Unit 1 Syllabus

Introduction to Derivatives:
forwards, Futures, options, swaps,
trading mechanisms, Exchanges,
Clearing house (structure and
operations, regulatory framework),
Floor brokers, Initiating trade,
Liquidating or Future position, Initial
margins, Variation margins, Types
and orders. future commission
merchant.

Introduction to
Derivatives
RAVI IBA

D e ri v a ti v e s m e a n i n g a n d
de fi n iti o n
Derivatives are instruments in respect
of which the trading is carried out
as a right on an underlying asset.
In normal trading, an asset is
acquired or sold. When we deal with
Derivatives, the asset itself is not
traded, but a right to buy or sell the
asset, is traded.

D e ri v a ti v e s m e a n i n g a n d
de fi n iti o n
Thus a derivative instrument does not directly
result in a trade but gives a right to a person
which may ultimately result in trade.
A buyer of a derivative gets a right over the
asset which after or during a particular period
of time might result in her buying or selling
the asset.
A derivative is often defined as a financial
instrument whose value derives from
that of something else

D e ri v a ti v e s m e a n i n g a n d
de fi n iti o n
In abstract, a derivative is a price guarantee.
Nearly every derivative out there is just an
agreement between a buyer and a future seller.
Every derivative specifies a future price at
which some time can or must be sold.
Thus item is an underlier, which might be some
physical commodity such as corn or natural gas
or some financial security such as stock or a
govt. bond or something abstract like price
index.

D e ri v a ti v e s m e a n i n g a n d
de fi n iti o n
Every derivative must specifies a future date on or
before which the transaction must occur.
These are common elements of all derivatives: buyer
and seller, underlier, future price and future date.
Some derivatives guarantee something other than a
price.
Credit Derivatives give performance guarantee not
price guarantees.
Weather derivatives guarantee things like
temperature or rainfall.
Vast derivatives guarantee price guarantees.

D e ri v a ti v e s m e a n i n g a n d
de fi n iti o n
Derivatives are risk transferring
instruments. They are called derivatives
since they derive their value from the
value of underlying, which may be either
may be either
interest rate, foreign exchange, index,
commodity or shares or any securities.
Derivatives can be classified as OTC (over
the counter) and Exchange Traded
Derivatives.

History of derivatives exchange

Derivatives exchanges have existed for a long

time. The Chicago Board of Trade (CBOT)
was established in 1848 to bring farmers and
merchants together.
Initially its main task was to standardize the
quantities and qualities of the grains that were
traded. Within a few years the first futurestype contract was developed

History of derivatives exchange

It was known as a to-arrive contract. Speculators

soon became interested in the contract and found
trading the contract to be an attractive alternative
to trading the grain itself.
A rival futures exchange, the Chicago Mercantile
Exchange (CME), was established in 1919.
Now futures exchanges exist all over the world.

Electronic markets
Traditionally derivatives exchanges have used
what is known as the open outcry system.
This involves traders physically meeting on
the floor of the exchange, shouting, and using
a complicated set of hand signals to indicate
the trades they would like to carry out.

Electronic markets
Exchanges are increasingly replacing the open
outcry system by electronic trading. This
involves traders entering their desired trades at
a key board and a computer being used to
match buyers and sellers.
The open outcry system has its advocates, but,
as time passes, it is becoming less and less
common.

OTC Derivatives
Over-the-counter (OTC) derivatives
are contracts that are traded (and
privately negotiated) directly between
two parties, without going through an
exchange or other intermediary.
Products such as swaps, forward rate
agreements, exotic options and
other exotic derivatives are almost
always traded in this way.

OTC Derivatives
The OTC derivative market is the largest
market for derivatives, and is largely
unregulated with respect to disclosure of
information between the parties, since the
OTC market is made up of banks and other
highly sophisticated parties, such as hedge
funds.
Reporting of OTC amounts is difficult
because trades can occur in private, without
activity being visible on any exchange.

Over-the-counter markets
The over-the-counter market is an important alternative
to exchanges and measured in terms of the total volume
of trading, has become much larger than the exchangetraded market.
It is a telephone- and computer-linked network of dealers.
Trades are done over the phone and are usually between
two financial institutions or between a financial
institution and one of its clients.

 Trades in the over- the-counter market are

typically much larger than trades in the
exchange-traded market. A key advantage of
the over-the-counter market is that the terms
of a contract do not have to be those
specified by an exchange. Market participants
are free to negotiate any mutually attractive
deal. A disadvantage is that there is usually
some credit risk in an over-the-counter
trade.

Market size
Both the over-the counter and the exchangetraded market for derivative are huge.

Exchange-traded
Derivatives
Exchange-traded derivatives (ETD) are those
derivatives instruments that are traded via
specialized derivatives exchanges or other
exchanges.
A derivatives exchange is a market where
individuals trade standardized contracts that
have been defined by the exchange.
A derivatives exchange acts as an intermediary
to all related transactions, and takes initial
margin from both sides of the trade to act as a
guarantee.

Exchange-traded
Derivatives
The exchange market is sometimes known as the
Listed Market
In the exchange market buyer and seller do no
need to worry about finding each other.
Futures and most options are traded on exchange.
In OTC trade, the two parties have no fundamental
assurance that the other side will hold up their end
of the deal.
Exchange trade, the exchange itself guarantees
that all counterparties will fulfil their
responsibilities.

Vanilla and Exotics Derivatives

Types
Simple derivatives are known as Vanilla
Some complex derivatives are known as
Exotics
Derivatives are variation or combinations
of four basic types
Forward contract
Futures contract
Swap contract
Option contract

How are derivatives used ?

Derivatives are used primarily for Hedging
(Risk Management) or for Speculation.
Hedgers used derivatives to reduce
financial risk or the prospect that the price
of things might move against them.
Speculators use derivatives not to reduce
financial risk but potentially profit from it.
Other uses of Derivatives : Market-makers
and arbitrageurs.

How are derivatives used ? Contd.

Market Maker :a dealer in securities or other assets who
undertakes to buy or sell at specified prices at all times
'Market Maker' A broker-dealer firm that accepts the risk of
holding a certain number of shares of a particular security
in order to facilitate trading in that security.
Each market maker competes for customer order flow by
displaying buy and sell quotations for a guaranteed
number of shares.
Arbitrageur' A type of investor who attempts to profit
from price inefficiencies in the market by making
simultaneous trades that offset each other and capturing
risk-free profits.
Arbitrageurs search for pricing mistakes or inefficiencies

Basic Derivatives Types

Forward contract: A forward contract
is an agreement to buy something at
a specified price on specified future
date.
Futures contract: A futures contract is
a standardised forward contract
executed at an exchange, a forum
that brings buyers and settlers
together.

Basic Derivatives Types

Swap contract : A swap contract is an
agreement to exchange cash flows.
Typically, one cash flow is based on a
variable or floating price and other on a
fixed one.
Option contract : An option contract grants
the holder the right but not the obligation
to buy or sell something at a specified
price, on or before a specified future date.
Most are executed at an exchange.