INTRODUCTION TO DERIVATIVES

©2018 BSE Institute Limited

Objective

In this session, you will be able to understand and comprehend about

the following:
• Definition of derivatives
• Elements of derivatives
• Characteristics of derivatives
• Underlying assets
• Origin and development of derivatives
• Derivative market in India
• Benefits of derivatives
• Factors driving growth of derivatives / need for derivatives
• Risk in derivatives
• Pitfalls of derivatives

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Definition of Derivatives
 As per Securities Contract Regulation Act:
Derivative is a contract that derives its value from the prices
or index of prices of the underlying asset.

 As per Indian Accounting Standard (IAS):

Its value changes in response to the change in underlying
asset. Example:-
» specified interest rate
» financial instrument price
» commodity price
» foreign exchange rate
» index of prices or rates
» credit rating or credit index etc.
 It is settled at a future date
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Elements of Derivatives Contract

• A legally binding contract

• There are two parties : buyer & seller
• There is an underlying asset
• Future date
• Future price (decided at the time of contract)
• Transfer of risk

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Characteristics of Derivatives

• It is a contract whose value is derived from an underlying asset

i.e. their value depends on the movement in the prices of their
underlying.
• Price discovery
• Vehicles for transferring risk
• Mechanism for speculation, arbitrage and hedging
• Leveraged Instruments
• Maximize returns & minimizes risks
• Settlement of obligations at a future date (maturity period)
• Can be cash / delivery settled, depending upon the derivative –
forward or future

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 Underlying Assets

Financial Assets Non - Financial Assets

Equity Debt Agricultural E.g. Cereals & Pulses, Vegetables etc.

Index Interest Rates Non - Agricultural

E.g. Sensex, E.g. LIBOR, Dairy Animal Energy

NIFTY T-Bill etc. Metals products Products Products

E.g. Gold, E.g. Butter, E.g. Crude

Silver, Margarine E.g. Egg,
Individual Stock Credit Lamb etc. Oil, Gases
Platinum etc. etc. etc.

E.g. Infosys, E.g. Bonds,

Other Assets
Tata Motors Etc. Receivables
Currencies Weather Emissions

E.g. US E.g.
Dollar, GBP, Temperature, E.g. Carbon
EURO etc. Rainfall etc. Credits etc.

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Origin & Development of Derivatives

• Started with agriculture commodities

• Unorganized market began with Rice in China 6000 years ago
DEVELOPMENT OF DERIVATIVES

1850 Chicago Board of Trade CBOT – Modern Futures

Market

1960 Black & Scholes Model for Option Pricing (Fischer

Black & Myron Scholes)

1970 Financial Futures – Currencies, Shares

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Origin & Development of Derivatives
Development of Derivatives
1971 Bretton Woods system of fixed exchange rate was removed
.
US suspended the convertibility of Dollar & Gold
1973 CBOT – promoted a new exchange – Chicago Board OF
Options Exchange (CBOE)

1975 CBOT – launched first futures contract, Ginnie Mae

Mortgage Bond future
19th Century Trading began in US – CBOT

1982 First index S&P 500 introduced in CME

1989 Traders formed Chicago Mercantile Exchange (CME)

1990 Financial Institutions got involved in Derivatives

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Origin & Development of Derivatives
• Chicago Mercantile Exchange (CME) underlying's:
 Pork Bellies, Hogs, Cattles
 Financial Currencies (Euro – dollar contract) &
 Index Futures
• Variety of products available today:
 Swaps
 Forward Rate Agreement (FRA’s)
• Participants include :
 Institutional Investors
 CFOs
 Fund managers
 Retail
 DII & FII etc.
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Emergence of Derivatives Markets in India

1977 Morarji Desai’s Government banned Forwards

1991 Liberalization of Financial Reforms

1995 NSE asked SEBI for permission to trade in Index Future

1996 Dr. L C Gupta Committee was set up to make regulatory

framework of Derivatives Trading.

1998 Dr. L. C. Gupta Committee submitted the report

1999 RBI gave permission for OTC forward rate agreement

and interest rate swaps

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Emergence of Derivatives Markets in India

DERIVATIVES MARKETS IN INDIA

2000 National Agriculture Policy directed development of

Commodity Derivatives

May 2000 SEBI approved trading of derivatives on NSE & BSE

June 2001 Index option introduced on NSE

July 2001 Stock options and stock futures introduced in NSE

2003 Government gave notifications for Trading in Commodities

2008 Trading in currency future commenced

2009 Interest rate derivatives were introduced

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Emergence of Derivatives Markets in India
National Stock Exchange (NSE)

June 2001 Index Options introduced

July 2001 Stock Options introduced

Nov 2001 Stock Futures

Aug 2008 Currency Derivatives

Aug 2009 Interest Rate Derivatives

Bombay Stock Exchange (BSE)

June 2001 Sensex Option

July 2001 Stock Options

Nov 2001 Futures on Stocks

D1/ Introduction to Derivatives ©2018 BSE Institute Limited

Benefits of Derivatives

• Price Risk Management – buying selling of risk

• Price Discovery
• High Financial Leverage
• Helps as an asset class to diversify the portfolio
• It is a tool for HNI
• Beneficial to Banks & Financial Institutions
• Lower Transaction Cost
• Operational advantages
• Market efficiency
• Ease of speculation

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Factors Driving Growth of Derivatives

• Volatility in assets prices

• Increased economic integration
• Increased sophistication in communication facilities
• Sophisticated risk management tools
• Financial engineering

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Risk in Derivatives

• Credit risk (only OTC contracts)

• Market risk
• Operational risk
 Settlement risk
 Legal risk
 Risk of error
• Strategic risk
• Systematic risk – risk of bankruptcy

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Pitfalls of Derivatives

• Speculative & Volatile

• Restrictive Regulation

• Increased Bankruptcy

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 THANK YOU
©2018 BSE Institute Limited