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Financial Derivatives

Financial Derivatives

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Published by bhushanorpe
This is a project work on financial derivatives how they operate..etc.
This is a project work on financial derivatives how they operate..etc.

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Published by: bhushanorpe on Mar 26, 2010
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This project would never have been complete if it had not been for the support by a magnitude of very exemplary people, each even more outstanding in their own area of specialization. First of all, my sincere thanks to my project guide Prof. Mr. S. Krishnan for his support and encouragement during the entire course of work. I would also like to thank our principal Mrs. Shakuntala Singh and our coordinator Prof. Mr. D. Murdeshwar for their support during the entire project work. Also I would like to thank my family and friends for their suggestions and contributions to the fulfillment of the project.


I Bhushan Orpe student of N.G. Bedekar College of Commerce studying in T.Y. B.com Banking and Insurance (semester V) hereby

declare that I have completed this project on
DERIVATIVES´ for the academic year 2009 -2010.

The information in this project is true and original to my best knowledge.

(Bhushan Orpe) Signature



SR. NO. 
2. 3. 4. 5. 6. 7.   DESIGN OF STUDY


1-2 3-21 22-33 34-50 51-72 73-84 85-90 91-93 94 95




Table no. 3.1 Table no.4.1 Figure 4.1 Figure 4.2 Figure 4.3

Specification of major US grain futures contract Cash flows in fully hedged position flows at T Interest rate cap Interest rate floor Interest rate collar



56 57 58


Objective of Study: y To study the meaning of derivatives. y To understand how derivative instruments are valued . y To study the various pricing models such as Cost-of-carry model,

Binomial model, Black-Scholes model
Scope of Study: y Chapter 1 contains introduction of derivatives, basic of financial

derivatives, definition, participants in the derivatives market, history, and development of derivatives in India.
y Chapter 2 has the derivatives instrument ³Forward´.

It has

definition of forwards, types of forwards, valuation and pricing of various forwards.
y Chapter 3 contains information about ³Futures´ like its structure,

type, mechanics, valuation, cost -of-carry model.
y Chapter 4 is about ³Option´ like call and put options, caps, floors

and collars, The Binomial model, Black-Scholes model.
y Chapter 5 has information on ³Swaps´ like its definition, types,

valuation, forward swaps and swaptions.
y Chapter 6 is about derivatives and risk management and topics

such as risk identification and qualification, decision to accept or manage risk, strategy development and implementation.
y Chapter 7, the last chapter has findings, suggestion and conclusion.


Limitations of Study: y The derivative in a nut shell is a very wide topic and could not be

covered completely.
y Various formulae¶s for valuation difficult to understand. y Derivative instruments are complex so very difficult to understand

by common man.
Research Methodology: y The primary data has been collected by asking question to the

active trader of derivative market.
y The collection of secondary data is done mainly by the use of

various books on derivatives, the list of which has been given in the bibliography.




1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8

Introduction Basis Of Financial Derivatives Definition Of Derivatives History Of Derivatives Participants In Derivatives Market Derivatives In India Development Of Derivatives In India Factors Contributing To Growth Of Derivatives


Derivatives are one of the most complex instruments. The word derivative comes from the word µto derive¶. It indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset, known as the un derlying asset, which could be a share, a stock market index, an interest rate, a commodity, or a currency. The underlying is the identification tag for a derivative contract. When the price of the underlying changes, the value of the derivative also changes. Without an underlying asset, derivatives do not have any meaning. For example, the value of a gold futures contract derives from the value of the underlying asset i.e., gold. The prices in the derivatives market are driven by the spot or cash market pr ice of the underlying asset, which is gold in this example. Derivatives are very similar to insurance. Insurance protects against specific risks, such as fire, floods, theft and so on. Derivatives on the other hand, take care of market risks - volatility in interest rates, currency rates, commodity prices, and share prices. Derivatives offer a sound mechanism for insuring against various kinds of risks arising in the world of finance. They offer a range of mechanisms to improve redistribution of risk, which can be extended to every product existing, from coffee to cotton and live cattle to debt instruments. In this era of globalization, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk adverse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk adverse individuals by offering a mechanism for hedging risks. Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity prices. Commodity futures and

options have had a lively existence for several centuries. Financial derivatives came into the limelight in the post-1970 period; today they account for 75 percent of the financial market activity in Europe, North America, and East Asia. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. In commodity derivatives, the underlying asset is a commodity; it may be wheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice, crude oil, natural gas, gold, silver, and so on. In financial derivatives, the underlying includes treasuries, bonds, stocks, and stock index, foreign exchange, and Euro dollar deposits. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover. Presently, most major institutional borrowers and investors use derivatives. Similarly, many act as intermediaries dealing in derivative transactions. Derivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding, quantifying and managing financial risk. Derivatives contracts are used to counter the price risks involved in assets and liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk averse to those who are risk neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off -balance sheet activity for traditional lines of business. The exposures to derivatives by banks have implications not only from the point of capital adequacy, but also from the point of view of establishing trading norms, business rules and settlement process. Trading in derivatives differ from that in equities as most of the derivatives are market to the market.


Financial derivative assets are assets whose values are determined by the value of some other assets, called the underlying. There are two common types of derivative contracts, those patterned on forwards and on options. Derivatives based on forward have linear payoffs, meaning their pay offs move one for one with the changes in the underlying price. Such contracts are generally relatively easy to understand, value and mange. Derivatives based on options have non linear payoffs, meaning their payoffs may move proportionally more or less than the underlying price. Such contracts can be quite difficult to understand, value, and manage. Options are traded both on organized exchan ges and over-the-counter. The two modes of trading are quite different and lead to important differences in market conventions. The over -the-counter currency and interest rate option markets have become much more liquid in recent years. Many option market participants prefer the over-the-counter

markets because of the ease with which option contracts tailored to a particular need can be acquired. The exchanges attract market

participants who prefer or required to minimize the credit risk of derivatives transactions, or who required to transact in markets with publicly posted process. There are many types of options. A European option can be exercised only at expiration. An American option can be exercised at any time between initiation of the contract and expiration. In a market, the basic options are call and put. A call option is a contract giving the owner the right, but not the obligation, to purchase, at expiration, an amount of an asset at a specified price called the strike or exercise price. A put option is a contract giving the owner the right, but to the obligation, to sell, at expiration, an amount of an asset at the exercise price. The amount of the underlying asset is called the notional

principal or underlying amount. The price of the option contract is called the option premium. The issuer of the option contract is called the writer and is said to have the short position. The owner the option is said to be long. There are thus several ways to be long assets: long the spot assets; long a forward on the asset; long a call on the asset; and, short a put on the asset. In a forward contract, one party agrees to deliver a specified date in the future at a specified price. The commodity may be a commodity in the narrow sense, e.g. fold or wheat, or a financial asset e.g. shares or foreign exchange. The price of the underlying asset for immediate

delivery is called the cash or spot price. The party obliged to deliver the commodity is said to have a short portion and the party obliged to take delivery of the commodity and pay the forward price for it is said to have a long position. A party with no obligation offsetting the forward contract is said to have an open position. A party with an open position is something called a speculator. A party with an obligation offsetting the forward contract is said to have a covered portion. A party with a closed position is sometimes called a hedger. Derivatives assets, e.g. forwards, can often be constructed from combinations of underlying assets. Such constructed assets are called synthetic assets. Covered parity or cost-of-carry relations are between the prices o forward and underlying assets. These relations are enforced by arbitrage and tell us how to determine arbitrage based forward asset prices. One condition for markets to be termed efficient is absence of arbitrage.


Futures are similar to forwards in except two important and related respects firs, futures trade on organized commodity exchanges. Forwards, in contrast, trade over-the-counter, that is, as simple bilateral transactions, conducted as a rule by telephone, without posted prices. Second, a forward contract involves only one cash flow, at the maturity of the contract, while futures contracts generally require interim cash flows prior to maturity. The most important consequence of the restriction of the futures contracts to organized exchanges is the radical reduction of credit risk by introducing a clearinghouse as the counter party to each contra ct. The clearing house composed of exchange members. Becomes the counter party to each contract and provides a guarantee of performance in practice, default on exchange traded futures and option is exceedingly rare. Over-the-counter contracts are betwee n two individual

counterparties and have as much or as little credit risk as those counter parties. Clearing houses bring other advantages as well, such as consolidating payment and delivery obligations of participants with positions in many different contracts. In order to preserve the advantages, exchanges offer only a limited number of contract types and maturities. For example, contracts expire on fixed dates that may or may not coincide precisely with the needs of participants. While there is much standardization in over-the-counter markets. It is possible in the principle to enter into obligations with any maturity date. It is always possible to unwind a futures position via an offsetting transaction, while over -the-counter contracts can be offset at a reasonable price only if there is a liquid market in the offsetting transaction. Settlement of future contracts may be by net cash amounts or by delivery of the underlying.

In order to guarantee performance while limiting risk to exchange members, the clearing house requires performance bond from each counterparty. At the initiation of a contract, both counterparties put up initial or original margin to cover potential default losses. Both parties put up margin because at the time a contrac t is initiated, it is not known whether the terminal spot price will favour the long or the short. Each day, at that day¶s closing price, on counterparty will have gained and the other will have lost a precisely offsetting amount. The loser for the day i s obliged to increase his margin account and the gainer is permitted to reduce his margin account by an amount, called variation margin, determined by the change on the basis of the change in the futures price. Both counterparties earn a short term rate o f interest on their margin accounts. Swap-a plain vanilla interest rate swap is an agreement between two counterparties to exchange a stream of fixed interest rate payments of a stream of floating interest rate payments, both streams are denominated i n the same currency and are based on a notional principal amount. The notional principal is to exchange. The design of a swap has three features that determine its price: the maturity of the swap, the maturity of the floating rate, and the frequency of payments. At initiation, the price of a plain vanilla s wap is set so is current valuethe net value of the two interest payments streams, fixed and floating is zero. The swap can be seen as a portfolio which, from the point of view of the payer of fixed interest is long a fixed rate bond, both in the amount of the notional principal. The payer of floating rate interest is long the floater and shorts the fixed rate bond.


The price of a swap is usually quoted as swap rate that is as the yield to maturity on a notional par bond, what determines this rate? A floating rate bond always trades at par at time it is issued, the fixed rate bond, which represents the payers commitment in the swap must then also trade at par if the swap is to have an initial value of zero. In other words, the swap rate is the market adjusted yield to maturity on a par bond. Swap rates are also often quoted as a spread over the government bond with a maturity closest to that of the swap. This spread, called the swap treasury spread, is almost invariably positive, but varies widely in response to factors such as liquidity and risk appetites in the fixed i ncome markets. A forward swap is an agreement between two counter parties to commence a swap at some future settlement date. As in the case of a cash swap, the forward swap rate is the market adjusted par rate on a coupon bond issued at the settlement date. The rate on a forward swap can be calculated from forward rates or spot rates. Many of the derivatives instruments do not, in fact, involve the delivery of a financial instrument in the future. They are contracts for differences. If it were not for the purposes of avoiding the gambling laws of various countries, such financial instruments would be more honestly called bets. Interest rate futures contracts are no less than bets on the future course of a particular interest rating. The price written into the contract is compared with the interest rate outcome at the agreed date or dates in the future and cash is exchanged based on the difference.


Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, Forex, commodity or any other asset. According to Securities Contracts (Regulation) Act, 1956 {SC(R) A}, a derivative is: ³A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security.´ ³A contract which derives its value from the prices, or index of prices, of underlying securities.´ Derivatives are securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act.

The history of derivatives is quite colorful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk.


The first organized commodity exchange came into existence in the early 1700¶s in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of µcredit risk¶ and to provide centralized location to negotiate forward contracts. From µforward¶ trading in commodities emerged the commodity µfutures¶. The first type of futures contract was called µto arrive at¶. Trading in futures began on the CBOT in the 1860¶s. In 1865, CBOT listed the first µexchange traded¶ derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of µChicago Produce Exchange¶ (CPE) and µChicago Egg and Butter Board¶ (CEBB). The first financial futures to emerge were the curre ncy in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and optio ns emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982. The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore Interna tional Monetary Exchange (SIMEX) and the CME on September 7, 1984. Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip

craze of seventeenth century Holland. Tu lips, the brightly colored flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms. The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealers Association was set up in early 1900¶s to provide a mechanism for bringing buyers and sellers together. On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black -Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975. The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of


financial derivatives which served as effective risk management tools to cope with market uncertainties. The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 2 11 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options. The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the NASDAQ 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.

1. Trading Participants: a. Hedgers:

The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk.
b. Speculators:

Speculators do not have any position on which they enter into futures and options market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various fact ors like demand and

supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets ± commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity.
c. Arbitrageurs:

Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.
2. Intermediary Participants: a. Brokers:

For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to trans act with other members of the same exchange.


All persons hedging their transaction exposures or speculating on price movement need not be and for that matter cannot be members of futures or options exchange. A non-member has to deal in futures exchan ge through member only. This provide s a member the role of a broker. This activity of a member is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more involvement of non -members in hedging and speculation in futures and options market will increase brokerage business for member and more volume in turn reduces the brokerage. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options market.

India has started the innovations in financial markets very late. Some of the recent developments initiated by the regulatory authorities are very important in this respect. Futures trading have been permitted i n certain commodity exchanges. Bombay Stock Exchange has started futures trading in cottonseed and cotton under the BOOE and under the East India Cotton Association. Necessary infrastructure has been created by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and the commencement of operations in selected scripts. Liberalized exchange rate management system has been introduced in the year 1992 for regulating the flow of foreign exchange. A committee headed by S.S.Tarapore was constituted to go into the merits of full convertibility on capital accounts. RBI has initiated measures for freeing the interest rate structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of

London Inter Bank Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex. Badla transactions have been banned in all 23 stock exchanges from July 2001. NSE has started trading in index options based on the NIFTY and certain Stocks .

The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24±member committee under the Chairmanship of Dr. L. C. Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre±conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as µsecurities¶ so that regulatory framework applicable to tra ding of µsecurities¶ could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof. J. R. Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real ±time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in Decembe r 1999 to include derivatives within the ambit of µsecurities¶ and the regulatory framework were developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recogn ized stock

exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE±30 (Sense) index. This was followed by approval for trading in options based on these two indexes and options on individual securities. The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Invest ors (FII¶s) are permitted to trade in all Exchange traded derivative products.


1. Price Volatility:

A price is what one pays to acquire or use something of value. The objects having value maybe commoditi es, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another person¶s money is called interest rate. And the price one pays in one¶s own currency for a unit of another currency is called as an exchange rate. Prices are generally determined by market forces. In a market, consumers have µdemand¶ and producers or suppliers have µsupply¶, and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price are known as µprice volatility¶. This has three factors: the speed of price changes, the frequency of price changes and the magnitude of price changes. The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The breakdown of the BRETTON WOODS agreement brought an end to the stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization of the markets and rapid industrialization of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east -Asian currency crisis of 1990¶s has also brought the price volatility factor on the surface.

The advent of telecommunication and data processing bought i nformation very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly. This price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.
2. Globalization Of Markets:

Earlier, managers had to deal with domestic economic concerns; what happened in other part of the world was mostly irrelevant. Now globalization has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtai n better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our p roducts vis-à-vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south East Asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalization of industrial and financial activities necessitates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.


3. Technological Advances:

A significant growth of derivative instruments has bee n driven by technological breakthrough. Advances in this area include the

development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communication s allow for instantaneous worldwide conferencing, Data transmission by satellite. At the same time there were significant advances in software programs without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on mar ket price. Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.




2.1 2.2 2.3 2.4 2.4

Introduction Definition Types And Features Of Forward Contracts Valuing Forward Contracts Pricing And Valuation Of Foreign Currency Forward Contract


A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future is known as a forward contract. Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlying, including the traditional agricultural or physical commodities, as well as currencies and interest rates. The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset. These contracts create credit exposures. As the value of the contract is conveyed only at the maturity, the parties are exposed to the risk of default during the life of the contrac t. Forward contracts are customized with the terms and conditions tailored to fit the particular business, financial or risk management objectives of the counter parties. Negotiations often take place with respect to contract size, delivery grade, de livery locations, delivery dates and credit terms.

A forward contract can be defined as an agreement between two parties, a buyer and a seller, that calls for the delivery of an asset at a future date with a price agreed today. It is a personalized contract

between parties. The forward market is a general term use to describe the informal market through which these contracts are entered into. Standardized forward contracts are known as futures contracts and are traded on futures exchanges. Often, the buyer of the contract is called long and seller of the contract is called short.








1. Commodity Forwards:

A commodity forwards contract can be defined as a contract wherein one party agrees to deliver the underlying commodity to another party a specified future time. The underlying commodity can be oil, a precious metal or any other commodity. Producers of commodities take

production decisions based on expectations of price they would receive when the actual output arrives. Similarly, purchasers of commodities of inputs or final goods take decisions based on the availability and cost of commodity at different points of time in a year. To protect against price volatility and uncertainty in production as well as availability, often buyers and sellers enter in forward contracts. At the initiation of contract, the parties also specify the quantity, quality and price of the commodity they would deliver for sale or acquire for purchase at a predetermined ate in future. However, commodity forwards are very cumbersom e. As there is no centralized market or exchange where a forward contract is established, the prices tend to vary and there is uncertainty about the delivery of underlying commodity. Hence, investors prefer commodity futures rather than commodity forwards.
2. Currency Forwards Contracts:

Currency forward market¶s development over the years can be attributed to relaxation of government controls over exchange rates of most of the currencies. Currency forwards contracts are mostly used by banks and companies to manage foreign exchange risk. For example, Microsoft its European subsidiary to send it ¼12 million in period of 3 months. On receiving the Euros form the subsidiary, Microsoft will convert them into dollars. Thus, Microsoft is essentially long on Euros,

as it has to sell Euros. At the same time it is short on dollars as it has to buy the dollars. In such a situation, a currency forward contract proves useful because it enables Microsoft to lock-in the exchange rate at which it can sell Euros and buy dollars in 3 months. This can be done if Microsoft goes short on forwards. This implies than Microsoft will go short on euro and long on dollar. This arrangement will offset its

otherwise long-euro, short-dollar position. In other words, Microsoft requires a forward contract to sell Euros and buy dollars.
3. Equity Forwards:

Equity forward can be defined as a contract calling for the purchase of an individual stock, a stock portfolio or a stock index on a forward date.
a. Forward Contract On Individual Stocks:

A portfolio can consist of small number of stocks or sometimes stocks that have been over a number of years. For example, lets us consider a stock XYZ. The client has heavily invested in this stock and her portfolio is not diversified. The client informs her portfolio manager of her

requirement of $2 million in cash in a period of 6 months. This amount is raised by selling 16000 shares at the current price of $125 per share. Thus, the risk exposure is related to the market value of $2 million of stock. It is better not to sell the stock any earlier than is required. The portfolio manager feels that forward contracts to sell the stock XYZ in 6 months will serve the purpose. Hence, the manager contacts a forward contract dealer and obtains a quote of $128.13 per share. This implies that the portfolio manager will enter into a contract with the dealer to sell the stock at $128.13. Let us assume that the shares will be delivered when the actual sale is made. Further, lets us assume that the client has some flexibility in the required amount. So the contract is signed for the sale of 15000 shares at 128.13 per share. This will raise an amount of

$1,998,828. However, if the contract expires, the stock could be sold for any price. The client may either gain or lose on the transaction. Even if the stock price rises above $128.13 during the 6 months, the client must and should deliver the stock for $128.13. Conversely, if the price falls, still the client will get $128.13 per share.
b. Forward Contracts On Stock Portfolio:

To understand the concept of stock portfolios, let us look at pension funds. Suppose, a pension fund manager knows that he has to sell around $20 million of stock in 3 months in order to make payments to retirees. The manger has analyzed the portfolio and identified the precise stocks to be sold and number of shares of each to be sold. Now, the problem is, the prices of these stocks in 3 months are not certain. To solve this problem, the manager can enter into a forward contract to lock-in the sale price. For this, he can either enter into a forward contrac t on each stock or can enter into a forward contract on the overall portfolio. The first option will prove expensive as each contract would incur administrative expense, where as in the second option there is only one set of costs. If the manager chooses the second option then he will provide a list of stock and number of shares he wishes to sell to the dealer and will obtain quote. The dealer gives him a quote of $20,200,000. So, in 3 months period, the manager of the pension fund will sell the stock t o the dealer and will receive $20,200,000 for the stock.
4. Interest Rate Forwards:

An Interest Rate Forward contact is commonly known as a Forward Rate Agreement or FRA. FRAs are contracts wherein the underlying instrument is interest payment is made in dollars, Euros or any other currency at an appropriate rate of that currency. To understand the mechanics of FRA, let us use dollar LIBOR. Now, let us consider a

FRA in 90 days for which the underlying is 180-day LIBOR. Assume the dealer quotes this instrument at a rate of 5.5 percent and the end user goes long while the dealer goes short. The end user is essentially long and it will benefit if the interest rates rise. On the other hand, the dealer is essentially short the rate and will benefit if the interest rates fall. The contract covers a given amount of notional principal, which we shall assume to be $10 million. According to the forward contract, the parties to the contract at the time of expiration must identify the rate on new 180-day LIBOR time deposits. Such rate is known as 180-day LIBOR. This is the underlying rate on which the contract is based. At the time of expiration in 90 days, suppose the rate on 180 -day LIBOR is 6 percent, then that 6 percent interest will be paid after 180 days. Hence, the present value of a Euro dollar time deposit at that point of time will be, 

At the time of expiration the end user will receive the following payment form the dealer

In case the underlying interest rate is less than 5.5 percent, then the payment is calculated on the basis of difference arising between the 5.5 percent interest rate and the underlying interest rate. A significant point to be noted here is, though the contract expires in 90 days, the rate is on a 180-day LIBOR instrument. Hence, the calculated rate of interest is


adjusted by the factor 180/360. The 90 days period of expiration is considered in calculating the payoff. In the above equation, by examining the numerator we see that the contract is paying the difference between the actual rate that is prevailing in the market on the expiration date of the contract and the agreed -upon rate, adjusted for the fact that the rate applies to a 180-day instrument, multiplied by the notional principal. This happens because, when the Eurodollar rates are quoted in the market, they are based on the assumption that the rate applies to an instrument that accrues in terest at that rate with the interest paid after a certain number of days (in this case 180 days). Hence, it is essential to adjust the FRA payoff to reflect the rate which implies that a payment would be made after 180 days based on a standard Eurodollar deposit. This adjustment is made by just discounting the payment at the current LIBOR, which is 6 percent, prorated over 180 days. The same conventions are used in the FRA markets with other underlying rates.

The value of a forward contract at the time it is first entered into is zero. At a later stage, it may prove to have a positive or negative value. It is important for banks and other financial institutions to value the contract each day. (This is referred to as marking to market the contract.) Using the notation introduced earlier, we suppose K is the delivery price for a contract that was negotiated some time ago, the delivery date is T years from today, and r is the 7year risk-free interest rate. The variable Fo is the forward price that would be applicable if we negotiated the contract today.


We also define, f: Value of forward contract today It is important to be clear about the meaning of the variables Fo, K, and f. If today happens to be the day when the contract is first negotiated, the delivery price (K) is set equal to the forward price (F0) and the value of the contract (f) is 0. As time passes, K stays the same (because it is part of the definition of the contract), but F o changes and f becomes either positive or negative. A general result, applicable to all long forward contracts (both those on investment assets and those on consumption assets), is F= To see why equation (5.4) is correct, we use an argument analogous to the one we used for forward rate agreements. We compare a long forward contract that has a delivery price of F o with an otherwise identical long forward contract that has a delivery price of K. The difference between the two is only in the amount that will be paid for the underlying asset at time T. Under the first contract, this amount is Fo; under the second contract, it is K. A cash outflow difference of F o ² K at time T translates to a difference of (F o ² K)e-rT today. The contract with a delivery price F o is therefore less valuable than the contract with delivery price K by an amount (Fo ² K)e-rT. The value of the contract that has a delivery price of F o is by definition zero. U follows that the value of the contract with a delivery price of K is (Fo ² K)e-rT. This proves equation. Similarly, the value of a short forward contract with delivery price K is 


A long forward contract on a non-dividend-paying stock was entered into some time ago. It currently has 6 months to maturity. The risk-free rate of interest (with continuous compounding) is 10% per annum, the stock price is $25, and the delivery price is $24. In this case, So = 25, r = 0.10, T = 0.5, and K = 24. From equation, the 6month forward price, F0, is given by F0 = 

From the above equation the value of the forward contract is f = (26.28 - 24) 

Equation shows that we can value a long forward contract on an asset by making the assumption that the price of the asset at the maturity of the forward contract equals the forward price Fo. To see this, note that when we make the assumption, a long forward contrac t provides a payoff at time T of Fo ² K. This has a present value of (Fo - K)e-rT, which is the value of f in equation. Similarly, we can value a short forward contract on the asset by assuming that the current forward price of the asset is realized. f= 

Similarly, expression for the value of a long forward contract on an investment asset provides a known income with present values I: f =S0 ± 1 Finally expression for the value of a long forward contract on an investment asset that provides a known yield at rate q: f = S0 

Thus, using this equation one can value a forward contract








Foreign currency transactions must be dealt with very carefully. Exchange rate is quoted in terms of units of domestic currency per unit of foreign currency. This is also known as direct quote. Let S o denote exchange rate, r denote foreign interest rate and r denote domestic interest rate. Now, let us discuss the following transactions executed today (time 0). The contract expiration date is taken as T. Take S0/ (l+ rf) T units of domestic currency and convert it into 1/ (1+ r f) T units of foreign currency. This implies that, if one unit of foreign currency costs SO, then So /(I + rf )T units of domestic currency would buy 1/(1 + rf )T units of foreign currency. Sell a forward contract to deliver one unit of foreign currency at the rate F(0,T). Hold the position until time T. That is (1+ r f)

units of foreign

currency will result in accrued interest at the rate r f and grow to one units of foreign currency at t given as follows:

(1 +


Thus, at the time of expiration one unit of foreign currency will be left, which is then delivered to the holder of long forward contract. The holder of the long forward contract will pay the amount F(0,T). This amount is known at the beginning of the transaction as the risk has been hedged and the exchange rate at the time of expiration is not much

relevant. The present value of F(0,T), which is determined by discounting at the domestic risk-free interest rate must be equal to the initial outlay of S0/(l+ rf)T. By equating these amounts and solving for F(0,T) we get, F (0,T) = The term in the brackets indicates the spot exchange rate that is discounted by the foreign interest rate. This term is again compounded at the domestic interest rate to the expiration day. In the international financial markets, the above formula is known as interest rate parity or sometimes covered interest rate parity. It explains the equivalence or parity of spot and forward exchange rates after adjusting the existing differences in the interest rates of two countries. One of the implications of interest rate parity is that, the forward rate will exceed the spot rate if the domestic interest rate exceeds the foreign interest rate. When the exchange rate is quoted directly, in such a case, if forward rate exceeds the spot rate, the foreign currency is said to be selling at a premium. Based on this statement we cannot arrive at the conclusion that a currency selling at a premium is expected to increase or a currency selling at a discount is expected to decrease. Whether it is forward premium or discount, they merely implicate the existing relationship between the interest rates of two countries. If the forward rate in a market is not equal to the forward rate given by the interest rate parity, it could result in an arbitrage transaction. This arbitrage transaction is called covered interest arbitrage. If the forward rate in the market is greater than the rate given by the interest rate parity, this implies the forward rate is very high. Whenever the price of an asset or derivative is too high, it should be sold. Hence, an investor would:

‡ ‡ ‡ ‡

Sell the forward contract at the market rate Buy of 1/(1+rf)T units of the foreign currency Hold the position, thereby earning interest on the currency At the maturity of the forward contract, deliver the currency and

get the payment at Forward rate. This arbitrage transaction will result in a return which is in excess of domestic risk free rate without any risk. In case the forward rate is less than the rate given by the formula, then the investor will do the opposite. He will sell the foreign currency and buy a forward contract. The combined actions of more number of investors undertaking the same transaction will make the forward pric e in the market in line with the forward price given by the model. Now, let us consider the value of a foreign currency forward contract at some point of time during its life. The formula for foreign currency forward can be given as,

Vt(0,T) =  

This implies that, the current exchange rate at time t will be discounted by the foreign interest rate over the remaining life of the contract and forward price discounted by the domestic interest rate over the remaining life of the contract is subtracted from it. If we assume that were using continuous compounding and discounting, the formula would be given as follows:

Vt(0,T) = 




3.1 Introduction 3.2 Structure Of Global Futures Markets 3.3 Types Of Contracts and Characteristics 3.4 The Mechanics Of Futures Trading 3.5 Valuation Of Futures Contracts 3.6 The Cost-Of-Carry Model


A future contract is an agreement between two parties to buy or se ll an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange-traded contracts. Equities, bonds, hybrid securities and currencies are the commodi ties of the investment business. They are traded on organized exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions, so that the identity of the buyer or the seller is a matter of indifference to the opposite party. Futures contract protect those who use these commodities in their business. Futures trading are to enter into contracts to buy or sell financial instruments, dealing in commodities or other financial instruments for forward delivery or settlement on standardized terms. The futures market facilitates stock holding and shifting of risk. They act as a mechanism for collection and distribution of information and then perform a forward pricing function. The futures trading can be performed when there is variation in the price of the actual commodity and there exists economic agents with commitments in the actual market. There must be a possibility to specify a standard grade of the commodity and to measure deviations from this grade. A futures market is established specifically to meet purely speculative demands is possible but is n ot known. Conditions which are thought of necessary for the establishment of futures trading are the presence of speculative capital and financial facilities for payment of margins and contract settlement. In addition, a strong infrastructure is required, including financial, legal and communication systems


1. Exchanges:

Development of futures markets can be traced back to the medical times, when trade fair merchants often entered into contracts for deferred delivery of goods at a price agreed to advance. In the centuries that followed, organized spot markets for com modities developed in major European cities. Consequently, the futures markets were developed to meet the needs of the farmers and merchants. In 1948, the first modern futures markets came into existence with the formation of Chicago Board of Trade and evolved gradually to cater to the needs of investors in addition to the existing class of farmers and merchants.
2. Chicago Board Of Trade:

The Chicago Board Trade (CBOT) is the oldest and the largest future exchanges in the world. It is organized as a not-for-profit membership association. Chicago¶s strategic location at the base of lakes close to fertile agricultural lands contributed to its rapid growth and development as a grain center. It was established to bring the producers (farmers) and buyers (merchants) together. It was initially formed to facilitate

standardizing the quantities and qualities of grains. Currently, CBOT offers futures contracts on many underlying assets, which include corn, wheat, soybeans, soybean oil, Treasury bonds and Tr easury notes.
3. Chicago Mercantile Exchanges:

Chicago Mercantile Exchange¶s (CME) is one of the leading futures exchanges in the world. Constituted in 1874, it was initially known as Chicago Produce Exchange. It was established to provide a systematic market for butter, eggs, poultry and other farm products. In 1919, the


butter and egg board became Chicago Mercantile Exchange (CME) to accommodate public participation. In 1981, CME introduced Eurodollar futures, which gave way to futures on stock indexes and option products. A post market Global Electronic Transaction System (GLOBEX) was finalized with Returns in 1988 and live trading started in 1992. In 1998, it introduced GLOBEX 2R, the next generation first global electronic trading system. In 1999, CME became the first American exchange to construct concrete plan for demutualization. Currently, CME trades for many underlying assets, including commodities like pork bellies, live cattle, live hogs and feeder cattle; contracts on stock indic es and currencies are also traded on the exchange.
4. Trading:

There are two parties involve in a future contract. The seller of the contract, who agrees to deliver the asset at the specified time in future and the buyer of the contract, who agrees to p ay a fixed price and takes delivery of the asset. The futures contract is used by a buyer and seller in order to hedge other positions of the underlying asset. Any price change in the underlying asset after the futures contract agreement creates gain to one party at the expense of the other party. In other words, if the price of the underlying asset increases after the agreement is made, the buyer stands to gain and the seller incurs loss. Inversely, if the price of asset decreases, the seller gains and the buyer is at loss.
5. Clearing House:

A clearing house is an institution that clears all the transactions undertaken by a futures exchange. It can either be a part of the same exchange or can be a separate entity. It computes the daily settlement

amount due to or from each of the members and from other clearing houses and matches the same.
a. Floor Brokers:

These brokers will execute the orders on others¶ account. These people are normally self-employed individual members of the exchange.
b. Floor Traders:

These traders execute the trades on their own account. Some floor traders may also execute the orders for the account of others. This

mechanism is known as dual trading and such traders are known as dual traders. Some of the floor traders are classified as ³scalpers.´ A scalper is a person who stands ready either to buy or sell. liquidity of the market as they are market makers. Scalpers add to the

1. Commodity Futures:

Commodity futures refer to the contracts made to buy or sell a commodity at a specific price and on a specific delivery date. Commodities may be agricultural commodities, metallurgical

commodities, energy commodities and precious metals such as gold, silver etc. The oldest commodity futures market is the Chicago Board of Trade (CBOT). It began trading the first futures contract, a standardize forward agreement, in the year 1865. Initially, commodity futures were available only for agricultural prod ucts. Later on other commodities were included. Agricultural commodities are further segregated into grains, soft commodities and meat futures. Commodities such a Red beans, corn, wheat, soybeans and soybean meal etc form part of grains while cocoa,

coffee, dried cocoon, cotton yarn etc form part of soft commodities. Animal products like live hogs, live cattle, pork bellies, eggs and poultry products form a part of meat futures. The following table shows the specifications of the major futures contracts for grains, soft commodities and meat futures in the US .
Table 3.1: Specification of Major US Grain futures Contracts
'beans Exchange Symbol CBOT Open Auction: S Electronic: ZS 5,000 bu


Soybean Meal CBOT

Soybean Oil CBOT

Wheat CBOT

Open Auction: Open Auction: SM Open Auction: BO C Electronic: ZC Electronic: ZM Electronic: ZL 5,000 bushels 100 tons 60,000 lbs 5,000 bu No.1 &No. 2

Trading unit Deliverable Grade

No.2 Yellow at No.2 yellow at One grade of meal Crude soybean oil par, No.1 par, No.1 Yellow at 6 At V/j cents cents per bushel over per bushel over contract price, contract price No.3 yellow at and No.3 11/2 cents per at 6 cents per bushel under bushel under contract price contract price* % cent/bu ($ % cent/bushel ($ 12.50/contract) 12.50/contract) Sep, Nov, Jan, Dec, Mar, May, Mar, May, July, Jul, Sept Cents/bushel only with protein of 48 percent

meeting exchange soft Red, No.1 - approved grades No.2 Hard Red and standards winter, No.1 & No.2 Dark Northern spring, No.1 Northern Spring at 3 cent/ bushel premium and No.2 Northern.0 1/100 cent ($ 0.0001 )/lb ($6/contract) Oct, Dec, Jan, Mar, Jul, Aug, Sept Cents/Ib % cent/bu ($12.50/contract Jul, Sept, Dec, Mar, May Cents and quarter² cents/bu The business day prior to the 15"1 calendar day of the contract month Seventh business day following the trading day of delivery month prior to the 15* calendar day of contract month Last business day of the delivery month

Tick size

10 cents/ton ($ 10/contract) Oct, Dec, Jan, May,Mar,Aug, Jul, Sept Dollars and cents /

Contract Months Price quote

Cents and quartercents/bu Last Trading The business The business day prior to this day prior to the 15* calendar 15* calendar day of the day of the contract month contract month Second Second

The business day The business day prior to the 15* calendar day of contract month Second business


Last Delivery


business day business day day following the following the following the last trading day of last trading day trading day of the delivery month of the delivery the delivery month month


The metallurgical category includes the genuine metals and petro products. The metals are further grouped into precious and industrial metals. In general, the precious metals are in relatively short supply and they retain their value irrespective of the conditions of the economy. On the other hand, the values of the industrial metals are based on the demand and supply conditions.
2. Foreign Currency Futures :

A forex futures contract can be defined as an agreement between two parties in which one of the parties agrees to buy the currency from the other party at a later date at an exchange rate agreed upon today. Its working is similar to traditional stock and commodity futures. Forex Futures were actually the first financial futures contracts. The forex futures contract calls for delivery of certain number of units of foreign currency. Prices are always quoted in dollars per unit of that currency. For example, let us consider British Pound contract. Assume the pound contract calls for delivery of 65, 000 pounds. If the contract price is $1.5612, then the actual price is $1.5612(65,000) = $101,478. There are many advantages in using forex futures for hedging as well as speculating. The significant feature of forex futures is that the y are not traded on a centralize d exchange. They can be used to hedge against currency fluctuations.
3. Index Futures:

The first index futures contract was introduced in 1982 at the Kansas City Board of Trade and today, index futures are one of the most popular types of futures as far as trading is concerned. An index futures contract is basically an obligation to deliver at settlement, an amount equal to µx¶ times the difference between the stock index value on the expiration date


of the contract and the price at which the contract was originally struck. The value of µx¶, which is referred to as the multiple, is predetermined for each stock market index. Stock index futures are based on complex cash instruments. The multiple enables to calculate the monetary value of an index futures contract. For example, if the settlement price of the S&P 500 futures contract is 350, the value of the contract in monetary terms is 350X250=$87,500.
4. Interest Rate Futures:

An interest rate futures contract is an agreement to buy or sell a standard quantity of underlying asset, at a predetermined future date and at a price agreed upon between parties. The underlying assets will be different interest bearing instruments like T-bills, T-notes, T-bonds, deposits, etc. For example, Treasury Bond Futures Contract is the most popular long-term interest rate futures contract and the underlying asset will be a bond. The main factor behind the growth of interest rate futures are as follows:
y Enormous growth of the market for fixed income securities. y Increased fluctuation in interest rates worldwide.

In the case of long-term interest rate futures, the most important contracts are the Treasury bond futures contract, the 10 -year Treasury note futures contract and municipal bond futures contract. In the US, only short-term interest rate futures like futures on US 90day treasury bills and 3 months Eurodollar time deposits are popular.


Initially, an individual willing to trade futures contracts must place an order. For that purpose he needs to open an account with a broker. The individual is required to make minimum deposit of at least $5,000 and must sign a disclosure statement agreeing to all the possible risks.
1. Placing An Order:

An investor can place different types of orders. When an investor places an order the broker makes a phone call to the firm¶s desk on the exchange floor and conveys the order to the firm¶s floor b roker, who in turn goes to the pit in which the contract is traded. The pit can be described as an octagonal or polygonal shaped ring with steps descending to the center. Bids and make offers are placed through hand signals and verbal activity. This is known as open outcry system. Open outcry system is very old tradition. Today, many of the futures exchanges are fully automated. The bids and offers are submitted

through the computer and trades are executed off the floor.
2. Role Of Clearing House:

Every future exchange has its own independent clearing house which acts as an intermediary and guarantor to each transaction. Stock holders of clearing house are its members clearing firms. Each firm maintains a margin account with the clearing house and must also maintain minimum amount in the account. All the parties to the futures transactions should maintain an account with the clearing firm or with the firm that has an account with the clearing firm.


3. Daily Settlement:

Daily settlement is a significant feature of futures market and is the major difference between futures and forwards markets. Every futures contract involves initial margin and maintenance margin. The amount required to be deposited in the margin account at the time of enter ing the contract is called initial margin. Generally, the initial margin is set

between 5% and 15% of the total value of the contract. It covers losses arising because of price fluctuations. On closure of position or at time of maturity of contract, the initial margin is released again. The margin account is readjusted at the end of each trading day to reflect the investor¶s gain or loss on its open position. The amount that is

maintained everyday thereafter is called maintenance margin. At the close of each day, a committee comprising clearing house officials determines a settlement price. Usually, settlement price is an average of the prices of the last few trades of the day. Using the settlement price, each account is marked to market. Marked to m arket is a unique feature of futures contract wherein the positions of both buyers and sellers of the contracts are adjusted everyday for the change in the market price that day. In other words, the profits or losses related with the price

movements are either credited or debited from an investor¶s account even if he does not trade.
4. Delivery And Cash Settlement:

All the contracts expire at some or the other time. Every contract has a delivery month and the delivery procedure differs from one contract to the other. While some contracts can be delivered on any business day of the delivery month, others can be delivered only after the contract is traded for the last day. This last day also varies from contract to contract. In case of contracts that are cash settled there is no delivery at all.

1. Factors Determining Contract Price:

Futures market prices bear economically important relationships to other significant observable factors. For example, the futures price for delivery of wheat in three moths must be related to the current spot price of wheat or current cash price of wheat at a particular physical location. As the futures contract requires the delivery of some good at a particular time in future, we can make it sure that the expectations of the market participant assists to determine the futures prices. Similarly, the cost of storing the goods underlying the futures contract helps to determine the relationship between the futures prices and the cash prices. When a commodity in futures market is delivered at a later date as per the futures contract, these may be more than one cash price for a commodity at one point of time.
2. The Basis And Spreads:

We can analyze the relationship between two prices by using basis and spreads. The basis is the relationship between the cash price of a product and the futures price of that product. A spread is the difference between two futures prices. Basis represents the difference between the cash price and the future price of a single product. Basis = Current cash price ± Futures price Here, the cash price is for a specific location, time and quantity of product. The futures price is for a contract for the same time the cash price represents. Generally, the basis is calculated as the difference

between the cash price and the nearby (closest to ex piration) futures contract. A spread can be either intracommodity spread or an intercommodity spread. For the same underlying good, if there are two different prices on two different expirations dates, the underlying spread is referred as µintercommodity¶ spread (also known as µtime spread¶). If the spread is between two futures prices for two different but related commodities, such as corn oil futures and cottonseed oil futures, it is referred to as µintercommodity spread¶. If the price difference is between two markets for the same commodity, it is known as µinter -market spread¶.
3. Futures Prices And Expected Spot Prices :

While examining the futures prices, the concept of relationship between futures prices and expected spot prices is very significant. To understand this concept, let us consider the relationship between spot prices and expected spot prices. Consider an asset which incurs carrying costs but does not involve any risk. At time 0, the investor will purchase the asset with certainty that he will surely cover his opportunity cost and carrying cost. If not, he would not purchase the asset at all. Thus, at time 0, the spot price is the present value of the total of the spot price at time T less costs minus benefits. Thus, FV(CB,O,T) is the future value of the carrying cost and FV, (C,B,OT)/(Tr)T is the present value of the carrying cost. Hence, on one hand we can state that the spot price is the future spot price minus the future value of the carrying cost, all discounted to the present. On the other hand, we can state that the spot price is the discounted value of the future spot price minus the pre sent value of the carrying cost.


However, in case the future price is uncertain, some adjustments are mandatory. As we do not know at time 0 what S T will be, we must make an expectation which is denoted as E 0 (ST). At the same time, we can just replace the St above with E0 (St). This would not be rational as we would be paying a price today and expecting compensation only at the risk -free rate along with coverage of carrying cost. One of the most significant and intuitive elements of finance is that risky assets require a risk premium. Risk premium denoted as

(ST) represents a discount-off of

the expected value that is imbedded in the current price S 0. Here, current price can be given as E0 (ST) ± FV(C,B,O,T) ±
0 (ST)

S0 = ------------------------------------------(1+r)T We can see that the risk premium lowers the current spot price. Investors intuitively pay less for risky assets all other things equal. So far we have not violated rule of no arbitrage, as we have worked with only spot price only. Hence the futures pricing formula F0 (T) = S0 (1+r)T + FV (C,B,O,T) -----------------------------------------(1+r)T Can still be applied. In case we rewrite the futures pricing formula for FV(C,B,O,T), substitute the result into the formula for S0 by solving the futures price FV(C,B,O,T) we obtain;


f0 (T)=f0(ST) ±

0 (ST).

According to this equation, the futures price equals the expected future spot price minus the risk premium. From the above formula, we conclude that the futures price is not equal to the expectations of the futures spot price. The futures price will be biased on the lower side. If the futures price were an unbiased (T) = E (ST) one can expect an

predictor of the future spot price, f0

average to be able to predict the future spot price, but this is unlikely to occur. The intuition behind this can be seen easily. Let us start with the assumption that all units of the asset must be held by some individual. The person holding the asset is willing to transfer the risk of its future selling price, he must offer a futures contract for sale. If the futures contract is offered at a price equal to the expect ed spot price, then the buyer of the futures contract takes on the risk expecting to earn a price equal to the price paid for the futures. Thus, the buyer incurs the risk without any expected gain in the form of risk premium. Conversely, the holder of the asset would enjoy a risk-free position with an expected gain in excess of the risk-free rate. Clearly, the holder of the asset cannot carry out such a transaction. Hence, he must lower the price to the level where it will be sufficient to compensate th e buyer for the risk he is taking up. All this process will lead to futures prices equal to the

expected spot price minus the risk premium. The risk premium gets transferred from the holder of the asset to the buy er of the futures contract.



Cost-of-carry model is popular and simple model used in pricing of futures. For the sake of simplicity in understanding, let us assume that the futures market is perfect. The cost-of-carry or carrying charge is the total cost incurred in carrying a storable good forward in time. For example, rice from crop in December can be carried forward or stored until December next till the next crop or even beyond it. The significance of carrying costs cannot be ignored because they play a crucial role in determining pricing relationship between the spot and futures prices. Moreover, it plays a key role in determining the prices of various future contracts of different maturities. The following formula determines the relationship between the cash price and the futures price of any commodity: Ft,T = C+Ct * St,T * T-t/365 + Gt,T Where, Ct = cash price at time t St,T= annualized interest rate on borrowings Gt,T = storage costs T-t = time period Ft,T = time futures at time t, which is to be delivered at time period T. According to cost-carry concept, the future price should be equal to the spot price of the commodity plus t he carrying charges required to carry the spot commodity forward to deliver.

2. Pricing Of Interest Rate Futures:

Pricing of interest rate futures is very difficult because of its peculiar characteristics. Theoretically, the fundamental no -arbitrage equation for bond futures is an applied version of the no-arbitrage relationships of assets with payouts. Hence, the fair value of an interest rate futures contract for a bond depends on the forward price of the underlying asset. This forward price can be determined using arbitrage. The 'fair' futures price determined by the basic no arbitrage condition is given by: Ft,T+ Al T (S+AIt ) .(l+Rt,T)  Ct,T. The futures 'fair' price at date t is represented by F t,T and future value of all coupons paid and reinvested between t and T is represented by C t,T While St represents the spot value of the underlying bond at time t AI t and AIT respectively represent accrued interest on the underlying bond at time T. The above equation can be rewritten as Ft,T = (S + AIt) * (1 + Rt,T) AIT .

The cost-of-carry model states that an investor must be indifferent between buying the bond and carrying it through time or buying the futures. Hence, to purchase the bond to be delive red, (St + AIt) will be the total price paid at time t. Purchasing this bond by borrowing the total price paid for a bond held until time T involves total borrowing costs of (St + AI T).The value of all coupons paid and reinvested between t and T is indicated by Ct.T. This amount is gained by the owner of the bond and is lost by the futures buyer. The accrued interest (Al t) of the delivered bond at time T is paid by the futures buyer to the bond owner at delivery.

Therefore, Forward price = Cash price + Financing ± Income As, Income - Financing = Cost of carry, We can also write as: Forward price = Cash price - Cost of carry. The cost of carry can be either positive or negative based on the shape of yield curve and the coupon of the underlying bond. In reality, valuing interest rate futures is very complicated as all the contracts have a multi-deliverable grade feature. In other words, the contract facilitates delivery of any bond within a set of maturities and coupons and thus involves different market values.




4.1 4.2 4.3 4.4 4.5 4.6

Introduction Call And Put Option Underlying Instruments Option Trading The Binomial Model Black-Scholes Model


A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as µoption¶. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the µstrike price¶.

There are two types of options i.e., CALL OPTION AND PUT OPTION.
1. Call Options:

A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a µCall option¶. The owner makes a profit provided he sells at a higher current p rice and buys at a lower future price.
a. In-The-Money:

A call option is In-the-Money if the prevailing stock price (of the underlying asset) is greater than the exercise price.
b. At-The-Money:

In case the call¶s market price is the same as its exercise price, it would be called at-the-money or at-the-market.
c. Out-Of-The-Money:

Similarly, if the market price of the stock is less than the exercise price, it shall be called out -of-the-money.


2. Put Options:

A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a µPut option¶. The owner makes a profit provided he buys at a lower current price and sells at a high er future price. Hence, no option will be exercised if the future price does not increase.

Options exist on a variety of underlying instruments ranging from stock, indices to foreign currencies and commodities. The value o f an option depends heavily upon the price of its underlying asset.
1. Stocks:

Options on individual stocks are known as equity options and are the most actively traded options on any exchange. In the US, options on stocks are actively traded on the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), and the New York Stock Exchange (NYSE), in India they are traded on the National Stock Exchange (NSE), and the Bombay Stock Exchange (BSE). These

exchanges provide liquidity, competitive and structured markets for the sale and purchase of standardized options. In the US, a stock option is usually for 100 shares whereas in India, the number of underlying shares on an option varies from 100 to 250 to 375 and so on. The exercise prices are usually given as the number of units of currency of per share. The price of a stock option is influenced by the price of the underlying stock, remaining time until expiration, volatility of the underlying stock price, cash dividends and the level of interest rates.


2. Stock Index:

A stock index consists of a group of stock and measures the overall value of the group. An option on such an index is called an index option. Though indexes have been constructed to measure the combined performance of a group such as equities, debt securities, foreign currencies, cost of living, etc, stock indices are the most popular and often used. The index options have gained popularity over the stock over the stock options because there options enable the investors to trade in options without taking or making the delivery of the stocks, and also can be settled in cash. Though stock options exist for a large number of stocks, investors find it a tedious to analyze and make use of them. As such, they prefer analyzing the market as a whole to use index options and act on their predications. The strike price is in terms of a level. The holder of a call option will have a positive pay off when the value of the index on expiration is more than the value given in the option. Index option helps investors to get exposure to a market or in particu lar sector or industry. The price of an index option is greatly affected by the changes in the levels of the index, which is in turn affected by the changes in the prices of the shares of the components comprising the index.
3. Bonds:

Options on bonds are, mostly found on treasury bonds as they are actively traded than any other bonds on an exchange. The options are traded actively on the over -the-counter market, than on a recognized exchange. Options on bonds are deliverable or settled in cash. Except for the bond prices and specific values of the bond, the mechanics are similar to that of stock options. In the case of a call option, the buyer will profit from a fall in interest rates and a rise in bond prices, and in case of

a put option, the buyer will profit from a rise in interest rates and a fall in bond prices. The strike price on these options is in terms of yield to maturity. Prices of bond options are affected by the level of interest rates in the country. An investor anticipating a d ecline in the interest rates purchases call interest rates. The investors can also use instruments such as caps, floors or collars to hedge interest rate risk.
4. Caps, Floors And Collars:

An interest rate cap and floor are special types of borrowings and lending options which are meant for long term hedging. On the next page you will see the various graphs or Caps, Floors and Collars.



Caps (Interest Rate Caps):

A cap is a series of interest rate options, which guarantee a fixed rate payable on a borrowing over a specific time period at specific future dates. If interest rates rise above the agreed cap rate then the seller pays the difference between the cap rate and the interest rate to the purchaser. A cap is usually bought to hedge against a rise in interest rates and yet is not a part of the loan agreement and may be bought from a completely different bank. In a cap, usually an upfront fee is any given time will never exceed the current existing rates or the cap rate. The cap working is depicted in the following graph
Figure 4.1: Interest Rate Cap


b. Floors (Interest Rate Floors):

A floor is an agreement where the seller agrees to compensate the buyer if interest rates fall below the agreed upon floor rate. It is similar to a cap, but ensures that if the interest rate falls below certain agreed floor limit, the floor limit interest rate will be paid.
Figure 4.2: Interest Rate Floor


c. Collars:

A collar is a combination of a cap and a floor where you sell a floor at a lower strike rate and buy a cap at a higher strike rate. Thus, they provide protection against a rise in interest rates and some benefit from a fall in interest rates. The pay off profile of a cap and a collar are given below
Figure 4.3: Interest Rate Collar

5. Commodities:

Commodity options give the option buyer to purchase or sell a specific quantity of a commodity at specific price. Commodity options help a farmer in looking his selling price, by purchasing a put option to sell the commodity at a strike price in case the price of the commodity falls. Similarly, they help a trader to purchase the commodities in case there is an increase in the purchase price .


6. Currencies:

The largest portion of the currency option market is the interbank market. Some of the stock exchanges list currency options also.

Currency options are used by the companies in order to hedge against the adverse movement of exchange rates. A curren cy call is similar to a call on a stock that gives the holder the right to buy a fixed amount of foreign currency at a fixed exchange rate on or before the options expiration date. A currency put gives the holder there right to sell a fixed amount of foreign currency at a fixed exchange rate on or before the options expiration date. For example, investors expecting an adverse movement or exchange of Can$/US$ from for 1.12 to 1.14 (meaning Canadian Dollar will be expensive for an American investors) will purchase a call option on Can$/US$ to gain for a rise in exchange rates. The currency options can be settled either through physical delivery or through cash.
Individual Currency Options

The underlying asset of these options is an individual currency.
Currency Baskets:

More popular known as a ³basket option´, an option on a currency basket is an option whose value is based on the value of a basket comprising multiple currencies. It is availed by a company when it wants to hedge a combined exposure in various currencies as it proves to be inexpensive to purchase option on a basket of currencies than purchasing individual options to hedge exposure on individual currencies. The price of a basket option is based on the value or a currency basket, whic h is in turn derived as the weighted sum of the underlying values of the currencies.


Options in the interbank market are quoted in terms of implied volatility. Implied volatility is a measure or possible fluctuations in

future exchange rates. The greater the volatility measure the greater will be the benefit for calls or puts.
7. Interest Rates:

Interest rates options have the underlying asset as a reference rate such as the LIBOR and the strike price as an interest rate. These options are not deliverable but are settled in cash based on an estimated amount and the spread between strike rate and reference rate. The interest rate

options used mostly are European options. An interest rate option holder gets the right to buy or sell the underlying ca sh instrument or the financial futures contract. The treasurer may use these options to protect his

position form rising interest rates or falling interest rates by buying put option or call options respectively. The significance of options reaches beyond the profit motivated trading. Today, many sophisticated institutional trader adopt options in order to execute very complex strategies.

Options that are traded on an exchange are called exchange traded option. For example, stock options are traded on the Chicago Board Options Exchange (CBOE), the American Stock Exchange (AMEX), and the New York Stock Exchange (NYSE). Different types of traders such as, market makers, floor brokers etc trade in an exchange. A market maker can be defined as a person or a firm that quotes the buy and sell price in a financial instrument or commodity, intending to make a profit through bid/ask spread. A market maker creates liquidity in the market. When the investors wish to sell or buy and have no counter parties for the

transaction to materialize, the market maker acts as a buyer to a seller and a seller to a buyer facilitating the immediate execution of the tra nsaction. However, most of the market makers act as scalpers on a short term basis. A scalper purchases and sells at a price higher than the purchase price. He trades in a matter or few minutes before the prices move slightly upwards.
1. Brokerage:

In an option market, the orders are done through brokers as such and most of the strategies result in substantial brokerage commissions because brokerage has to be paid on multiple legs. For example, while executing a long straddle strategy, commissions have to be paid on buying a call and buying a put. In fact, many clients do complain that the brokerage house have pushed these strategies on them to generate additional commissions.
2. Over-The-Counter (OTC) Dealers:

Any security that is not traded on an exchange because of its inability to meet listing requirements is called over-the-counter security. Such securities are called over-the-counter dealers in OTC market through direct negotiation with one another over computer networks or by telephone. OTC dealer can be an individual or a firm that is engaged in the business of underwriting, trading and selling securities.
3. Settlement And Exercise:

Options can be settled in cash or delivered physically At the timer of exercise, the option can be settled by physical delivery or cash settled. A physical delivery of a call option on Aurobindo Pharma gives the buyer or holder of the option the right to take delivery or say, 350 shares of Aurobindo Pharma at a strike price of Rs. 540 a


Similarly, a physical delivery of a put option on Aurobindo

Pharma gives the holder the right to take delivery of 350 shares of the stock at Rs. 560 a share. However, in case or cash settled option, the difference or the exercise price and the market price on the exercise date multiplied by a multiplier as fixed by the option market is paid to the holder of the option. For example, a holder of call option on index with a strike price of $120 exercises it when the exercise settlement value is $140. Assuming the multiplier to be 100, the holder will receive an amount of: [(140-120)*100] = $2000 In general, exchanges sometimes impose position and exercise limits to avoid a single individual or a group from having a significant stake in the market.
Position Limits: A position limit is a maximum number of options that

can be held by an investor on one side or the market. Options are on one side or the market in the case of long and short put or long put and short call. These limits are published by exchanges and vary based on the

volume or trade in the underlying stock and number or outstanding shares.
Exercise Limits: Exchanges may also fix an exercise limit which is the

number of options that can be exercise by an investor. Members of an exchange dealing in options could be either individual or institutions. On the other hand, the members of and over -the-counter market are usually institutions such as banks and brokerage houses, who stand ready to buy or sell and make a market.


The binomial model is a continuous time model ³in the limit´. It is called binomial because it assumes that during the most ³period of time´ share prices will to only one or two values. Although this assumption might seem to be a strange one on which to develop a practical valuation model, it really is not if the investor thinks or a ³period of time´ as being very short and of the eventual expiration date as being many periods from now. We now move on to consider option pricing formula. The basis of this valuation formula is that it is possible to construct a risk -free hedged portfolio by buying shares and writing call options on the shares. As the resulting portfolio is risk free it would be expected that only a risk-free rate of return would be obtained. This then enables the investors to obtain a value for the call option. A general formula for the value of a call option with one period to expiry can be written as:

Vc = H ’
Where, Vc is the value of the call option with one period to expiry, r is the risk-free rate of interest, Po is the current share price, P, is the lower value of the share at the end period and H = (Vu- V1 )/ (Pu- P1 )is the hedging ratio. Vu is the upper value of the option at the end of the period and V 1, is the lower value of the option at the end of the period; P u is the upper value of the share at the end of the period. In the binomial option price formula it is required to value a call one period before expiration. To illustrate, given the following information: present price of share, Rs. 10, exercise price of call option Rs.10, risk67

free interest 25 per cent, assume that the share price will either increase to Rs.15 or decrease to Rs. 5 by the exercise date. It should be possible to construct a fully hedged position by buying shares and writing call option.
TABLE 4.1: Cash Flows in Fully Hedged Position Flows at T

Flow at 10

Possible share prices Rs. 15

Rs. 5

Buy one share Write two calls

-10 +2C

15 -10 5

5 5

Table-2 shows the cash flows at the beginning of the period and the end of the period when one share is purchased and two calls written. It can be seen that at the end of the period the net outcome will be same irrespective of whether the Rs. 15 price or the Rs. 5 price prevails. The reason for this is that if the share price at the end of the period is Rs. 15 then the share purchased will be worth Rs. 15 while the holder of the call written will require two shares to be delivered for which Rs. 20 will be paid. These shares will have to be purchased in the market at the price of Rs. 15 each and a total cost of Rs. 30 giving a loss of Rs. 10. However, if the price of the exercise date is Rs. 5, then the value of the one share held will be Rs. 5 and the call will go unexercised and will have a value of zero. Because the strategy results in a certain outcome whichever possible share price results, the return on the strategy should be certain return, i.e. the risk-free rate of return. We can, therefore, say (10-2C) 1.25 = 5 C

= Rs. 3

It can be observed from the above equation that investors have a net investment of Rs.4 i.e. the cost of one share minus the premium received on writing two calls, and as the outcome of this investment is certain, investors would expect to earn the risk-free rate of return. In this case investors require one share for every tow calls written. The share to option ratio is often called the hedge ration or option date. example, the option rate is 0.5. In the

Option will have to be priced in

accordance with this model otherwise opportunities would occur for dealers to earn riskless profits. Arbitrage activity would ensure that call option are priced in accordance with the formula above. While the foregoing illustrates the principles of option valuation, it makes the non realistic assumption that there are only two possible prices for the share at the end of the period. While it would be possible to

make the example slightly more realistic, by assuming sub periods, the calculations would become more complicated without adding great to the realism. Fortunately, Black and Scholes have devised an option valuation formula which assumes that shares return is normally distributed and this allows for a more realistic assessment of option values.

Every theory in science starts out with assumptions. When applying his laws of motion, Isaac Newton assumed that the world was frictionless. With the option formula, and more importantly the law of dynamic replication that allowed virtually any deriv ative on earth to be price. Black, Scholes and Merton could claim to be the Newton of finance. By leaving aside the details, they could take their i dea from one market to the next from options on stocks to the hidden option on crude oil prices that a company owns when it has oil drillings rights. It really was a universal law of finance.

Fischer Black and Myron Scholes developed a precise model for determining the equilibrium value of an option. The model is widely used by those who deal with options to search for situations where the market price of an option differs substantially from its fair value. In particular, the model provides rich insight into the valuation of debt relation to equity.

The Black Scholes option model is based on following assumption: 1. There are no transaction costs and no taxes. 2. The risk form interest rate is constant 3. The market operates continuously. 4. The share prices are continuously, i.e. there are no jumps in the share prices; if one plots a graph of the share price against time, the graph must be smooth. To be more specific, the share price is log normally distributed for ay finite time interval. 5. The share pays no dividends 6. The option is of European type, that is, options that can be

exercised only at maturity 7. Shares can be sold short without penalty and short sellers receive the full proceeds from the transaction. Given these assumptions, the equilibrium value of an option can be determined. Should the actual price of the option differ from that given by model, the investor could establish a riskless hedged position and a return in excess of the short-term interest rate. As enterprise entered the scene, the excess return would eventually be driven out and the price of the option would equal the value given by the model.

The Specific Model:

The black-scholes formula for estimating the fair value of a call option (Vc) is Vc=• † d1 = In 
š ‡  



d2 =



= d1 - 

and where Ps = the current price of the share, Px = the exercise price of the call, e = 2.7183, RF = the continuously compounded annual riskfree rate, = the standard deviation of the continuously compounded

annual rate of return of the share, In = the natural log of the bracketed number, T = the time remaining to expiration on an annual basis, and Nd1 and Nd2 = the value of the cumulative normal distrib ution at d1 and d2. To illustrate, consider XYZ share to value a call option. Assume Ps = Rs. 68.125, Px = Rs.60.00, RF = 0.1325 per year, and T = 2 months. In addition, the estimated continuous annual standard


deviation of returns on XYZ to be 0.4472 ( values in the above equations we get ; d1 =0.91 d2 = 0.72


= 02). By putting the

Second, the value of Nd1 and Nd2 must be found. These represent the cumulative probability of the normal standard distribution from to dl and from - to d2 respectively. Consider

first d1. The cumulative probability below the zero mean of the standard normal distribution is 50 percent. The value of d 1, is 0.91, meaning it is 0.91 standard deviation above the zero mean. The standard deviation of 0.91 corresponds to a cumulative probability of 0.3186. In total, Nd1 would be 05+ 0.3186 = 0.8186. Using a similar procedure for d2 equal to 0.72 provides an Nd2 = O.7642. Finally, we can calculate the call option's price by substituting in the equation, we get Vc = Rs. 10.92
Dividend Adjustment:

Cash dividends have three possible impacts on call valuation. First, if the dividends are large enough, the calls might be exercised early. Second, if dividends are unknown, risk-free hedge portfolio cannot be formed. For these reasons, the calls cannot be valued without relying on investor preference models such as the capital asset pricing model. However, both these problems are relatively minor for most call options. The third case consists of known cash dividends which are not large enough to threaten an early exercise. If this is true, a relatively simple adjustment can be made to the Black -Scholes model.


To illustrate, let Dt represent a known cash dividend to be paid on day t from now. There may be one or more D, values, let only those paid during the option's life are considered. The Black-Scholes model can still be used, but now with an adjusted stock price P*s:

P*s = Ps
If known cash dividends equals to Rs. 2.00 are to be paid exactly one and two months from now:

P*s =Rs. 64.19
Put Valuation:

The valuation of a European put can be found by inserting the BlackScholes call price into the put -call parity model. The result is:

Pp =  

The cumulative normal density function is evaluated at negative d1 and d2 values. Assume that the stock price is Rs.40, the put exercise price is Rs.40, the expiration date is 4 months, the continuous risk- free interest rate is 12%, and the standard deviation of continuously compound stock returns is 30% per year so, d1 = 0.26 N-d1 = 0.3974 d2 = 0.09

N-d2 = 0.4641


So from the above values, we get Pp

= Rs.1.94

When options traders or analysts get together, they almost certainly use the term delta early in their conversation. Deltas are an important by-product of the Black-Scholes model, and they provide particularly useful information to investors who use options in portfolios. Delta is defined as the change in option premium expected from a small change in the strike price, all other things being the same. Symbolicall y, 

Where AS is a small change in stock price and AC is the corresponding change in the call price. Consider a call option whose delta is 0.6. Suppose that the option price is Rs.10 and the strike price is Rs. 100. Suppose an investor who has sold 20 option contracts, that is, options to buy 2000 shares. The investor's position could be hedged by buying 0.6 x 2000 = 1,200 shares. The gain (loss) on the option position would tend to be offset by the loss (gain) on the stock position. For example, if the stock price goes up by Rs. 2 (producing a gain of Rs. 2, 400 on the shares purchased), the option price will tend to go up by 0.6 x Rs. 2 = Rs.1.2 (producing a loss of Rs. 2, 400 on the options written); if the stock price goes down by Rs. 2 (producing a loss of Rs. 2, 400 on the shares purchased), the option price will tend to go down by Rs. 0.60 (producing a gain of Rs. 2,400 on the options written).


In the example, the delta of the investor¶s option is 0.6 * (-2000) = -1200. In other words the investor loses 1200 by when the stock price increases

. The delta of the stock by definition 1.0 and the long position in 1200

shares has a delta of +1200. The delta of the investors overall positions, therefore, zero. The delta of the asset position offsets the delta of the option position. A position with a delta of zero is referred to a being delta neutral. But delta neutral remains for a relatively short period of time Black -Scholes valued options by setting up a delta neutral position and argued that the return on the position should be the risk -free interest rate.

The theta of a portfolio of option, , is the rate of change of the value of the portfolio as time passes with all else remaining the same. It is sometimes referred to a time decay of the portfolio. Theta is almost always negative for an option. (An exception to this could be an in-the-money European put option on a non dividend paying stock or in -the-money European call option on a currency with a very high interest rate). This is because as the time to maturity decreases, the option tends to become less valuable.


The gamma of a portfolio on underlying assets is the rate of change of the portfolio¶s delta with respect to the price of the underlying asset. If gamma is small, delta changes very slowly, and adjustments to keep a portfolio delta neutral would only be made relatively infrequently. However, if gamma is large in absolute terms, delta is highly sensitive to the price of underlying asset. It is then quite risky to leave a delta neutral portfolio unchanged for any length of time.



Vega, also referred to as Kappa or as Sigma or as Lambda, of a portfolio of options is the rate of change of the value of the portfolio with respect to the volatility of the underlying asset. If Vega is high in absolute terms, volatility changes have relatively lit tle impact on the value of the portfolio. If a hedger requires a portfolio to be born gamma and Vega neutral, at least two traded options dependent on the underlying asset must be used.

The rho of a portfolio of options is the rate of change of the value of the portfolio with respect to the interest rate. It measures the sensitivity of the value of a portfolio to interest rates.




5.1 5.2 5.3 5.4 5.5 5.6

Introduction Definition Types Of Swap Valuing Swaps Forward Swaps And Swaptions Termination Of A Swap


Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (Swap) payments, based on some notional principle amount is called as a µSwap¶. In case of swap, only the payment flows are exchanged and not the principle amount.

Many scholars define swap in many ways. Few of them are given below:
y An agreement or transaction in which two or more parties

exchange their cash flows at a predetermined series or payments.
y Exchange or interest rate payment for specific maturity on an

agreed upon notional principal.
y An agreement whereby one party exchanges with the other a set of

interest payments for another, say fixed rate to floating rate or vice versa. With the help of swap, a floating rate liability can be converted into a fixed rate liability, ensuring that the volatility in the interest rates does not increase the burden of payments or else, vice versa convert a fixed rate liability into a floating rate liability when the interest rates fall steeply in the market.


1. Commodity Swaps:

In a commodity swap, the counterparties make payments based on the price of fixed amount or a certain commodity in which one party pays a fixed price for the good and the other party pays a market rate over the swap period.
2. Currency Swaps:

A currency swap is a mutual understanding of parties for exchange or interest payments either fixed or floating on loan in new currency to an equivalent loan in another currency. This may or may not involve initial exchange of principal; a plain vani lla currency swap is a fixed-fixed currency swap in which each party pays a fixed payment on the loan taken by them. With the rise in interest rate swaps, the currency swaps market also rose from the earlier parallel and back to back loan structures w hich were developed and designed in the United Kingdom as a mean of circumventing foreign exchange controls and to prevent an outflow or British capital. In the 1970s the British government imposed taxes on foreign exchange transactions that involved its currency. Due to this, the parallel loan became a widely accepted transaction by which these taxes could be avoided. In 1979, these taxes on foreign exchange transactions were removed and due to these British firms need not have to take back to-back loans. However, during the 1980s, banks modified those loans and launched currency swaps. They achieved similar economic purposes like those or parallel and back-to-back loans. Currency swaps effectively decreased the use of these loans due to the followin g advantages:



In currency swaps, termination or contract can be done if one party defaults the other party and can claim damages.


Since currency swap is not a loan, it does not appear as a liability on the contracted party balance sheet unlike other loans.


Currency swaps give greater liquidity. Due to this many banks agree to take the risk in swaps transaction.
3. Equity Swaps:

An equity swap means an exchange or dividends earned and capital gains on a portfolio, which is based on a stock index aga inst period interest payments. It is similar to an interest rate swap, in that it has a fixed period, a fixed rate payer and a floating rate payer.
4. Interest Rate Swaps :

Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas; the floating rate payer takes a long position in the forward contract.
5. Others:

Other types of swaps include power swaps, weather swaps, etc. The swaps that are privately negotiated financial contracts that allow two parties to exchange specific weather risk exposures over a predetermined period of time are called weather swa ps. They are ³over-the-counter´ instruments that can be customized to the parties specific needs. These swaps are simply designed to help to protect against warmer than normal winters, for example, by selling a swap at a predefined number of heating degree days indexed at a specified weather station . There is no cost for a swap, and, although there are standardized industry contracts.

Since swap is an exchange of two streams of cash flows it can be price by determining the value of each stream of cash flows. The value of each stream of cash flows is the net present value of the cash flows in the stream. If the cash flow are in different currencies (as in currency

swaps), the present values are converted to a single currency at the prevailing exchange rate. The price of the swap is the difference

between the values of the two cash flows. This comparison helps us in pricing and valuing swaps.
1. Equivalence Of Swaps And Other Instruments:

Swaps and Assets: A currency swap is similar to a fixed or floating rate bond which is issued in one currency, and whose proceeds cab be converted into other currencies and used to purchase a fixed or floating rate bond denominated in a different currency. An interest rate swap is identical to a fixed or floating rate bond whose proceeds cab be used to purchase a floating or fixed rate bond. Whose notional price is equivalent to the face value of thes e hypothetical bonds. Equity swaps cab ne compared to issuing one type of security and using the proceeds to purchase another. At least one of the types of the securities should be a stock or stock index.
a. Swaps And Forward Contracts:

A forward contract is an agreement for one party to make a fixed payment to other party, while the latter party is obliged to make a variable payment to the former. A swap can be said as a series of forward

contracts combined into single transactions. There are some differences between swaps and forward contracts, for example. Swaps are a series of equal fixed payments, nut a series of forward contracts, the component

contracts are mostly priced at different fixed rates. In case of interest rate swap, the next payment that each party has to make is known beforehand, but in a single forward contract it is unknown. Keeping aside these differences, it is generally acceptable to compare a swap to series of forward contracts.
b. Swaps And Future Contracts:

A swap can be compared to a future contract only to the extent to which a future cab be compared to a forward. A future contract can be compared to a forward contract only when the future interest rates are known. Since swaps are usually used to manage uncertain interests, it may not always be appropriate to compare a swap with a future contract.
c. Swap And Option:

A swap payment can be compared to buying a call and selling a put and forcing the transacting party, when the underlying is below the exercise rate at expiration, to make a net payment or resulting in receipt of payment when the underlying is above the exercise rate. The

connection between swaps and options is very clear and straightforward for interest rate instruments than currency and equ ity instruments.
2. Valuation Of Swap:

At the timer of entering into the swap both the parties will have the same value for all inflows and outflows, but after entering into swap the value may change due to changes in the interest rates. If the interest rates increase, the value of the fixed rate payer will decrease and if the interest rate decreases the value of fixed rate payer will increase. Depending on the value increase, if a party in the swap wants to realize the gain, it can reverse the existing swap with a new market swap.


Swap can be valued on similar lines as bonds as they essentially involve a series of cash flows at different points of time. We first have to discount the inflows at an appropriate rate and determine the present value. We repeat this process in the same way for outflows also. This difference between the value of inflows and outflows is nothing but the value of swap. Generally, the prevailing LIBOR rate is used for discounting the cash flows associated with fixed rate.
3. Valuation Of Currency Swaps:

In the case of currency swaps, the valuation can be done considering the swap as a portfolio of two bonds. So, the swap value will be the difference between the current values of both the bonds, as per the following formula: V= PF ± PL Where, V = value of the swap PF = value of the foreign currency bond PL= value of the local currency bond. Suppose a Western firm is in need of $40 million to finance a foreign investment. The French franc yields were higher than the US dollar yields. The French firm would have to pay 9% on a 5-year US dollar loan and 10% on a 5-year French franc loan. Similarly, a US firm needs a loan of 291.2 million French francs for its French subsidiary but has an easier access to the US bond market. The US firm has to pay 8% on a 5 year US dollar loan and 11% on a 5 -year French franc loan. Current spot rate is 7.68 Fr/$. The US firm can borrow in $ at 8% and the French firm


in French franc at 10%. Then they swap their borrowings to meet their requirements. Let P$ and P F represent the values of the dollar and French franc bonds given the market interest rates r$ and rF on the bonds in the two countries. Then the French franc value of the swap for a spot exchange rate S is, Swap value = P F - SP$ This is the value of the swap to pay dollar and receive French franc. The dollar value of the swap can be deduced for the French franc value of the swap by dividing it by spot exchange rate S. The value of the swap for the other party, which has agreed to pay francs and to receive dollar, is exactly the opposite of that computed above. At the time of issue, the two interest rates were assumed to be equal to the market yield to maturity on five year risk-free bonds in dollars (8%) and French francs (10%). Assume that after a year the yield curves in dollars and French francs are flat and the interest rates have dropped to 7% and 8% on US dollar and French franc respectively. The exchange rates drops to 7.56 FFr/$. A swap payment of French franc 4.928 million has just been made. The dollar bond was worth $40 million (its par value) when the swap was constructed with a dollar interest rate of 8%. The value of the bond after one year when the interest rate falls to 7% is, P$ =3.2PVIFA +40 PVIF

= 41.355 million.


Similarly the French franc bond was worth Fr 291.2 million (par value) when the swap was contracted. After one year, the bond value is PF =29.12 PVIFA + 291.2 PVIF =310.49 million The franc value of the swap is, Swap value = 310.49 - 41.355 * 7.56 = - 2.1538 The dollar value of the swap will be, Swap value = - 2.1538/7.56 = - 0.2849 million. The practical difficulty encountered in this problem is the determination of interest rates used on both legs of the swap. For each cash flow on the fixed leg, we should use a zero coupon term structure.
4. Valuation Of Equity Swaps:

An equity swap means an exchange of dividends earned and capital gains on a portfolio, which is based on a stock index against periodic interest payments. It is similar to an interest rate swap, in that it has a fixed period, a fixed rate payer and a floating rate payer. Assuming that you are managing a portfolio of stocks invested in an index fund. The underlying index is the S P 500. You turn bearish following the recent movement in the stock prices and you wish to hedge your position against any adverse movement in the future. So, you can use a swap where you pay the return on S&P 500 and receive a fixed payment in exchange. Both fixed rate receipts and floating rate payments

are based on the notional principal i.e. your portfolio value. This is possibly say, if you find another party which is interested in the S&P 500 investment and is ready to pay you the fixed interest re turns on say, sterling pounds and sterling interest rates.
5. Valuation Of Interest Rate Swaps:

While valuing the plain vanilla interest rate swap, the fixed leg should be considered a fixed coupon bond and the floating rate should be considered a floating rate note. Considering that at maturity level the fixed and floating parties give each other equal amount of money, the pricing of the swap becomes simply the value of the fixed coupon bond minus the value of the floating rate note. This is denoted by formula given below: V = FB - FF Where, V = Value of the swap FB = Value of the fixed coupon bond FF = Value of the floating rate note. In the above said formulae, the values of both the fixed leg and the floating leg swaps will be different as market rates change after the initial pricing of the swap. On the fixed leg, the cash flows do not change but the discount factor changes and hence the value. While on the floating side, both the cash flows and the discounting factor change and hence the value change. Such kind of swap called an off -market swap.

This states that the value of an off-market swap can be neither positive nor negative but not zero.

Forward swaps are those which are arranged in which the commencement date is set as a future date helping in locking the swap rates and use them later as and when needed. They are known as deferred swaps. This is attractive to these users who do not need funds

immediately but would like to benefit from the existing rates of interest. While options on swaps or Swaptions can be written on any kind of swap and give the holder the option to enter into swaps at a certain date in future on terms agreed at the time of purchase of the swaption. They ensure that the interest paid on a swap in future will not exceed a certain pre-decided level. Swaptions give a right but not obligation to the buyer to exercise his choice. Swaptions can be either America n or European. European swaptions are more popular and can be exercised only on maturity, while the American ones can be exercised any time before maturity. Swaptions can be of two types:
1. Call Swaption:

A call swaption gives its buyer the right to enter into a swap as a fixed rate payer. The writer of the call swaptions will be floating rate payer if the option is exercised. Assume that your firm wishes to enter into a fixed floating rate swap because you expect the rates to rise and hence you w ant to pay a fixed rate and receive a floating rate. But there is a speculation that the rates may start falling after a certain period and hence you may buy a call swaption sot that depending on the rate of movement in the future you can enter into a swap deal or allow your option to expire.


2. Put Swaption:

Here, the buyer gets the right to enter into a swap as a floating rate payer. The writer becomes the fixed rate payer when the option is


Many swaps are terminated early by entering into a separate and offsetting swap. Suppose a company is engaged in a swap to make fixed payments of 5% and in return receive floating payment based on LIBOR, with the payments made on 15 January and 15 July for 3 years. 3 years remain on the swap. That company can offset the swap by entering into an entirely new swap in which it makes the payment based on LIBOR and receives a fixed rate with payments made on 15 January and 15 July for 3 years. The swap fixed rate is determined by market conditions at the time the swap is initiated. Thus the fixed rate on the new swap is not likely to match the fixed rate on the old swap, but the effect of this transaction is simply to have the floating payments offset: the fixed payments will be out to known amount. Hence the risk associated with the floating rate is eliminated. The default risk, however, is not

eliminated because both swaps remain in effect.




6.1 Risk Identification And Qualification 6.2 Decision To Manage Or Accept Risk Exposure 6.3 Risk Management Alternative 6.4 Strategy Development And Implementation


For financial intermediaries there are five main risk types, all of which are capable of being managed to acceptable levels. These risks include: 1. Interest rate. 2. Price (valuation). 3. Prepayment. 4. Credit. 5. Exchange rate. Once the type of risk to be managed has been identified, the next issue becomes the objective quantification of that risk. Depending on the type of risk, there are several commercially supported computer models available. Regardless of the specific modeling approach emp loyed, there are at least three key elements that need to be included in the quantification effort to enable subse quent risk management decisions.
1. Underlying Assets And Liabilities Creating The Risk Exposure :

Key issue is to examine both the asset and liability side of the risk exposure to enable an understanding of the individual portfolio exposure as well as the net exposure created by the combination.
2. Term Of Risk Exposure:

Key issue is to determine the length of time the exposure is expected to exist. An important sub -issue is to determine if the exposure is a onetime event, or if it is a continuing series of events.
3. Direction Of Risk Exposure:

Key issue is to determine the directional interest rate, price, or exchange rate movement to which the underlying risk position is

exposed. This is not a forecast; it is simply a determination of the market environment within which the underlying risk position is negatively (and positively) impacted. As a result of addressing the foregoing risk identification and quantification issues, it is fairly easy to construct a graphical representation of the "as is" performance profile of the underlying balance sheet or portfolio. This can be as simple as cre ating a graph of a single security portfolio, or as complex as executing a series of sophisticated balance sheet, cash flow, income statement, and econometric models representing the relationships of a myriad of interrelated business activities or portfolio holdings. Regardless of how simple or complex the effort, an "as is" profile can, and must, be produced before implementing strategies to alter the profile. The reasons for this are fairly straightforward:
y Without an understanding of the "as is" profile, it is difficult, if not

impossible, to evaluate the effectiveness of any strategy implemented to alter the "as is" profile.
y Regardless







management efforts might be, without an understanding of the "as is" profile, many risk management strategies actually end up exacerbating risk exposure as opposed to managing it towards the desired profile. This "as is" performance profile will be very useful in establishing a reference point by which all subsequent decisions can be evaluated and facilitated.


The driving force of any effort to manage risk is the conscious decision, by management, to either accept or modify the risk exposure quantified as being inherent in the underlying balance sheet or portfolio. Naturally, this type of decision needs to be made within the context established by the goals and objectives that make up the Company's business plan, and the environment within which the resulting risk management strategies will be implemented.

Once a conscious decision has been made to manage a given risk exposure, management's attention should then turn to an evaluation of the effectiveness (risks, costs, and benefits) of the various risk management alternatives. As a general rule, there are three main alternative risk management categories from which to draw:
1. Policy Decisions:

This category is made up of the business policy decisions management makes in their on-going effort to achieve their competitive position and financial performance objectives. These are usually the least costly to implement, but are somewhat limited in their utility to manage all the exposure to be managed without eliminating profit potential. Regardless of this limitation, this alternative, at minimum, should be exhausted before utilizing derivatives.


2. Cash Market Transactions:

This category is made up of the conventional transactions management employs to manage the Company's balance sheet in conformance with industry practices and regulatory guidelines. For financial intermediaries these are usually money market, fixed income, mortgage-backed, and equity securities related

transactions. These alternatives are best utilized when there is exposure remaining to be managed after management has exhausted policy decision alternatives and before utilizing derivatives.
3. Derivatives:

This category is made up of financial instruments that have been derived from underlying instruments that have similar, if not the same, characteristics as the assets and liabilities that make up the Company's risk position (balance sheet or portfolio). These instruments include; forwards, futures, options, swap, etc. Since this category tends to have more inherent risks, derivative alternatives should be utilized only when there is risk remaining to be managed after management has exhausted all policy decision and cash market transaction alternatives. It is important to note that even though management may make a conscious decision to manage a given portion of the Company's risk exposure, and may deliberately act to conscientiously exhaust all policy decision and cash market transaction alternatives, there may remain some exposure still yet to be managed. When this occurs, management's attention needs to be focused on evaluating the risk/reward profile associated with utilizing derivatives to manage the remaining exposu re. Therefore, there are times, wherein, there is no practical alternative

available to management other than continued acceptance of the unmanaged risk exposure.






Regardless of the type of risk exposure and how it was quantified, regardless of why management decided to manage the exposure, and regardless of the risk management category from which the strategy is drawn, there are five basic issues that need to be addressed in order to develop and implement a strategy in such a way as to minimize, as opposed to exacerbate, the Company's exposure: 1. Establish a reference point from which strategies will be developed and by which strategies will be evaluated. The "as is" performance profile as previously described is helpful in this regard. 2. Clearly state and document the objectives underlying the strategy. 3. Ensure suitability of strategy, both initially and by tactical adjustments on an on-going basis, by making sure that the decisions, actions, and instruments making up the strategy and tactics produce a profile that, when added to the "as is", mitigates as opposed to exacerbates the underlying position's exposure. This can be accomplished by modeling the effect the strat egy and related tactical adjustments have on the "as is" performance profile. 4. As a general rule there is more than one strategy and related set of tactical adjustments that can be considered suitable for accomplishing most objectives. Therefore, managemen t needs to objectively evaluate (in both favorable and unfavorable market environments) and select the most implementation.

suitable strategy for



7.1 Findings 7.2 Suggestions 7.3 Conclusion


y Derivatives market in India is still in its development stage. It is

not at par with worlds derivatives market
y Speculation has caused many small investors to lose their valuable

y Derivatives instruments are only for higher value of transaction.

An individual trader finds it difficult to invest in derivative market.
y As it is still in development stage people are unaware of derivative

instruments available.

y Derivatives market should be developed in order to keep it at par

with other derivative markets in the world.
y Speculation should be discouraged. y There must be more derivative instruments aimed at individual

y FEDAI and RBI should conduct seminars regarding the use of

derivatives to educate to various sections of traders which should include individuals, money changers, bank dealers, corporate dealers, etc.

The economic benefits of derivatives are not dependent on the size of the institution trading them. The decision about whether to use derivatives should be driven, not by the company¶s size, but by its strategic objectives. However, it is important that all users of derivatives, regardless of size, understand how their contacts are structured, the

unique price and risk characteristics of those instruments, and how they will perform under stressful and volatile economic conditions. Without a clearly defined risk management strategy, use of financial derivatives can be dangerous. It can threaten the accomplishment of a firms long range objectives and result in unsafe and unsound practices that could lead to the organization insolvency. But, when used wisely, financial derivatives can increase shareholders value by providing a means to better a firms risk exposures and cash flows. When using financial derivatives,

however, organizations should be careful to use only those instruments that they understand and that fit best with their corporate risk management philosophy. The SEBI¶s advisory committee to derivatives has proposed a set of measures to improve liquidity in the markets. These measures once

approved by the SEBI board, would permit FII participation in all derivatives products. The committee also suggested that banks funds could be channeled through the stocks exchange cleari ng

corporation/house The minimum value of a contract for stock derivatives at present is fixed at RS.2 lakh and it is viewed as high for retail participation. However, only a fraction of it has to be paid on the option contract in the form of premium as the option price. With only a marginal investment, one can take large, positions in the market. The options market would pick up in Indian subcontinent fairly quickly despite the nuances of the complex mathematics involved in the valuation of the options, in view of intuitive understanding of options is excellent. Hence there is reason to be hopeful that it would grow rapidly.


Following is the list of books referred:
y Derivatives Analysis and Valuation

- The ICFAI University Press
y Financial Derivatives: Risk Management

- V. K. Bhalla
y Option, Futures and Other Derivatives ± 5th And 6th Revised

Editions - John C. Hull
y Introduces Quantitative Finance


Paul Wolmott

The following websites were used: 1. http://www.strategies-tactics.com/derivatives.htm#risk 2. http://www.numa.com/ref



Q1. What are derivatives in plain English? Q2. What is the difference between derivatives and shares? Q3. How are they used? Q4. What is the attraction of derivatives? Q5. What is gearing? Q6. Are they very complex? Q7. Are derivatives very risky? Q8. Were derivatives the cause of Barings¶ downfall? Q9. How do I invest in derivatives?


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