fixed.

30 times the average number of shares traded daily, during the previous calendar month in the cash segment of the exchange.

Or 10% of the number of shares held by non-promoters, i.e., 10% of the free float in terms of number of shares of a company.

ELIGIBILITY CONDITIONS

The SEBI has laid down some eligibility conditions for Derivative exchange/Segment and its clearing Corporation/House. They are as follows: 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.

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.

The Derivatives Exchange/Segment should have arbitration and investor grievances redressal mechanism operative from all the four areas/regions of the country.

The Derivatives Exchange/Segment should have satisfactory system of monitoring investor complaints and preventing irregularities in trading.

The Derivative Segment of the Exchange would have a separate Investor Protection Fund.

The Clearing Corporation/House shall perform full innovation, i.e., the Clearing Corporation/House shall interpose itself between both legs of every trade, becoming the legal counter party to both or alternatively should provide an unconditional guarantee for settlement of all trades.

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.

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 or initial margins. The initial margins should be large enough to cover the one-day loss that can be encountered on the position on 99% of the days.

The Clearing Corporation/House shall establish facilities for electronic fund transfer (EFT) for swift movement of margin payments.

In the event of a member defaulting in meeting its liabilities, the Clearing Corporation/House shall transfer client positions and assets to another solvent Member or close- out all open positions.

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 Corporations/House shall hold the clients margin money in trust for the client purposes only and should not allow its diversion for any other purpose.

The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades executed on Derivatives exchange/ segment.

INVESTORS PROTECTION

The SEBI has taken the following measures to protect the money and interest of investors in the Derivative market. They are as follows:

Investor's 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.

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.

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 reconfirmation slip with his ID in support of the contract note. This will protects him from the risk of price favour, if any, extended by the Member.

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 utilized 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, byelaws and regulation of the derivative segment of the exchanges.

DERIVATIVES

MEANING OF DERIVATIVES

In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For instance, equity shares itself is a derivative, since, it derive its value from the firms underlying assets. Similarly, one takes insurance against his house. Again, if one signs a contract with a building contractor stipulating a condition, if the cost of materials goes up by 15% the contract price will also go up by 10%. This is also a kind of derivative contract. Thus, derivatives cover a lot of common transactions. In a strict sense, derivatives are based upon all those major financial instruments, which are explicitly traded like equity, debt instruments, forex instruments and commodity based contracts. Thus, when we talk about derivatives, we usually mean only financial derivatives, namely, forward, futures, options, swaps etc. The peculiar features of these instruments are that: They can be designed in such a way so as to the varied requirements of the users either by simply using any one of the above instruments or by using a combination of two or more such instruments. They can be designed and traded on the basis of expectations regarding the future price movements of underlying assets. They are all off balance sheet instruments and They are used as device for reducing the risks of fluctuations in asset values. As the word implies, a derivative instrument is derived from something backing it. This something may be a loan, an asset, an interest rate, a currency flow, a stock trade, a commodity transaction, a trade flow etc. Derivatives enable a company to hedge this something without changing the flow associated with the business operation.

DEFINITION OF DERIVATIVES

It is very difficult to define the term derivatives in a comprehensive way since many developments have taken place in this field in recent years. Moreover, many innovative instruments have been created by combining two or more of these financial derivatives so as to cater to the specific requirements of users, depending upon the circumstances. Inspite of this, some attempts have been made to define the term derivatives. y y y Derivatives involve payment/receipt of income generated by the underlying asset on a notional principal. Derivatives are a special type of off-balance sheet instruments in which no principal is ever paid. Derivatives are instruments which make payments calculated using price of interest rate derived from a balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments.

All these definitions point out the fact that transactions are carried out on a notional principal, transferring only the income generated by the underlying asset.

Importance of Derivatives

Thus, derivatives are becoming increasingly important in world markets as a tool for risk

Derivative instruments can be used to minimize risk. Derivatives are used to separate the risks and transfer
management.

them to parties willing to bear these risks. The kind of hedging that can be obtained by using derivatives is 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 derivative 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 insurance, he runs a big risk. Suppose he buys 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. 'Offsetting of risks' 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 positions 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

In finance, a derivative is a financial instrument whose value depends on other, more basic, underlying variables[1] Such a variable is called an "underlying" and can be a traded asset, for example, a stock or commodity, but can also be something which is impossible to trade, such as the temperature (in the case of weather derivatives), unemployment rate, or any kind of (economical) index. A derivative is essentially a contract whose payoff depends on the behavior of some benchmark.

The most common derivatives are futures, options, and swaps.


Among the oldest of these are rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[2]

Derivatives are usually broadly categorized by: the relationship between the underlying asset and the derivative (e.g., forward, option, swap); the type of underlying asset (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives or credit derivatives);

the market in which they trade (e.g., exchange-traded or over-the-counter); and their pay-off profile.

Derivatives can be used for speculating purposes ("bets") or to hedge ("insurance"). For example, a speculator may sell deep in-the-money naked calls on a stock, expecting the stock price to plummet, but exposing himself to potentially unlimited losses. Very commonly, companies buy currency forwards in order to limit losses due to fluctuations in the exchange rate of two currencies.

Hedging
Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on

the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade.

Derivatives can serve legitimate business purposes. For example, a corporation borrows a large sum of money at a specific interest rate.[3] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[4] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings. [edit] Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[5]

HISTORY OF DERIVATIVE