succeed Derivaties

The term "Derivative" indicates that it has no independent value, i.e. its value is entirely "derived" from the value of the underlying asset. The underlying asset can be securities, commodities, bullion, currency, live stock or anything else. In other words, Derivative means a forward, future, option or any other hybrid contract of pre determined fixed duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index of securities. With Securities Laws (Second Amendment) Act,1999, Derivatives has been included in the definition of Securities. The term Derivative has been defined in Securities Contracts (Regulations) Act, as:A Derivative includes: a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; a contract which derives its value from the prices, or index of prices, of underlying securities

Derivatives are used by investors for the following:

provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;[8] speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level); hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out;[9] obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);[10] create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level).

Types of 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. 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 are difficult because trades can occur in private, without activity being visible on any exchange. Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counterparty relies on the other to perform. Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where [15] 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 [16] of the trade to act as a guarantee. The world's largest derivatives exchanges (by number of transactions) are theKorea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange)..

forward contract or simply a forward is a non-standardized contract between two parties to buy or sell [1] an asset at a specified future time at a price agreed upon today. This is in contrast to aspot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to theforward price at the time the contract is entered into. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
The advantages of forward contracts are as follows: 1) They can be matched against the time period of exposure as well as for the cash size of the exposure. 2) Forwards are tailor made and can be written for any amount and term. 3) It offers a complete hedge. 4) Forwards are over-the-counter products. 5) The use of forwards provide price protection. 6) They are easy to understand.

The disadvantages of forward contracts are: 1) It requires tying up capital. There are no intermediate cash flows before settlement. 2) It is subject to default risk. 3) Contracts may be difficult to cancel. 4) There may be difficult to find a counter-party.

Futures Contract means a legally binding agreement to buy or sell the underlying security on a future date. Future contracts are the organized/standardized contracts in terms of quantity, quality (in case of commodities), delivery time and place for settlement on any date in future. The contract expires on a pre-specified date which is called the expiry date of the contract. On expiry, futures can be settled by delivery of the underlying asset or cash. Cash settlement enables the settlement of obligations arising out of the future/option contract in cash.
The advantages of trading futures contracts: 1) The commission charges for futures trading are relatively small as compared to other type of investments. 2) Futures contracts are highly leveraged financial instruments which permit achieving greater gains using a limited amount of invested funds. 3) It is possible to open short as well as long positions. Position can be reversed easily. 4) Lead to high liquidity. The disadvantages of trading futures contracts: 1) Leverage can make trading in futures contracts highly risky for a particular strategy. 2) Futures contract is standardized product and written for fixed amounts and terms. 3) Lower commission costs can encourage a trader to take additional trades and lead to over-trading. 4) It offers only a partial hedge. 5) It is subject to basis risk which is associated with imperfect hedging using futures.

Futures contract based on an index i.e. the underlying asset is the index, are known as Index Futures Contracts. For example, futures contract on NIFTY Index and BSE-30 Index. These contracts derive their value from the value of the underlying index. Options Contract is a type of Derivatives Contract which gives the buyer/holder of the contract the right (but not the obligation) to buy/sell the underlying asset at a predetermined price within or at end of a specified period. The buyer / holder of the option purchases the right from the seller/writer for a consideration which is called the premium. The seller/writer of an option is obligated to settle the

option as per the terms of the contract when the buyer/holder exercises his right. The underlying asset could include securities, an index of prices of securities etc. An Option to buy is called Call option and option to sell is called Put option. Further, if an option that is exercisable on or before the expiry date is called American option and one that is exercisable only on expiry date, is called European option. The price at which the option is to be exercised is called Strike price or Exercise price. the options contracts, which are based on some index, are known as Index options contract. However, unlike Index Futures, the buyer of Index Option Contracts has only the right but not the obligation to buy / sell the underlying index on expiry. Index Option Contracts are generally European Style options i.e. they can be exercised / assigned only on the expiry date.

Two type of margins have been specified Initial Margin - Based on 99% VaR and worst case loss over a specified horizon, which depends on the time in which Mark to Market margin is collected. Mark to Market Margin (MTM) - collected in cash for all Futures contracts and adjusted against the available Liquid Networth for option positions. In the case of Futures Contracts MTM may be considered as Mark to Market Settlement.
Some of the economic functions of derivatives market Some of the salient economic functions of the derivative market include: 1. Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices. 2. The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite for risk. 3. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk. 4. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment. 5. A significant accompanying benefit which is a consequence of derivatives trading is that it acts as a facilitator for newEntrepreneurs. The derivatives market has a history of alluring many

optimistic, imaginative and well educated people with an entrepreneurial outlook, the benefits of which are colossal. In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented [18] activities by derivative Market participant.

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Forward Contract
A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time.

Futures Contract
A futures contract is a standardized contract, traded on a futuresexchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.

Meaning:

Structure:

Customized to customers need. Usually no initial payment required.

Standardized. Initial margin payment required.

Transaction method:

Negotiated directly by the buyer and seller

Quoted and traded on the Exchange

Market regulation:

Not regulated

Government regulated market

Institutional guarantee:

The contracting parties

Clearing House

Risk:

High counterparty risk

Low counterparty risk

Guarantees:

No guranantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid

Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.

Contract Maturity:

Forward contract mostly mature by delivering the commodity

Future contracts may not necessarily mature by delivery of commodity

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Forward Contract
Depending on the transaction

Futures Contract
Standardized

Expiry date:

Method of pretermination:

Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty.

Opposite contract on the exchange.

Contract size:

Depending on the transaction and the requirements of the contracting parties.

Standardized