Unit - I

FINANCIAL DERIVATIVES
UNIT - I
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UNIT - I
DEFINITION & TYPES FORWARD CONTRACTS FUTURE CONTRACTS OPTIONS SWAPS DIFFERENCES BETWEEN CASH AND FUTURE MARKETS USES AND ADVANTAGES OF DERIVATIVES RISKS IN DERIVATIVES
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INTRODUCTION
In the present state of the economy, there is an imperative need for the corporate clients to protect their 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.
INTRODUCTION
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.
INTRODUCTION
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks,
bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
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DEFINITION
Derivatives
A derivative is a financial instrument whose return is derived from the return on another instrument. Derivatives are instruments which make payments
calculated using price of interest rates derived from on balance sheet or cash instruments, but do not actually employ those cash instruments to fund payments.
DEFINITION
The Securities Contracts Regulation Act 1956 defines Derivative as under: Derivative includes
1. Security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security. 2. A contract which derives its value from the prices, or index of prices of underlying securities.
MEANING
In a broad sense, many commonly used instruments can be called derivatives since they derive their value from an underlying asset. For Eg: Equity Share itself is a derivative, since it derives its value from the firms underlying assets. In a strict sense derivatives are based upon all those major financial sense, instruments which are explicitly traded like equities, debt instruments and commodity based contracts.
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WHAT IS A DERIVATIVE
In short, a derivative is a contractual relationship established by two (or more) parties where payment is based on (or "derived" from) some agreedupon benchmark. Since individuals can "create" a derivative product by means of an agreement, the types of derivative products that can be developed are limited only by the human imagination. Therefore, there is no definitive list of derivative products. Some common financial derivatives.
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WHY HAVE DERIVATIVES

Derivatives are risk-shifting devices. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes. For example, if an American company expects payment for a shipment of goods in British Pound Sterling, it may enter into a derivative contract with another party to reduce the risk that the exchange rate with the U.S. Dollar will be more unfavorable at the time the bill is due and paid. Under the derivative instrument, the other party is obligated to pay the company the amount due at the exchange rate in effect when the derivative contract was executed. By using a derivative product, the company has shifted the risk of exchange rate movement to another party.
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LEVERAGING
Some derivative products may include leveraging features. These features act to multiply the impact of some agreed-upon benchmark in the derivative instrument. Negative movement of a benchmark in a leveraged instrument can act to increase greatly a party's total repayment obligation. Remembering that each derivative instrument generally is the product of negotiation between the parties for riskshifting purposes, the leveraging component, if any, may be unique to that instrument.
LEVERAGING
For example, assume a party to a derivative instrument stands to be affected negatively if the prime interest rate rises before it is obliged to perform on the instrument. This leveraged derivative may call for the party to be liable for ten times the amount represented by the intervening rise in the prime rate. Because of this leveraging feature, a small rise in the prime interest rate dramatically would affect the obligation of the party. A significant rise in the prime interest rate, when multiplied by the leveraging feature, could be catastrophic.
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COMBINED DERIVATIVE PRODUCTS

The range of derivative products is limited only by the human imagination. Therefore, it is not unusual for financial derivatives to be merged in various combinations to form new derivative products. For instance, a company may find it advantageous to finance operations by issuing debt, the interest rate of which, is determined by some unrelated index and where the company has exchanged the liability for interest payments with another party. This product combines a derivative known as a Structured Note with another derivative known as an interest rate Swap
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TRADING OF DERIVATIVES
Some derivative products are traded on national exchanges. Regulation of national futures exchanges is the responsibility of the U.S. Commodities Futures Trading Commission. National securities exchanges are regulated by the U.S. Securities and Exchange Commission (SEC). Certain financial derivative products, like options traded on a national securities exchange, have been standardized and are issued by a separate clearing corporation to sophisticated investors pursuant to an explanatory offering circular. Performance of the parties under these standardized options is guaranteed by the issuing clearing corporation. Both the exchange and the clearing corporation are subject to SEC oversight.
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TRADING OF DERIVATIVES
Other derivative products are traded over-the-counter (OTC) and represent agreements that are individually negotiated between parties. If you are considering becoming a party to an OTC derivative, it is very important to investigate first the creditworthiness of the parties obligated under the instrument so you have sufficient assurance that the parties are financially responsible.
TYPES OF ORDERS
The following are the important types of orders allowed for trading in derivatives.
Limit Order: An order for buying or selling at a limit price. Any unexecuted portion of the order remains as a pending order till it is matched or its duration expires. Market order: An order placed to buy or sell at the best price prevailing in the market at the time of submission of the order. Good Till Cancelled: This is an order which remains in the system until the trader cancels it. Good Till Days or Date: This order will remain till a specified number of days or till a specified date.
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Disclosure of Derivative Investments by Mutual Funds and Public Companies

Mutual funds and public companies are regulated by the SEC with respect to disclosure of material information to the securities markets and investors purchasing securities of those entities. The SEC requires these entities to provide disclosure to investors when offering their securities for sale to the public and mandates filing of periodic public reports on the condition of the company or mutual fund.
Disclosure of Derivative Investments by Mutual Funds and Public Companies

The SEC recently has urged mutual funds and public companies to provide investors and the securities markets with more detailed information about their exposure to derivative products. The SEC also has requested that mutual funds limit their investment in derivatives to those that are necessary to further the fund's stated investment objectives.
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SELLING OF DERIVATIVE PRODUCTS

Some brokerage firms are engaged in the business of creating financial derivative instruments to be offered to retail investment clients, mutual funds, banks, corporations and government investment officers. While not all derivative products may be subject to the jurisdiction of the Pennsylvania Securities Commission (Commission), these firms and their representatives generally are licensed by the Commission to conduct business in the Commonwealth of Pennsylvania. The Commission maintains a public record on each licensed brokerage firm and its agents that includes any disciplinary history.
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FEATURES
1. A derivative instrument relates to the future contract between two parties. It means there must be a contractbinding on the underlying parties and the same to be fulfilled in future. The future period may be short or long depending upon the nature of contract, for example, short term interest rate futures and long term interest rate futures contract.
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FEATURES
2. Normally, the derivative instruments have the value which derived from the values of other underlying assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of derivatives depends upon the value of underlying instrument and which changes as per the changes in the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related.
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FEATURES
3 In general, the counter parties have specified obligation under the derivative contract. Obviously, the nature of the obligation would be different as per the type of the instrument of a derivative. For example, the obligation of the counter parties, under the different derivatives, such as forward contract, future contract, option contract and swap contract would be different.
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FEATURES
4
The derivatives contracts can be undertaken directly between the two parties
or through the particular exchange like financial futures contracts. The exchangetraded derivatives are quite liquid and have low transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are Dow Jons, S&P 500, Nikki 225, NIFTY option, S&P Junior that are traded on New York Stock Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
.
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FEATURES
5. In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract depends upon its notional amount. The notional amount is the amount used to calculate the payoff. For instance, in the option contract, the potential loss and potential payoff, both may be different from the value of underlying shares, because the payoff of derivative products differs from the payoff that their notional amount might suggest.
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FEATURES
6. Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved; rather underlying transactions are mostly settled by taking offsetting positions in the derivatives themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in respect of underlying assets.
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FEATURES
7. Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier to take short or long position in derivatives in comparison to other assets or securities. Further, it is possible to combine them to match specific, i.e., they are more easily amenable to financial engineering. 8. Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh capital by the corporate world; however, warrants and convertibles are exception in this respect.
FEATURES
9. Although in the market, the standardized, general and exchange-traded derivatives are being increasingly evolved, however, still there are so many privately negotiated customized, over-the-counter (OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such derivatives. 10. Finally, the derivative instruments, sometimes, because of their off-balance sheet nature, can be used to clear up the balance sheet. For example, a fund manager who is restricted from taking particular currency can buy a structured note whose coupon is tied to the performance of a particular currency pair.
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FUNCTIONS OF DERIVATIVE MARKETS

Discovery of Prices: Prices in an organized derivatives market reflect the perception of market participants about the future and lead the prices of underlying to the perceived future level. Transfer of Risk: The derivatives market helps to transfer risks from those who have them but may not like them to those who have an appetite for them. Liquidity of Volume Trading: Third, derivatives, due to their inherent nature, are linked to the underlying cash markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes because of participation by more players who would not otherwise participate for lack of an arrangement to transfer risk.
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FACTORS
Factors contributing to the growth of derivatives. Price Volatility: A price is what one pays to acquire or use something of value. The objects having value may be commodities, local currency, or foreign currencies. The price one pays for use of a unit of another persons money is called interest rate and the price one pays in ones own currency for a unit of another currency is called exchange rate. Prices are generally determined by market forces- supply and demand. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in price is known as price volatility.
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FACTORS
Factors contributing to the growth of derivatives. Globalization of markets: Globalization has increased the size of the markets and has greatly enhanced competition. In the Indian context the South East Asian currency crisis of 1997 had affected the competitiveness of our productions. Exports of certain goods from India declined because of this crisis. Suddenly Blue chip companies turned into red. It is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses.
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FACTORS
Factors contributing to the growth of derivatives. Technology Advance: A significant growth of derivative instruments has been driven by technological breakthroughs. Derivatives can help a firm to manage the price risk inherent in a market economy. To the extent that technological developments increase volatility, derivatives and risk management products become that much more important.
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FACTORS
Factors contributing to the growth of derivatives. Advances in Financial Theories: Advances in financial theories gave birth to derivatives. Initially, Forward contract in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. The work of economic theorists gave rise to new productions for risk management, which led the growth of derivatives in financial markets.
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TRADERS IN DERIVATES MARKETS

Hedgers( Those who desire to off load and their risk exposure on a position.) Speculators Those willing to absorb risk of hedgers for a cost. Arbitragers Those who wish to have riskless gain the transaction of hedgers and speculators.

Hedgers: Hedgers are risk averse traders and are just opposite to speculators; they want to reduce the risks normally encountered in their business
operations or those associated with the holding of investments.
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Speculators are risk seeking traders who believe they have some specialized knowledge about the market and they can predict the direction of the markets movement. With this hope they buy/sell the assets.
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Arbitrageurs are set of traders who are on the look out for risk free profits predominantly interested in exploiting and mispricing between spot market and the derivatives market. Arbitrage entails zero intial investment and zero risk. When these two conditions are met in perfect markets returns will be zero.
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Hedgers: Hedgers are those who wish to eliminate price risk associated with the underlying security being traded. The objective of these king of traders is to safeguard their existing positions by reducing the risk. For Eg: an investor holding shares of ITC and fearing that the share price will decrease in future, takes an opposite position to minimize the extent of loss if the share will to dwindle.

Speculators: While hedgers might be adept at managing the risks of exporting and producting petroleum products around the world, there are parties who are adept at managing and even making money out of such exogenous risks. Using their own capital and that of clients, some individuals and organisations will accept such
TYPES OF FINANCIAL DERIVATIVES
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FORWARDS Forwards are the oldest of all the derivatives. A forward contract refers to an agreement between two parties to exchange an agreed quantity of an asset for cash at a certain date in future at a predetermined price specified in that agreement. The promised asset may be currency, commodity, instrument etc.,

FORWARDS Eg: On June 1, X enters into an agreement to buy 50 bales of cotton on Dec 1 at Rs. 1000/- per bale from Y, a cotton dealer. It is a case of a forward contract where X has to pay Rs. 50,000/- on Dec 1 to Y and Y has to supply 50 bales of cotton.

In a forward contract, a user who promises to buy the specified asset at a agreed price at a fixed date is said to be in the Long position On the other hand, the user who promises to sell at an agreed price at a future date, is said to be in Short position. Thus long position and short position take the form of buy and sell in a forward contract.

In a forward contract, a user who promises to buy the specified asset at a agreed price at a fixed date is said to be in the Long position On the other hand, the user who promises to sell at an agreed price at a future date, is said to be in Short position. Thus long position and short position take the form of buy and sell in a forward contract.

Futures: The future contract has been designed to remove the disadvantage of a forward contract. The future contract is like forward contract, an agreement between two parties to buy or sell an asset at a certain time in the future for a certain price.

A future contract is standardized contract, traded on a future exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a pre set price. The future date is called the delivery date or the final settlement date. The pre set price is called the future price. The price of the underlying asset on the delivery date is called the settlement price.

Future contract can be broadly grouped into two types: Commodity Futures Financial Futures A future contact in which the underlying asset is a commodity is referred to a commodity future contact. Similarly if the underlying asset is financial future it is referred to a s financial future contract. Commodity Futures E.g.: Food grains, metals, wheat, wool, gold, copper etc. Financial Futures E.g.: Equity shares, debentures, bonds, currencies etc., In Future contract the buyer is called a long position and the sellter is said to have a short position.

Features of Future contract 1. Standardized: One of the most important features of future contract is that the contact has certain standardized specification, quantity, quality of the asset, and date and month of the delivery etc. 2. Clearing House: The clearing house acts as an intermediary in future contract. It gives the guarantee for the performance of the parties to each transactions. 3. Settlement Price: Since the future contracts are performed through a particular exchange, each contract is marked to market. This settlement price is used to compute the profit or loss on each contract.
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Features of Future contract 4. Daily settlement and margin: Another features of future contract is that when a person enters into a contract, he is required to deposit funds with the broker which is called margin. 5. Delivery: Future contracts are executed on the expiry date. The counter parties with a short position are obligated to make delivery to the exchange, whereas the exchange is obligated to make delivery to the long position.
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OPTIONS: An option is a particular type of contract between two parties, where one person gives the other person the right to buy or sell a specified asset a specified price within a specific time period. As the very name implies , an option contract gives the buyer an option to buy or sell an underlying asset at a predetermined price on or before a specified date in future. The price so predetermined is called the STRIKE PRICE OR EXERCISE PRICE. In an options contract, the seller is usually referred to as a WRITER since he is said to write the contract. It is similar to the seller who is said to be in Short position in a forward contract. He is obliged to buy shares. In an option contract, the buyer has to pay a certain amount at the time of writing the contact for enjoying the right to buy or sell.
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AMERICAN OPTION VS EUROPEAN OPTION In an option contract, if the option can be exercised at any time between the writing of the contract and its expiration, it is called as an American option. On the other hand, if it can be exercised only at the time of maturity it is termed as European option.
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SWAPS SWAP is yet another exciting trading instrument. Swaps are private agreements between two parties, which are not traded on exchanges but are normally traded among dealers. The two swaps used commonly are currency swaps and interest rate swaps.
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DISTINCTION BETWEEN FUTURE & FORWARD CONTRACT

Forward contracts are private deal and are traded between two parties. Future contracts are always traded on an exchange. The price at which the contract is finally settled is different. Forwards are settled at the forward price agreed on the trade date(ie at the start) Future are settled at the settlement price fixed on the last trading date of the contract(ie at the end) In case of physical delivery, the forward contract specified to whom to make the delivery. The counterparty on a future contact is chosen randomly by the exchange. Forward contacts are self regulatory and do not require any registration. Future contracts are regulated through the respective exchanges where they are
registered.

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FINANCIAL DERIVATIVES

WHY HAVE DERIVATIVES

COMBINED DERIVATIVE PRODUCTS

Disclosure of Derivative Investments by Mutual Funds and Public Companies

Disclosure of Derivative Investments by Mutual Funds and Public Companies

SELLING OF DERIVATIVE PRODUCTS

FUNCTIONS OF DERIVATIVE MARKETS

TRADERS IN DERIVATES MARKETS

TRADERS IN DERIVATES MARKETS

operations or those associated with the holding of investments.

TRADERS IN DERIVATES MARKETS

TRADERS IN DERIVATES MARKETS

TRADERS IN DERIVATES MARKETS

TRADERS IN DERIVATES MARKETS

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

TYPES OF FINANCIAL DERIVATIVES

DISTINCTION BETWEEN FUTURE & FORWARD CONTRACT

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