DER IV ATI VES A ND

FIN ANC IA L
INNO VATIONS

SIP, 2009
Bangalore
INTRODUCTION TO
DERIVATIVES
Welcome to the Fascinating world of
Derivatives!
THE TERM DERIVATIVE….
 Indicates that the product/contract has no
independent value, i.e. it derives its value
from some underlying asset.
 The underlying assets can be securities,
commodities, bullion, currency, livestock and
so forth
DERIVATIVE CONTRACTS
 Are primarily of two kinds

 Contracts that are traded on the exchanges

called Exchange-Traded Derivatives

 Contracts that are traded outside the

exchanges called Over-the-counter
derivatives
Derivative Contracts
• World-wide large volume is traded in both
exchange-traded and OTC derivative
products.

• India also trades in both exchange-traded

and OTC derivative products on different
asset classes
Derivative Contracts
• Although, commodity derivatives
(forwards, futures and options) have been
in existence for a long time, derivatives on
financial assets like securities, currencies
etc. are relatively new phenomenon in
global markets.
Derivative Contracts
• Although, commodity derivatives
(forwards, futures and options) have been
in existence for a long time, derivatives on
financial assets like securities, currencies
etc. are relatively new phenomenon in
global markets.
THE FIRST FINANCIAL DERIVATIVE
 The first derivative on financial asset was
traded on currencies (currency futures) in
the International Monetary Market (IMM) of
the Chicago Mercantile Exchange (CME), U.S.
in 1972
 Since then, the growth of derivatives on
financial assets has been unprecedented
The First Financial Derivative
• Beginning with currency futures in 1972,
stock options in 1973 at Chicago Board
Options Exchange (CBOE), U.S.A.
• And Interest rate futures in 1975, the
derivative market has come a long way
• Swaps, which started in 1981-82,
accounts today for a trillion dollar business
opportunity at the international level.
DERIVATIVES
IN INDIA
An Overview
EQUITY DERIVATIVES
 India joined the league of exchange-traded
equity derivatives in June 2000, when futures
contracts were introduced at its two major
exchanges name the Bombay Stock
Exchange (BSE) and the National Stock
Exchange (NSE)
Equity Derivatives

• The BSE sensitive index, popularly

known as the SENSEX (comprising 30
scrips), and S & P CNX NIFTY index
(comprising 50 scrips), commenced
trade in futures on June 9, 200 and
June 12, 2000 respectively.
Equity Derivatives
• Index options and individual stock options
on 31 selected stocks were subsequently
added to the derivative basket, in 2001.
• November 2001 witnessed the
introduction of single stock futures in the
Indian market.
• The list of stocks were selected, based on
a pre-defined eligibility criterion linked to
the market capitalization of stocks,
floating stock, liquidity, etc.
Equity Derivatives
• As on July 26, 2006, the NSE’s Futures and
Options Segment (F & O Segment) trades
futures and options on 118 stocks and the
Derivatives segment of BSE trades in 77
stocks.
• This differentiation in the number of stocks
at the BSE and at the NSE is because the
eligibility criterion for a stock to figure in
the derivatives list is linked to various
measures at the respective exchanges.
Equity Derivatives
• It is important to note that most of the
derivatives business is concentrated in the
NSE which accounts for almost 100% of
the equity derivatives business.
• The growth of the equity derivatives
business on Indian bourses has been an
unprecedented one
• A modest start of an average daily volume
of Rs. 10 crores has developed into a
business of approximately of Rs. 30,000
crores per day.
Equity Derivatives
• Interestingly, over a period of time, there also has
been a shift in the market share of various
competing products (index futures, index options,
single stock futures, and single stock options)
available for trading.
• Today the most preferred product on the
exchanges is single stock futures, which account
for around 55% of total volumes
• NIFTY futures are the second most traded product
with a business share of around 35%
• Options account for approximately 10 % of the
total business with 2/3rd in Index options and 1/3rd
in single stock options.
Equity Derivatives
• There seems to be lack of clarity among market
participants about OTC about OTC products on
equity.
• Some market participants hold that OTC
derivatives are illegal.
• Others believe that they are not illegal but that
they are not legally enforceable in the country as
per the existing regulatory infrastructure.
• In 2005-06 some market participants were in the
process of seeking legal opinion as to whether
OTC equity derivatives can be offered in the
Indian Jurisdiction and if so how can it be done?
Commodity Derivatives
• The Forward Contract Regulation Act (FCRA)
governs the commodity derivatives in the
country.
• The FCRA specifically prohibits OTC commodity
derivatives.
• Accordingly we have only exchange-traded
commodity derivatives.
• Furthermore, FCRA does not even allow options
on commodities. Therefore, at present, India
trades only exchange traded commodity futures.
Commodity Derivatives
• Though commodity derivatives in the country have
existed for a long time, trading has been regionally
concentrated due to the regional nature of the
commodity exchanges.

• Further all these offered only a single product. For

example pepper exchange in Cochin trades only in
pepper. Soya exchange in Indore trades only soya

• In the last quarter of 2003 India began trading in

commodity derivatives through Nation-wide online
commodity exchanges – The National Commodities
and Derivative Exchange (NCDEX) and the Multi
Commodity Exchange (MCX)
Commodity Derivatives
• Though commodity derivatives in the country have
existed for a long time, trading has been regionally
concentrated due to the regional nature of the
commodity exchanges.

• Further all these offered only a single product. For

example pepper exchange in Cochin trades only in
pepper. Soya exchange in Indore trades only soya

• In the last quarter of 2003 India began trading in

commodity derivatives through Nation-wide online
commodity exchanges – The National Commodities
and Derivative Exchange (NCDEX) and the Multi
Commodity Exchange (MCX)
Commodity Derivatives
• They started functioning with the introduction of
futures contracts on various assets such as gold,
silver, rubber, steel, mustard seed, etc.

• Major banks and financial institutions in the country

(SBI, ICICI, Canara Bank, NSE, LIC, etc.) have
promoted both these exchanges.

• Business on these exchanges has increased

remarkably over a short period of time with monthly
volumes of business reaching as high as Rs. 140000
crores in May 2006 for NCDEX while it went upto as
high as RS. 200000 crores at MCX.
Commodity Derivatives
• It is important to mention here that both exchanges
are developing a niche for themselves

• For instance, bullion and energy products contribute

around 75-80 per cent of MCX business.

• On the other hand the primary business for the NCDEX

is agri-products, which contribute around 80% of the
total volume of this exchange.
• It is interesting to note that the growth in volumes of
commodity derivatives has been achieved without
institutional participation in the market.
Commodity Derivatives
• At present, banks, financial institutions, mutual funds,
pension funds, insurance companies and FIIs are not
allowed to participate in the commodities market.

• However the subject is under consideration by

respective regulators.

• Furthermore, both exchanges are now focusing their

attention on addressing issues like collateral
management, quality and quantity certification of
commodities, settlement price, methodology etc.
Commodity Derivatives

• Substantial progress these has been

made on these issues by the
exchanges.

• For example, warehousing receipts

have been made electronic with the
help of depositories – National
Securities Depositories Limited
(NDSL) and Central Depository
Services Limited (CDSL)
Commodity Derivatives
• The commodity exchanges are also concentrating
on the introduction of:
• Options on various agricultural, energy, metal
and bullion products, whenever this is permitted
by the government.
• Futures and options on various commodity
indices
• Introduction of exchange-traded funds (ETFs)
linked to commodities.
• Carbon credit derivatives (in association with
Chicago Climate Exchange.
• Weather Derivatives
Commodity Derivatives
Commodity Derivatives
Currency Derivatives
• Indian has been trading forward contracts in currency, for
the last several years.
• The RBI has allowed options in the over-the-counter market.
• The OTC currency market in the country is considerably
large and well-developed.
• However the business is concentrated with a limited
number of market participants, mainly banks – both
international and local as the corporates deal with these
banks for derivative contracts on various currencies.
• Some market participants are making a case for trading
currency derivatives (futures and options) on the
exchanges.
• Generally speaking, business in currency derivatives is
expected to grow in the near future.
Interest Rate Derivatives

• The National Stock Exchange

(NSE) introduced trading in cash
settled interest rate futures in
the year 2003.
• However, due to some structural
issues the product did not attract
market participants. A new
version of the product is till
pending.
Other Derivatives

• The Indian market participants have

also shown some interest in credit
and weather derivatives.
• Slowly but surely, these products too
are making strides in the Indian
Financial markets.
• Securitisation and exchange-traded
funds(ETF) linked to currencies and
bullion are being widely discussed.
Generic Derivative Products
• The emergence of a market for
derivative products can be traced to
the requirement of risk-averse
economic agents, to guard
themselves against uncertainties
arising out of fluctuations in asset
prices.
• It is possible to create certainty by
partially or fully, transferring the
price risk in assets from one entity to
another through use use of
Generic Derivative Products
• The emergence of a market for
derivative products can be traced to
the requirement of risk-averse
economic agents, to guard
themselves against uncertainties
arising out of fluctuations in asset
prices.
• It is possible to create certainty by
partially or fully, transferring the
price risk in assets from one entity to
another through use use of
Generic Derivative Products
• As instruments of risk management,
derivative products minimize the
impact of fluctuations in asset prices
on the profitability and cash flow
situations of risk-averse market
participants.
• The factors which have driven the
growth of financial derivatives in
India
Generic Derivative Products
• Increased volatility in asset prices in
the financial markets
• Increased integration of domestic
financial markets with global markets
• Development of more sophisticated
risk management tools, which
provide economic agents with a
wider choice of risk management
strategies.
Generic Derivative Products

• Innovation in the derivative markets

which optimally combine the risks
and returns over large number of
financial assets. This leads to higher
returns and reduced risk, as well as
low transaction costs when
compared to individual financial
assets.
• A marked improvement in
communication facilities with a sharp
Generic Derivative Products

• Without getting into the complexities

of Derivatives at this stage, it is
important to understand the
following three generic
products/contracts in detail:
2.Forward Contract
3.Futures Contract
4.Option Contract
Forward Contract

• A Forward Contract is one-to-one,

bipartite/tripartite contract which is
performed mutually by the contracting
parties, in future, at the terms decided
upon, on the contract date.

• In other words, a forward contract is an

agreement to buy or sell an asset at a
specified future date for a specified price.
Forward Contract

• One of the parties to the contract assumes

a long position i.e. agrees to buy the
underlying asset while other assumes a
short position, i.e. agrees to sell the asset.

• As this contract is traded off the exchange

and settled mutually by the contracting
parties, it is called the over-the-counter
product.
Forward Contract – An Illustration

• Assume there are two parties – Mr. A (buyer) and

Mr. B (seller) – who enter into a contract to buy
and sell 100 units of asset X at Rs. 350 per unit,
at a predetermined time of two months from the
date of contract

• In this case, the product (asset X), the quantity

(100 units), the product price (Rs. 350 per unit)
and the time of delivery (2 months from the date
of contract) have been determined and well
understood, in advance, by both the contracting
parties.
Forward Contract – An Illustration

• Delivery and payment (settlement of

transactions) will take place as per the terms of
the contract on the designated place as per the
terms of the contract on the designated date and
place

• This is a simple example of a Forward Contract.

• Forward contracts are extensively used in India in

the foreign exchange market
Forward Contract – An Illustration

• Forward contracts are negotiated by the

contracting parties on a one-to-one-basis and
hence offer tremendous flexibility in terms of
determining contract terms such as price,
quantity, and quality (in case of commodities),
delivery time and place.

• The parties may freely decide upon all these

terms, based on the circumstances and
negotiation powers. They may also carry out
subsequent alterations in the contract terms, by
mutual consent.
Forward Contract – Drawbacks

• Like other over-the-counter products, forward

contracts offer tremendous flexibility to the
contracting.

• However as they are customized, they suffer from

poor liquidity.

• Furthermore, as these contracts are mutually

settled and generally not guaranteed by any third
party, the counter party risk/default risk/credit
risk is considerable in such contracts need to be
understood in detail.
Liquidity Risk

• Liquidity is generally defined as the ability of a market to

buy or sell the desired quantity of an asset, at any time.

• Since forward contracts are traded one-to-one basis, they

are tailor made contracts and cater to the specific needs of
the contracting parties.

• Therefore, others may not be interested in these contracts

• Further as these contracts are not listed and traded on the

exchanges, other market participants do not have easy
access to the contracts or to the contracting parties.
Liquidity Risk

• In other words, it is very difficult for the contracting parties

to withdraw from a forward contract before the contract
matures. Hence the liquidity is these contracts is poor.

• Interestingly, in order to address the issue of poor illiquidity

of forward contracts, contracting parties have started listing
forward contracts on the exchanges in some international
markets.

• The display of products on the exchange creates visibility

and accessibility of products to other market participants.

• Thus an interested party may trade the product with the

contracting parties.
Default Risk/Credit Risk/Counter Party
Risk

• Forward Contracts, as defined, are transacted on a one-to-

one basis. Each party is, therefore, exposed to the counter
party’s credit risk i.e. risk of default.

• Market participants across the globe are trying to address

the issue of counter party risk in forward contracts. One
option chosen by market participants is the third party
guarantee to these contracts.

• For instance having entered into a forward contract, the

contracting parties may go to a third party who will
immunise their positions, through a guarantee.
Default Risk/Credit Risk/Counter Party
Risk

• This third party – essentially a risk taker ( such as a clear

corporation) – may collect some margin from both the
parties and immunise them against the risk of default
against each other

• Market participants across the globe are trying to address

the issue of counter party risk in forward contracts. One
option chosen by market participants is the third party
guarantee to these contracts.

• For instance having entered into a forward contract, the

contracting parties may go to a third party who will
immunise their positions, through a guarantee. The third
party – essentially a risk taker (such as a clearing
corporation) and may collect from both the parties and
immunize them against the risk of default by each other.
Futures Contract

• Although forward contracts provide a great deal of flexibility to the

contracting parties, they suffer from two important problems –
illiquidity and counter party risk.

• These two issues concerning forward contracts have offered the

exchanges a tremendous business opportunity and the have
started trading these forward contracts; but with a difference.

• In order to make the contracts attractive to a large set of market

participants, they have standardized these contracts.

• To further generate liquidity in these contracts by engendering

confidence among market participants, exchanges have
persuaded their clearing corporations to guarantee these trades.
Futures Contract

• Trading of forward contracts on the exchanges was considered a

means for addressing the issues in the forward contracts.

• Further, in order to differentiate between the exchange-traded

forward and the OTC forward, the market renamed the exchange-
traded forwards as Futures Contracts.

• Hence, futures contracts are essentially standardised forward

contract, which are traded on the exchanges and settled through
the clearing agency of the exchanges

• The clearing agency also guarantees the settlement of these

trades. In other words, futures contracts are standardised forward
contracts or the futures market is simply the extension of the
forward market.
Futures Contract

• As future contracts are organised/standardised, they cater to a

wider range of market participants.

• Further, their availability on the exchanges makes them accessible

to market participants scattered throughout the country and
perhaps the world.
• Therefore, the liquidity problem, which persists in the forward
market, does not exist in the futures market.

• The clearing agency of the exchange becomes the counter party

to all the trades or provides the unconditional guarantee for their
settlement, i.e. assumes the financial integrity of the entire
system. Hence, the market participants are not exposed to
counter party risk.
Difference between Forward and Futures
Contract

• The contracting parties negotiate forward

contracts, on a one-to-one basis. This offers
tremendous flexibility in articulating in terms of
the price, quantity, quality (in case of
commodities), delivery time and place.

• Future contracts do not have this flexibility as

such contracts have standard terms viz. quantity,
quality (in case of commodities) , delivery time
and place, which are decided by the exchanges.
Difference between Forward and Futures
Contract

• In the forward market, one party may be at an abundant

disadvantage due to non-availability of information regarding the
underlying factors.

• A typical example of this may be the exploitation of poor farmers

in remote areas as they do not have current information on their
commodities. They generally sell their produce to the Zamindar at
a price which is substantially lower than the expected cash price
of the produce at the time of the availability in the market.

• In the futures market, geographically segmented areas are

integrated, as futures market provide a common platform to all
market participants.

• It consolidates all orders through a common consolidated book

and reflects a better price, as price is the result of interaction of
the collective wisdom of a large number of market participants.
Difference between Forward and Futures
Contract

• Therefore, in case of futures, every bit of price information is

quickly reflected on the prices of assets.

• This results in elimination of non-availability of information risk,

which exists in the forward market.
Difference between Forward and Futures
Contract

• Another problem in forward contracts is that of the final settlement, which

becomes quite cumbersome if forward contracts are traded subsequently.

• To understand the concept, let us go back to the earlier example. Assume,

that after 15 days, Mr. A (the buyer) enters into a fresh transaction to sell
asset X to Mr. C on the same delivery date. Mr. B (the seller) is stranger to
the transaction between Mr. A and Mr. C.
• On settlement, Mr. A will take delivery of asset from Mr. B and give it to Mr.
C and then take the money from Mr. C to pay Mr. B

• Similarly, Mr. B may enter into a contract with another party, Mr. D which
will be unknown to Mr. A

• Now, assume a situation when there are 4-5 subsequent deals during the
life of the contract. Each of these subsequent deals will complicate the final
settlement of the trade.
 A B

C C

Money
Asset
Difference between Forward and Futures
Contract

• In the futures markets, the clearing agency maintains the account of all
participants on the exchange.

• Hence on the last trading day of the contract, it is in a position to declare

which of the two entities are the counter parties to each other

• It thus provides solution to the settlement problem, which is very acute in

the case of the forward market.

• Indeed at any point in time the clearing agency is in a position to indicate

which participants have open positions, i.e. outstanding/unsettled long
(buy) or short 9sell) positions
Difference between Forward and Futures
Contract

• Operational risks generated through human error, fraud, systems failure,

etc. exist in both forward and futures markets. These cannot be addressed
in any way other than by training, competence building, proper monitoring
and insurance .
DIFFERENCES BETWEEN FUTURES
AND FORWARD CONTRACTS -
SUMMARISED
Feature Forward Contracts Futures Contracts
Operational mechanism Traded directly between Traded on the exchanges
contracting parties (not
traded on the exchange)
Contract specifications Differ from trade to trade Contracts are standardised
contracts
Counter Party risks Exists but sometimes Exists but assumed by the
jettisoned to a guarantor clearing agency, which
becomes the counter party
to all trades or
unconditionally guarantees
their settlement
Liquidation profile Low, as contracts tailor- High, as contracts are
made contracts catering to standardized exchange-
the needs of the of the traded contracts
parties involved. Further,
they are not easily
accessible to other market
participants.
Differences Between Futures and
Forward Contracts - summarised
Feature Forward Contracts
Price Discovery Not efficient as markets are
scattered
Quality of information and Quality of information may
its dissemination be poor. Speed of
information dissemination is
weak.
Examples Currency market in India
Futures Contracts
Efficient, as markets are
centralised and all buyers
and sellers come to a
common platform to
discover the price through a
common order book.
As futures are traded on a
nation-wide basis, every bit
of decision related
information gets
disseminated very fast
Exists but assumed by the
clearing agency, which
becomes the counter party
to all trades or
unconditionally guarantees
their settlement
OPTION CONTRACTS
 In both forward and futures contracts, the
contracting parties undertake an obligation
to perform in accordance with the contract.
 Thus, for the buyer of the contract, profit is
generated in the price of the underlying
asset goes up.
 On the other hand, for the seller of the
contract, the profit proposition requires a fall
in the price of the underlying asset.
 However, unfavourable movements in price
of the underlying asset will create loss for the
contracting parties
Option Contracts

•Let us now consider a

situation.
•Assume that Mr. X needs
to honour an obligation of
a million U.S. dollars after
three months from a given
date.
OPTION CONTRACTS
 His first choice may be to do nothing at
present and buy the dollars after three
months, at the time when the payment is
due.

 The second option may be to buy the dollars

right away and keep them in safe custody.
Option Contracts

• Thirdly he can buy the dollars in the

forward or futures markets for
delivery in three months.
Option Contracts

• If he buys 1 million dollars at Rs. 47

per dollar (prevailing forward market
prices) in the forward market for
three months.

• He is, therefore, locked in to buy the

dollars at the contracted price.
Option Contracts
• This situation leads to another thought. Is it
possible to design a contract, which offers Mr X
an opportunity to buy the underlying asset only if
he desires, with no compulsion whatsoever?

• This essentially means that the contract needs to

confer a right on Mr. X to buy the asset (US $ in
this example) with no obligation, to ensure that
he is free to decide on buying the underlying
asset.
Option Contracts
• A similar concept may be thought of on the sell
side, wherein the seller may just need a right,
rather than a obligation to sell the underlying
asset.

• As a whole, this contract must offer the position

takers an opportunity to exercise the right (buy or
sell the underlying asset) only if it is favourable to
them, or else, they let it expire.

• These contracts are called Options.

OPTION CONTRACTS
 As in any other contract, the market also
needs the sellers of these rights

 But then why should someone sell these

rights?

 The answer to the question is that this is

done “in pursuit of money”.
Option Contracts
• Fundamentally, the seller of these rights
has an obligation under the contract and
so will want compensation in monetary
terms, from the buyer of the rights

• As long as there is counter party who is

prepared to pay the seller of the
rights/option who is prepared to pay the
seller of the rights/options, there will be
market for options.
Option Contracts
• Thus, one can say that an option is a right
given by the option writer/seller to the
option buyer/holder to buy or sell an
underlying asset at a pre-determined
price, within or at the end of a specified
period.

• The option buyer, who is also called long

on option, long premium or holder of the
option, has the right but no obligation.
Option Contracts
• On the other hand, the option seller/writer,
who is also called the short on option or
short on premium, has an obligation but
no right, with regard to buying or selling of
the underlying asset.

• The option buyer may or may not exercise

the option given. However if he decides to
exercise the option the option seller/writer
is bound to honour the contract.
Option Contracts
• Options can be categorised as Call and Put
options.
• An option which gives the buyer a right to buy
the underlying asset, is called a Call Option
and an option which gives the buyer a right to
sell the underlying asset, is called a Put
Option.
• Further , an option, which is exercisable any
time on or before the expiry date/day is called
an American Option
• An option which is exercisable only at expiry,
is called an European Option.
OPTION CONTRACTS
 Theprice at which the option is
exercisable is called the Strike price or
Exercisable Price

 Thedate/day on which the option

expires is called the Expiration
date/day.

 Theexpiration date/day is the date on

which the contract ceases to exist.
Option Contracts
• The date/day on which the option is exercised is
called the Exercise date/day of the option

• The date/day on which the option expires is called

the Expiration date/day.

• It may be noted that the expiration date/day and

the exercise date/day may differ in case of an
American option but will be the same in case of
an European Option, in the event that the option
is exercised at all, by the option buyer.
Option Contracts
• When the option writer gives a right to the
option buyer he will charge for that right.
The price that the option buyer pays to the
option/right is called the Option premium.

• The option premium is the inflow to the

option he option writer irrespective of
whether the option holder exercises his
option or not.
Option Contracts – A simple
example
• Assume that Mr A goes shopping and likes a
painting that costs Rs 15,000. As he does not
have the money required to make the full
down payment , he offers the shopkeeper Rs
2000, with a proposal to take delivery within
2 days, on the payment of balance amount.

• Further, assume that the shopkeeper makes

it clear that if painting was not bought within
2 days the contract will expire. This is a
typical example of a forward contract.
Option Contracts – A simple
example
• As the shopkeeper is not confident about the
counter party, he takes some money in
advance and this is treated as collateral or a
good faith deposit.

• It is also clear that if Mr A does not return in 2

days, the shopkeeper will have the right to
sell the painting to someone else but would
refund advance payment made by Mr A.
Option Contracts – A simple
example
• Another way to structure the deal is for Mr A
to offer the shopkeeper Rs 200 and reserve
the painting for two days.

• If Mr A does wishes, he may pay the full price

and purchase the painting during these two
days. Otherwise, he will lose the right to buy
it.

• In this case Mr. A is the option buyer and the

shopkeeper is the option seller.
CONTRACT OPTIONS
 Asan option buyer, Mr. A has a right to
buy painting but no obligation.

 If he finds another shop selling the

same painting at a price lower than Rs
15,000, he has the option to ignore the
first shop and buy the painting from the
second shop.

 Inother words, Mr A may let his right

expire if he finds it unattractive to
exercise his option.
Contract Options
• It must be understood however, that even if Mr A
does not exercise his right, the Rs 200. which he
paid as the price for reserving the painting for 2
days will not be refunded.

• This money, viz. Rs 200 may be called the cost of

the right or price of option.

• There is no difference in nomenclature for options

traded in OTC markets and exchange traded
markets.
SUMMARY
 The term Derivative indicates that the
product/contract has no independent value,
i.e. its value from some underlying asset.
This may be securities, commodities, bullion,
currency, livestock and so forth.

 Products/contracts are traded on the

exchanges that are called exchange-traded
derivatives. Products/contracts traded
outside the exchanges are called over-the-
counter products/contracts. The generic term
used for the market outside the exchanges is
Summary
• Although, commodity derivatives (forward,
futures and options) have been exercise for long,
derivatives on financial assets such as securities,
currencies etc. is a relatively new phenomenon in
global markets.

• In June 2000, India’s two major stock exchanges –

the BSE and the NSE introduced futures contracts
on BSE SENSEX (comprising 30 scrips) and S & P
CNX Nifty index (comprising 50 scrips)
respectively.
Summary
• India added index options and individual stock options
to the derivatives basket, in 2001. November 2001
witnessed the introduction of single stock futures in
the Indian market. The growth in the equity
derivatives business on Indian bourses has been an
unprecedented one.

• India started trading commodity derivatives through

two major nation-wide commodity exchanges –
National Commodities and Derivatives Exchange
(NCDEX) and Multi Commodity Exchange (MCX) on
various assets such as gold, silver, rubber, steel,
mustard seed etc. in the last quarter of 2003.
• In July 2006, the combined average daily volume on
these two exchanges was around Rs 15,000 crores.
Summary
• There are only three generic derivative
products/contracts – forward, futures and option
contracts.

• A forward contract is a one-to-one bipartite/tripartite

contract, which is performed mutually by contracting
parties, in the future, at the terms decided on the
contract date.
• In other words, a forward contract is an agreement to
buy or sell an asset on a specified future date at a
specified price. One of the parties to the contract
assumes a long position i.e. agree to buy the
underlying asset and the other party assumes a short
position, i.e. agrees to sell the asset. A forward
contract is an OTC product.
Summary
• Forward contracts, despite having a great deal of
flexibility in terms of structuring the contracts to
customised needs of individual players needs of
individual players, suffer from two main risks –
illiquidity (lack of sufficient volumes for trading) and
counter party or credit/default risk.
• Futures came into existence in order to address the
issues of illiquidity and counter party risk in forward
contracts. Basically, futures contracts are
standardised forward contracts traded on exchanges.
The clearing agency also guarantees the settlement of
these trades.
• In both forward and futures contracts, the contracting
parties undertake an obligation to perform the
contract.
Summary
• So, for the buyer of the contract, profit is generated if
the price of the underlying asset goes up and for the
seller of the contract, the profit proposition requires a
fall in the price of the underlying asset.
• However, unfavourable movements in the price of the
underlying asset will create losses for the contracting
parties.
• An option is a right given by the option writer/seller to
the option buyer/holder to buy or sell an underlying
asset at a predetermined price within or at the end of
the specified period.
• Therefore, an option is a contract that offers the buyers
an opportunity to exercise the right (buy or sell the
underlying) only if it is favourable to them. Otherwise,
they may let the right expire.
Summary
• Options can be categorised as call and put options. An
option, which gives the buyer a right to buy the
underlying asset, which gives the buyer a right to sell
the underlying asset, is called a put option.
• Further, an option, which is exercisable at any time on or
before the expiry date/day, is called an American option
and the option, which is exercisable only on its expiry, is
called a European option.
• The price at which the option is exercisable is called the
strike price or exercise price. The date/day on which the
option expires is called the expiration date/day. The
date/day on which the option is exercised is called the
exercise date/day of the option.