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Derivatives

Derivatives

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Published by: rameshmba on Jun 14, 2008
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05/03/2012

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DERIVATIVES
As the word implies, a derivative instrument is derived from “something” backing it. Thissomething may be – A loan, an asset, an interest rate, a currency flow, a stock trade, a commoditytransaction etc.Derivates enable a company to hedge a company to hedge “this some thing” withoutchanging the flow associated with the business operations.
Kinds of Financial Derivatives:
The Important financial derivatives are as follows;1.Forwards2.Futures3.Options4.Swaps.
FORWARDS
Forwards are the oldest of all derivatives. A forward contract refers to an agreement between two parties to exchange an agreed quality of an asset for cash at a certain date in futureat a predetermined price specified in the agreement.Features of Forward Contracts:
Over the Counter Trading (OTC).
 No down Payment
Settlement at Maturity.
Linearity (Loss of a forward buyer is the gain of the forward seller)
 No Secondary Market
 Necessity of a third party
Delivery.Forward Rate contracts for commodities.Forward Rate contracts for currency.Forward Rate contracts for Interest Rates.
FUTURES
A future contract is very similar to a forward contract in all respects excepting the factthat it is completely a standardized one. Hence, it is rightly said that a futures contract is nothing but a standardized forward contract. It is legally enforceable and it is always traded on anorganized exchange.Clark has defined future trading “as a special type of futures contracts bought and soldunder the rules of organized exchanges.”A future contract is one where there is an agreement between tow parties to exchange anyasset or currency or commodity for cash at a certain future date, at an agreed price. Both the parties to the contract must have mutual trust in each other. It takes place only in organizedfuture markets and according to well established standards.Short Position: This commits the seller to deliver an item at the contracted price onmaturity.
 
Long Position: This commits the buyer to purchase.
Key features of Futures contracts:
Standardization.
Intermediation by the Exchange.
Price Limits.
Margin requirements.
Marking to market.Standardization: It is standardized, so that it can be traded in the stock exchange.Intermediation by the exchange:Price Limits:Margin Requirements: (Initial Margin)Marking to market: while the forward contracts are settled down the maturity date futurescontracts are ‘marked to market’ on a periodic basis. This means that profits and losses on futurecontracts are settled on a periodic basis.
Types of Future Contracts – (The Global scene types of Futures)
1.Commodity Futures2.Financial Futures.
Commodity Futures:
A commodity futures is a future contract in commodities like agricultural products, metals and mineral etc. Some of the will established commodity exchanges are asfollows.
London Metal Exchange (LME) – to deal in gold.
Chicago Board of Trade (CBT) – to deal in Soya bean oil.
 New York cotton Exchange – to deal in cotton.
Commodity exchange in New York (COMEX) – to deal in agricultural products.
International Petroleum Exchange of London (IPE) – to deal in crude oil.
Financial Futures:
Financial futures refer to a futures contract in foreign exchange or financialinstruments like Treasury bill, commercial paper, stock market index or interest rate.Some of the well established financial futures exchanges are the following;1.International Monetary Market (IMM) to deal in US treasury bills, Euro dollar depositsetc.2.London International Financial futures exchange (LIFFE) to deal in Euro dollar deposits.3.New York Futures Exchange (NYFE) to deal in Euro dollar deposits etc.
Types of Future Contracts – (In Indian Context)
 
Buyer of thecontractFutureExchangeSeller of thecontract
 
Equity Futures in India:
Equity futures are of two types;1.Stock index futures2.Individual Securities.[Refer Prasanna Chandra (SAPM), Page number – 469 & 470 (old). 541& 542 (new)]
Derivative Instruments in Equity Market:
Futures – Index FuturesStock FuturesOptions – Index OptionStock OptionParticipants in the Derivatives Market:
Hedger: Reduces / eliminates his risk.
Speculator: Bets on future movements in the price of an asset.
Arbitrageur: Takes advantage of a discrepancy between prices in two different markets.Index Futures:
Index is the underlying security
Derive their value from the underlying index
Date of commencement of trading at NSE is 2/6/2000.Stock futures:
Stock is the underlying security.
Derive their value from underlying stock.
Date of commencement of trading is 9/11/2001
VALUATION OF FUTURES
I. Pricing future Contracts. 1. Cost & Carried modelF
o
= S
o
(1 + r 
)
t
 2. When dividend are expectedF
o
= S
o
(1 + r 
– d)
t
S
o
= Spot Price,
= Risk Freet = time period.

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