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dervatives unit1

# dervatives unit1

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12/19/2010

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1. INTRODUCTION TO DERIVATIVES
In the present state of the economy, there is an imperative need of the corporate clients to protect there operating profits by shifting some of the uncontrollable financial risks tothose who are able to bear and manage them. Thus, risk management becomes a must for survival since there is a high volatility in the present financial marketsThe primary objectives of any investor are to maximize returns and minimize risks.Derivatives are contracts that originated from the need to minimize risk. The word'derivative' originates from mathematics and refers to a variable, which has been derivedfrom another variable. Derivatives are so called because they have no value of their own.They derive their value from the value of some other asset, which is known as theunderlying.In this context, derivatives occupy an important place as risk reducing machinery.Derivatives are useful to reduce many of the risks discussed above. In fact, the financialservice companies can play a very dynamic role in dealing with such risks. They canensure that the above risks are hedged by using derivatives like forwards, future, options,swaps etc. Derivatives, thus, enable the clients to transfer their financial risks to thefinancial service companies. This really protects the clients from unforeseen risks andhelps them to get there due operating profits or to keep the project well within the budgetcosts. To hedge the various risks that one faces in the financial market today, derivativesare absolutely essential.
2. CONCEPT OF DERIVATIVES
In a broad sense, many commonly used instruments can be called derivatives since theyderive value from an underlying assets that is a derivative is a financialcontract that derives its value from another financial product / commodity (say spot rate)called underlying (that may be a stock, stock index, a foreign currency, a commodity).Credit derivatives are based on loans, bonds or other forms of credit.In a strict sense, derivatives are based upon all those major financial instruments whichare explicitly traded like equities, debt instruments, forex instruments and

commodity based contracts. As the word implies, a derivative instrument is derived from“something” backing it. This something may be a loan, an asset, an interestrate, a currency flow, a stock traded, a commodity transaction, a trade flow, etc.Derivatives enable a company to hedge ‘this somethingwithout changing the flowassociated with the business operation.Hence, derivatives can be used to mitigate the risk of economic loss arising from changesin the value of the underlying. This is known as hedging. Alternatively,derivatives can be used by investors to increase the profit arising if the value of theunderlying moves in the direction they expect. This activity is known as speculationFor example, a farmer fears that the price of soybean (underlying), when his crop is readyfor delivery will be lower than his cost of production.Let's say the cost of production is Rs 8,000 per ton. In order to overcome this uncertaintyin the selling price of his crop, he enters into a contract (derivative) with a merchant, whoagrees to buy the crop at a certain price (exercise price), when the crop is ready in threemonths time (expiry period). In this case, say the merchant agrees to buy the crop at Rs9,000 per ton. Now, the value of this derivative contract will increase as the price of soybean decreases and vice-a-versa.If the selling price of soybean goes down to Rs 7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of soybean goes down to Rs 6,000, thecontract becomes even more valuable. This is because the farmer can sell the soybean hehas produced at Rs .9000 per tone even though the market price is much less. Thus, thevalue of the derivative is dependent on the value of the underlying.If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold,silver, and precious stone or for that matter even weather, then the derivative is known asa commodity derivative.If the underlying is a financial asset like debt instruments, currency, share price index,equity shares, etc, the derivative is known as a financial derivative.

3. DEFINITION OF DERIVATIVES
Derivatives are defined as financial instruments whose value derived from the prices of oneor more other assets such as equity securities, fixed-income securities, foreign currencies, or commodities. Derivatives are also a kind of contract between two counterparties to exchange payments linked to the prices of underlying assets.One such definition is, “Derivatives involve payment / receipt of incomegenerated by the underlying asset on a notional principal”Derivative can also be defined as
“a financial instrument that does not constitute ownership,but a promise to convey ownership”.
The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures contractsin commodities all over India. As per this the Forward Markets Commission (FMC)continues to have jurisdiction over commodity futures contracts. Derivatives aresecurities under the Securities Contracts (Regulation) Act, 1956 (SCRA), and hence thetrading of derivatives is governed by the regulatory framework under the SCRA.The Securities Contracts (Regulation) Act, 1956 defines “derivative” to include-
A security derived from a debt instrument, share, loan whether secured or unsecured,risk instrument or contract differences or any other form of security”.“A contract which derives its value from the prices, or index of prices, of underlying  securities”.
According to JOHN C. HUL
“A derivatives can be defined as a financial instrument whose value depends on (or derives from) the values of other, more basic underlying variables.”
According to ROBERT L. MCDONALD
“A derivative is simply a financial instrument (or even more simply an agreement between two people) which has a value determined by the price of something else.
All these definitions point out the fact that transactions are carried out ona notional principal, transferring only the income generated by the underlying assets.

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