Introduction

What is a Derivative?
A derivative is an instrument whose value depends on, or is derived from, the value of another asset. Examples: futures, forwards, swaps, options, exotics

Underlying Assets
Commodities including grain, coffee beans, orange juice; Precious metals like gold and silver; Foreign exchange rates or currencies; Bonds of different types, including medium to long term negotiable debt securities issued by governments, companies, etc. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index Short term securities such as T-bills; and Over- the Counter (OTC)2 money market products such as loans or deposits.
3

Participants
Hedgers: They use derivatives markets to reduce or eliminate the risk associated with price of an asset. Majority of the participants in derivatives market belongs to this category. Speculators: They transact futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture. Arbitrageurs: Their behavior is guided by the desire to take advantage of a discrepancy between prices of more or less the same assets or competing assets in different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.
4

Financial Weapons of Mass Destruction??

Year Amount (USD in bn) Country Organization Key Player Instruments

2008
2008 2006

USD 9 bn
7.1 6.5

USA
France Canada

Morgan Stanley
Societe Generale Amaranth Advisors Long Term Capital Management Sumitomo Corporation Aracruz UBS Orange County

Howie Hubler
Jerome Kerviel Brian Hunter

credit default Swaps

Equity Index Futures Natural Gas Futures Interest rate/equity/currency futures Copper Futures FX options Equities, ETF and Delta 1 Interest rate derivatives Foreign Exchange Trading Oil Futures Foreign Exchange Trading Derivatives Nikkei Futures5

1998 1996 2008 2011 1994

4.6 2.6 BRL 4.62 bn USD 2 bn 1.7

USA Japan brazil UK USA

John Meriwether Yasuno Hamanaka Isac Zagury, Rafael Sotero Kweku Adoboli Robert Citron Helmut Elsner, Wolfgang Flottl, Johann Zwettler Heinz Schimmelbusch Frances Yung Boaz Weinstein Nick Leeson

2006 1993 2008 2008 1995

1.9 DEM 2.63 bn HKD 14.7 bn USD 1.8 bn 1.32

Austria Germany China USA UK

Bawag Bank Metallgesellschaft CITIC Pacific Deutsche Bank Barings Bank

Applications
Management of risk Efficiency in trading Speculation Price discovery Price stabilization function

CLASSIFICATION OF DERIVATIVES

Forward Contract
agreement between two parties to buy or sell an asset at a specified point of time in the future the price which is paid/ received by the parties is decided at the time of entering into contract It is the simplest form of derivative contract mostly entered by individuals in day to days life.

 One of the parties to a forward contract assumes a long position (buyer) and agrees to buy the underlying asset at a certain future date for a certain price. The other party to the contract known as seller assumes a short position and agrees to sell the asset on the same date for the same price.

 The specified price is referred to as the delivery price. The contract terms like delivery price and quantity are mutually agreed upon by the parties to the contract.

10

Futures Contracts
Agreement to buy or sell an asset for a certain price at a certain time Similar to forward contract Whereas a forward contract is traded OTC, a futures contract is traded on an exchange

11

Exchanges Trading Futures

CME Group (formerly Chicago Mercantile Exchange and Chicago Board of Trade) NYSE Euronext BM&F (Sao Paulo, Brazil) TIFFE (Tokyo) and many more (see list at end of book)

12

Futures Contract Standardized Terms

1. 2. 3. 4. 5. 6. 7. 8. 9. Quantity Quality Expiration months Delivery terms Delivery differentials Delivery dates Minimum price fluctuation Daily price limits Trading days and hours

13

Forward Versus Futures

COMPARISON FORWARD FUTURES
Trade on organized exchanges No Yes

Use standardized contract terms

No

Yes

Use associate clearinghouses to guarantee contract fulfillment

No

Yes

Require margin payments and daily settlements

No

Yes

Close easily Regulated by identifiable agencies Any quantity Any product

No No Yes Yes

Yes Yes No No

14

Options
An option is the right, but not the obligation, to buy or sell something at a stated date at a stated price A call option is an option to buy a certain asset by a certain date for a certain price (the strike price) A put option is an option to sell a certain asset by a certain date for a certain price (the strike price)

15

American vs European Options

An American option can be exercised at any time during its life A European option can be exercised only at maturity

16

Options vs Futures/Forwards
A futures/forward contract gives the holder the obligation to buy or sell at a certain price An option gives the holder the right to buy or sell at a certain price

17

SWAPS
A swap can be defined as a barter or exchange. a swap is an agreement between two or more parties to exchange stream of cash flows over a period of time in the future. The parties that agree to the swap are known as counter parties

18

 Interest rate swaps which entail swapping only the interest related cash flows between the parties in the same currency 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 the cash flows in the opposite direction.

19

How to Avoid Derivative Disasters?

Set up controls to ensure derivatives are being used for their intended purpose. Risk limits should be set and the activities of traders should be monitored daily to ensure that these risk limits are adhered to.

20

Indian Derivatives Market

Regulations
Based on the L.C. Gupta Committee Report, and the J.R. Varma Committee Report. It is mostly consistent with the IOSCO5 principles and addresses the common concerns of investor protection, market efficiency and integrity and financial integrity

Products traded in Derivatives Segment in BSE

Products traded in F&O segment of NSE

Index Futures

Turnover (Rs Cr)

Turnover (Rs Turnover (Rs Turnover (Rs Cr), 2009-10, 2010-11, Cr), Turnover (Rs 2008-09, Cr), 3934388 4356754 Cr), 2007-08, 3570111 Turnover (Rs 3820667 Cr), 2011-12, 3577998 Turnover (Rs Cr), 2006-07, 2539574 Turnover (Rs Cr), 2005-06, 1513755

Turnover (Rs Cr), 2004-05, Turnover (Rs 772147 Cr), 2003-04, Turnover (Rs Turnover (Rs 554446 Turnover Cr), 2001-02, (Rs Cr), 2000-01, 21483 2365Cr), 2002-03, 43952

Turnover (Rs Cr), , 0

Stock Futures
Turnover (Rs Cr), 2007-08, 7548563

Turnover (Rs Cr)

Turnover (Rs Cr), 2010-11, Turnover (Rs 5495756 Cr), 2009-10, 5195246 Turnover (Rs Turnover (Rs Cr), 2011-12, Cr), 2006-07, Turnover (Rs 4074670 3830967 Turnover (Rs Cr), 2008-09, Cr), 2005-06, 3479642 2791697 Turnover (Rs Cr), 2004-05, Turnover (Rs 1484056 Turnover (Rs Cr), 2003-04, Turnover (Rs 1305939 Cr), 2001-02, 2002-03, Cr), Turnover (Rs Turnover (Rs 51515 286533 Cr), 2000-01, 0 Cr), , 0

Index Options

Turnover (Rs Cr)

Column1, 2007-08, Column1, 3731501 2006-07, Column1, 1362110 2005-06, Column1, 791906 2004-05, Column1, 338469 2003-04, Column1, 121943 2002-03, Column1, 52816 2001-02, 9246 Column1, 2000-01, 3765

Column1, 2008-09, 8027964

Column1, 2010-11, Column1, 22720031 2009-10, 18365365

Stock Options

Turnover (Rs Cr)

Series 1, 2009-10, Series 1, 1030344 2010-11, 977031

Series 1, Series 1, 2002-03, 2004-05,Series 1, Series 1, 217207 Series 1, Series 1, 180253 2005-06, 2003-04, 2000-01, 2001-02, 193795 168836 25163 100131

Series 1, 2006-07, 359136

Series 1, 2008-09, 506065 Series 1, 2007-08, 229226

Global Perspective

Source: Bank of International Settlement

Foreign Exchange Contracts

Column1, Dec-13, 49181 Column1, Jun-14, 53153

USD Bn Column1, Column1, y =Jun-15, - 827495 21.849x Dec-15, R = 646980.9131 63349

Column1, Dec-14, 57796

Source: BIS

Interest Rate Contracts

Series 1, JunSeries 1, Dec14, 451831 13, 449875 Series 1, Dec14, 465260

USD Bn Series 1, JunSeries 1, Dec15, 553240 15, 504098

Source: BIS

Equity-linked Contracts
Series 1, Jun14, 6260 Series 1, Dec13, 5937

USD Bn Series 1, Jun15, 6841 Series 1, Dec14, 5635 Series 1, Dec15, 5982

Source: BIS

Commodity Contracts
USD Bn Column1, Dec-15, 3091 Column1, Jun-15, 3197

Column1, Dec-14, 2922

Column1, Jun-14, 2852 Column1, Dec-13, 2944 Source: BIS

Credit Default Swaps

Series 1, Dec13, 32693

USD Bn Series 1, Jun15, 32409

Series 1, Jun14, 30261

Series 1, Dec14, 29898 Series 1, Dec15, 28633

Source: BIS