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FINANCIAL DERIVATIVES

by Vishnu Vardhan (Reg # 093J1E0022)

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DEFINITION
 Derivative is a product whose value is derived
from the value of an underlying asset in a
contractual manner. The underlying asset

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can be equity, forex, commodity or any
other asset.


 Securities Contracts (Regulation) Act, 1956

defines Derivative as “A contract which
derives its value from the prices, or index of
prices, of underlying securities”.

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Participants in the Derivatives
Market
 HEDGERS:
 Hedgers face risk associated with the price of an
asset. They use futures or options markets to reduce or

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eliminate this risk.
 SPECULATORS:
 Speculators wish to bet on future movements in the
price of an asset. Futures and options contracts can
give them an extra leverage; that is, they can increase
both the potential gains and potential losses in a
speculative venture.
 ARBITRAGEURS:
 Arbitrageurs are in business to take advantage of a
discrepancy between prices in two different markets. If,
for example, they see the futures price of an asset
getting out of line with the cash price, they will take 3
offsetting positions in the two markets to lock in a
profit.
FUNCTIONS OF DERIVATIVES
MARKET
 Prices in an organized derivatives market
reflect the perception of market participants
about the future and lead the prices of

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underlying to the perceived future level.
 Derivatives market helps to transfer risks from
those who have them but may not like them
to those who have an appetite for them.
 Derivative trading acts as a catalyst for new
entrepreneurial activity.
 Derivatives markets help to increase savings
and investment in the long run.
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USES OF DERIVATIVES
Derivatives are used by investors to:


 provide leverage (or gearing), such that a small

movement in the underlying value can cause a large

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difference in the value of the derivative;
 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;
 obtain exposure to the underlying where it is not
possible to trade in the underlying (e.g., weather
derivatives);
 create option ability where the value of the derivative is
linked to a specific condition or event (e.g., the 5
underlying reaching a specific price level).

MAJOR TYPES OF DERIVATIVES
 FORWARDS:
 A forward contract is a customized contract

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between two entities, where settlement takes
place on a specific date in the future at
today’s pre-agreed price.


 FUTURES:
 A futures contract is an agreement between
two parties to buy or sell an asset at a certain
time in the future at a certain price.


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

 OPTIONS: Options are of two types - Calls and

Puts.


 Call Option: Calls give the buyer the right but not

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the obligation to buy a given quantity of the
underlying asset, at a given price on or before a
given future date.


 Put Option: Puts give the buyer the right, but not
the obligation to sell a given quantity of the
underlying asset at a given price on or before a
given date

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

 SWAPS:
 Swaps are private agreements between two
parties to exchange cash flows in the future
according to a prearranged formula. They can be

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regarded as portfolios of forward contracts.


 The two commonly used swaps are:

1. Interest rate swaps
2. Currency swaps


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Interest rate swaps:
 These entail swapping only the interest related
cash flows between the Parties in the same
currency.


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Currency swaps:
 These entail swapping both principal and interest
between the parties, with the cash flows in one
direction being in a different currency than those in
the opposite Direction.


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Trading of Derivatives
 In broad terms, there are two groups of
derivative contracts, which are distinguished
by the way they are traded in the market:

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

1.Over-the-counter (OTC) Traded

2.
3.Exchange-traded

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Over-the-counter (OTC)
Derivatives
 These are contracts that are traded (and
privately negotiated) directly between two
parties, without going through an exchange

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or other intermediary.
 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
counter-party relies on the other to perform.

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Over-the-counter (OTC)
Derivatives
 Products such as swaps, forward agreements,
and exotic options are almost always traded
in this way.

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

 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.

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Exchange-Traded Derivative
Contracts
 These are those derivatives instruments that
are traded via specialized derivatives
exchanges or other exchanges.

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 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.

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Exchange-Traded Derivative
Contracts
 The world's largest derivatives exchanges (by
number of transactions) are the Korea
Exchange (which lists Index Futures &

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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).

 These derivatives provide investors access to
risk/reward and volatility characteristics
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that, while related to an underlying
commodity, nonetheless are distinctive.
Valuation Of Derivative Contracts
 Two common measures of value are:


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 Market price : the price at which traders are
willing to buy or sell the contract.


 Arbitrage-free price: meaning that no risk-

free profits can be made by trading in these
contracts.


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Determining the Market Price
 For exchange-traded derivatives, market price
is usually transparent (often published in
real time by the exchange, based on all the

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current bids and offers placed on that
particular contract at any one time).
 Complications can arise with OTC, as trading is
handled manually, making it difficult to
automatically broadcast prices.
 In particular with OTC contracts, there is no
central exchange to collate and disseminate
prices.
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Determining the Arbitrage-Free
Price
 Arbitrage-free pricing is a central topic of
financial mathematics. The stochastic
process of the price of the underlying asset

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is often crucial.
 A key equation for the theoretical valuation is
the Black–Scholes formula, which is based
on the assumption that the cash flows can
be replicated by a continuous buying and
selling strategy using only the stock.
 OTC derivatives are priced by Independent
Agents that both counterparties involved in
the deal designate upfront (when signing the 17
contract).
Criticism on Derivatives Contracts
qPossible large losses:
q

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 The loss of US$7.2 Billion by Societe Generale
in January 2008 through mis-use of futures
contracts.
 The loss of US$6.4 billion in the failed fund
Amaranth Advisors, which was long natural
gas in September 2006 when the price
plummeted.

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q
qCounter-party risk:
 If any of the parties goes bankrupt.
q

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qLarge notional value:
 Could result in losses that the investor would
be unable to compensate for.
q
qLeverage of an economy's debt:
 Can cause a recession or even depression.

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Regulation of Derivative Trading
 SEBI set up a 24 member committee under
Chairmanship of Dr.L.C.Gupta to develop the
appropriate regulatory framework for

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derivative trading in India.
 On May 11, 1998 SEBI accepted the
recommendations of the committee and
approved the phased introduction of
Derivatives trading in India beginning with
Stock Index Futures.
 SEBI also approved the “Suggestive bye-laws”
recommended by the committee for
regulation and control of trading and 20
settlement of Derivatives contracts.
  Thanks

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for your time


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