Derivatives

The origin of derivatives can be traced back to the need of farmers to protect themselves against fluctuations in the price of their crop. From the time it was sown to the time it was ready for harvest, farmers would face price uncertainty. Through the use of simple derivative products, it was possible for the farmer to partially or fully transfer price risks by locking-in asset prices. These were simple contracts developed to meet the needs of farmers and were basically a means of reducing risk. A farmer who sowed his crop in June faced uncertainty over the price he would receive for his harvest in September. In years of scarcity, he would probably obtain attractive prices. However, during times of oversupply, he would have to dispose off his harvest at a very low price. Clearly this meant that the farmer and his family were exposed to a high risk of price uncertainty. On the other hand, a merchant with an ongoing requirement of grains too would face a price risk that of having to pay exorbitant prices during dearth, although favorable prices could be obtained during periods of oversupply. Under such circumstances, it clearly made sense for the farmer and the merchant to come together and enter into contract whereby the price of the grain to be delivered in September could be decided earlier. What they would then negotiate happened to be futures-type contract, which would enable both parties to eliminate the price risk. In 1848, the Chicago Board Of Trade, or CBOT, was established to bring farmers and merchants together. A group of traders got together and created the to-arrive contract that permitted farmers to lock into price upfront and deliver the grain later. These to-arrive contracts proved useful as a device for hedging and speculation on price charges. These were eventually standardized, and in 1925 the first futures clearing house came into existence. Today derivatives contracts exist on variety of commodities such as corn, pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts 1

also exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc. A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. four most common examples of derivative instruments are forwards, futures, options and swaps. there are several risks inherent in financial transactions. Derivatives allow you to manage these risks more efficiently by unbundling the risks and allowing either hedging or taking only one (or more if desired) risk at a time. u can also use below link to know more about derivatives. Types: FUTURES and OPTIONS. As the name suggests, DERIVATIVES means financial instruments having "DERIVED VALUE".

FUTURES: You buy a COMPANY ABC Stock today at Rs 1050/- (just for Eg). you enter into a contract with me, to sell the stock for Rs 1070/- after 1 month. On the D day, irrespective of whatever is the Market Price of the Stock you will have to sell it to me at Rs 1070. Reason being, you have entered into a Future Contract with me, and it is the obligation of both parties to fulfill the contract. OPTIONS: It is same as FUTURES, but you have the OPTION to cancel the contract. That is to say, if the Market price of the stock on the D day is more than 1070, u can withdraw your sale contract from me. Options are NOT OBLIGATORY. In both cases, you pay something called as a MARGIN MONEY, to enter the contract.

Types Of Derivatives Contract: In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market: 2

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, and exotic options 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. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008). Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. 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 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. The world's largest derivatives exchanges (by number of transactions) are the Korea 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). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 3

trillion during Q4 2005. Some types of derivative instruments also may trade on traditional exchanges. For instance, hybrid instruments such as convertible bonds and/or convertible preferred may be listed on stock or bond exchanges.

History of Derivatives in India

Starting from a controlled economy, India has moved towards a world where prices fluctuate every day. The introduction of risk management instruments in India gained momentum in the last few years due to liberalisation process and Reserve Bank of Indias (RBI) efforts in creating currency forward market. Derivatives are an integral part of liberalisation process to manage risk. NSE gauging the market requirements initiated the process of setting up derivative markets in India. In July 1999, derivatives trading commenced in India.

Derivative tools
FORWARD CONTRACTS A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are n o r m a l l y traded outside the exchanges. The salient features of forward contracts are: They are bilateral contracts and hence exposed to counter- party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. 4

 asset.

The contract price is generally not available in public domain. On the expiration date, the contract has to be settled by delivery of the If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

However forward very standardized,

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process of standardization reaches its limit in the organized futures market. Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially t he improvement same the economic func tions of allocating risk in the presence of future price uncertainty. However futures are a liquidity. significant over forward contracts as they eliminate counterparty risk and offer more

FUTURE CONTRACT In finance, a futures contract is a standardized contract, traded on a futures 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 final settlement date. The pre-set price is called the futures price. The price of the underlying asset on the delivery date is called the settlement price. The settlement price, normally, converges towards the futures price on the delivery date. A futures contract gives the holder the right and the obligation to buy or sell, which differs from an options contract, which gives the buyer the right, but not the obligation, and the option writer (seller) the obligation, but not 5

the right. To exit the commitment, the holder of a futures position has to sell his long position or buy back his short position, effectively closing out the futures position and its contract obligations. Futures contracts are exchange traded derivatives. The exchange acts as counterparty on all contracts, sets margin requirements, etc.

OPTIONS A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as option. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the strike price. There are two types of options i.e., CALL OPTION AND PUT OPTION. Call Option: A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Call option. The owner makes a profit provided he sells at a higher current price and buys at a lower future price. Put Option: A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a Put option. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase. Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options. SWAPS

Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a SWAP. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are: Interest Rate Swaps: Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas the floating rate payer takes a long position in the forward contract. Currency Swaps: Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates. Financial Swap: Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

Derivatives as a hedging tool

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Derivative contract is a contract whose value is determined by the changes in the value of underlying asset. Underlying assets includes: stocks, bonds, commodities, currencies, interest rates and market indices. Derivatives are generally used as a tool to hedge risk but some people used derivatives for speculation purpose also. Some investors called derivatives as financial instrument that has a value based on the expected future price movements of the asset. It also means a forward, future, options or any other contract that has a predetermined fixed duration. As per securities contract regulation act 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 Derivative includes three types of participants: Hedgers, Speculators and Arbitrageurs. Hedgers are the investors who use derivative as a hedging tool to reduce their future risk. Hedge is an investment made in order to reduce the risk of adverse price movements in a security by taking an offsetting position in a related security. Speculators are the persons who dont invest any money but makes money by speculating on up and down movements of stocks and indices, where as arbitrageurs are the persons who makes money out of the difference between the stocks prices in two different markets (equity and future markets), they buy low in one market and sell the same at a high price in other market. Derivative includes: Forwards, Futures, Options & Swaps. A forward contract is a non standardized contract between the two parties to buy or sell an asset at a specified future price and time agreed today. The price agreed upon is called the delivery price. Forward contract like other derivative contract is a tool to hedge risk. The other form of Derivative-Future is best defined as a standardized contract to buy or sell a specified commodity of standardized quality at a certain date in future and at a determined future price. The party agreeing to buy the underlying asset in future is said to have taken a long position and party which agrees to sell the underlying in future is said to have taken a short position. Options are the refined form of 8

Derivatives, in which one can go for a buy or sell positions. The trade in options is on premium. Option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying at a specific price on or before a certain date. A Stock option which gives the holder the right to buy an asset at a fixed price during a certain period is called as Call Option, while an option which gives the holder the right to sell a stock at a fixed price is a Put Option. An investor can trade in following types of options- exchange traded option, stock option, bond option, over the counter option, index options etc.

Recent development in Derivatives market

Financial Derivatives Market and its Development in India Financial markets are, by nature, extremely volatile and hence the risk factor is an important concern for financial agents. To reduce this risk, the concept of derivatives comes into the picture. Derivatives are products whose values are derived from one or more basic variables called bases. These bases can be underlying assets (for example forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a change in prices by that date. The transaction in this case would be the derivative, while the spot price of wheat would be the underlying asset. The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary preconditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as securities so that regulatory framework applicable to trading of securities 9

could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and realtime monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of securities and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized which stock exchange, forward thus precluding in OTC derivatives. The government also rescinded in March 2000, the three decade old notification, prohibited trading securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE30(Sensex) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved

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by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products. My Recommendation Regarding Further Developments In

Derivative Market
A knowledge need to be spread concerning the risk and return of the derivative market. More variation in stock index future need to be made looking a demand side of investors. RBI should play a greater role in supporting derivatives There must be more derivative instruments aimed at individual investors. SEBI should conduct seminars regarding the use of derivatives to educate individual investors.

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