Unit I

Meaning of Derivatives
• A derivative is a financial instrument which derives
its value from underlying asset or group of assets. A
financial derivative does not have any independent
value.
• 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 of Derivatives
• Accounting Standard SFAS 133 defines a derivative as, ‘a
derivative instrument financial derivative or other contract
with all three of the following characteristics: (i) It has (1) one
or more underlying, and (2) one or more notional amount or
payments provisions or both. Those terms determine the
amount of the settlement or settlements. (ii) It requires no
initial net investment or an initial net investment that is
smaller than would be required for other types of contract that
would be expected to have a similar response to changes in
market factors.
• An underlying may be financial or physical. The main
examples of such underlying assets are currency, previous
metals, crops, livestock, securities etc.
• For example, a wheat derivative may be used by a farmer for
managing the risk related to their crop.
 Meaning of Derivatives
• There are mainly two types of derivatives: a) Commodity
Derivatives b) Financial Derivatives
• In the case of commodity derivatives, the main
underlying are cotton, silver, sugar, gold, petroleum etc.
• Most prominent underlying in the case of financial
derivatives are stocks, foreign exchange, treasury bills.
• Further, derivatives may also be divided into two
categories on the basis of their complexity i.e. a) Simple
derivatives b) Complex derivatives
• Simple derivatives are Forward, Future, Option and
Convertibles while complex derivatives are Swaps and
Exotics.
 Scope of Derivatives
• Derived Value: any derivative derives its value from the
value of its underlying. Value of the derivative is dependent
upon the value of the derivative and changes accordingly. The
value of the gold derivative is dependent upon the price of
gold while the value of wheat derivative will depend on the
price of wheat.
• Direct or Exchange Traded: derivatives may be traded
directly or through an exchange. Some of the prominent
exchanges in India are National Stock Exchange and Multi
Commodity Exchange (MCX).
• Delivery of Underlying: Derivatives in general do not
involve delivery of underlying. For example, no actual
delivery of rice or cotton is done in the case of commodities
derivative.
• Contract: derivative is a future contract and assumes the
existence of an enforceable contract. Such contract may be
short term or long term in nature.
Mini-sized Chicago SRW Wheat
Futures at CME Group
Need for Financial Risk Management
• Risk management is the art and science of
managing exposure to risk. It involves
identification of potential risk in advance,
analyzing such risk and devising precautionary
steps .
• Financial risk is attached to a large number of
decisions taken by the businesses.
• Such risks are mainly caused by volatility in
capital markets, change in business
environment, change in internal environment
of the firm and inflation, among others.
 Derivative Market & Instruments
• The derivative market refers to the market where
derivatives such as futures and options are
traded.
• Derivative markets may generally be divided into
two categories: a) Exchange Traded Markets and
b) Over the Counter derivatives market.
• Exchange Traded markets such as NSE, BSE, MCX,
National Commodity and Derivatives Exchange
(NCDEX) and Indian Commodity Exchange (ICEX)
offer structured contracts.
• Over the Counter Derivatives markets transact off
Exchange Traded Markets. Such markets are more
popular with sophisticated institutional investors
such as Hedge Fund, Mutual Funds etc.
 Derivative Market & Instruments
• Forwards
• Futures
• Options
• Exotics/Synthetics
Hedging
 Hedging in Practice
• A Ltd. is a power company and uses crude as
fuel. The crude price is expected to fluctuate in
the coming months. Its January 1 now and
company uses 1 million barrel per month.
Suggest appropriate strategy for the company.
You are provided with the Future contract
prices for next SIX months
Futures Prices (As on January 1)
Actual Spot Prices
 Hedging in Practice – No Hedging Approach
• The company does not carry out any hedge.
Month Spot Price Consumption (in Million. Barrels) Total Exp. (In Mil $)
I 68 1 68
II 69 1 69
III 72 1 72
IV 74 1 74
V 73 1 73
VI 72 1 72
428
Hedging in Practice – Hedging with Futures
Hedging