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The instrument so purchased provides a means by which the wealth produced may beturned into money.

In the case of stock, this

may take the form of the company's dividendpayment, the part of aftertax profits distributed to shareholders, or it might take the

formof capital gains realized through the appreciation of the stock's value. Formerly, suchmonetization, or potential for

monetization, would have been more or less directly relatedto the economic performance of the company, in contributing to an

increasing overall rateof wealth generation through productivityenhancing increases in the powers of labor.

Sotoo are bonds directly related to economic activity, though where stocks represent equityownership, bonds represent indebtedness. The

interest paid corresponds, more or less, tothe dividend yield of a stock. And like stocks, bonds can provide capital appreciation.A

generation ago, such financial instruments were the means for transforming economicsurplus into monetized net profit. ``Hard''

commodities are different, because they are partof the materials-flow needed to sustain production and consumption, which ought to

bebought and sold so that production might proceed-outputs of production on the one side,are also the inputs for the next level of

productive transformation on the other: Wheatbecomes flour, flour becomes bread; iron ore becomes steel, steel

becomes machinery,buildin gs, automobiles, and household appliances. Such activities used to contribute togeneration of

surplus, but their monetization is not part of aftertax profits.Purchases of stocks and bonds would once have been seen as

investment for the long haul.Trade in commodities would have been seen not as investment, but as purchases and sales.With what

are now called derivatives, we move from investment, and purchases and salesof hard commodities, to speculating on the

future price or yield performance of what wereonce investments, and relatively simple, economically necessary transactions.All

derivatives are actually variations on futures trading, and, much as some insist to thecontrary, all futures trading is inherently

speculation or gambling. Thus until late in 1989, allfutures trading, of any sort, was outlawed in Germany, under the country's

gambling laws.Such activities were not treated as a legitimate part of business activity. And, who willcontend

against the observation, that Germany did quite well without them? There are two types of futures trading; each can

be applied to each of the instruments, likestocks and bonds, which, bought directly for cash, monetize what used to be

after-taxprofits. The first type is, as it were, a second step removed from economic activity as such.This is futures trading per

se: contracting to buy or sell at a future date, at a previouslynegotia ted price. Here the presumption used to hold, that commodities, for

example, wouldactually change hands for money, as the agreed-on contracts fell due.The other kind of futures

contract, called an option, moves another step further away fromeconomic activity as such. Now what is bought or sold is

the right, but not the obligation, tobuy or sell a commodity, stock, bond, or money, at a future price on an agreed-on date.Where the

futures contract speculates on what the price that would have to be paid againstdelivery will be, the option simply speculates

on the price.At yet another remove from economic activity per se is an index. An index is not the right tobuy a commodity or

stock in the future which is traded, but the future movement of anindex based on a basket of stocks, commodities,

bonds, or whatever.

Types of derivatives
The most commonly used derivatives contracts are

forwards, futures and options which weshall discuss in detail later. Here we take a brief look at various derivatives

contracts thathave come to be used.


: A forward contract is a customized contract between two entities, where

settlement takes place on a specific date in the future at todays pre

-agreed price.

: A futures contract is an agreement

between two parties to buy or sell an asset at acertain time in the future at a certain price. Futures contracts are special types

of forwardcontracts in the sense that the former are standardized exchange-traded contracts

: Options are of two types - calls and puts. Calls give the buyer the right but not theobligation to buy a given quantity of the

underlying asset, at a given price on or before agiven future date. Puts give the buyer the right, but not the obligation to sell a givenquantity of

the underlying asset at a given price on or before a given date.


: Swaps are private

agreements between two parties to exchange cash flows in thefuture according to a prearranged formula. They can

be regarded as portfolios of forwardcontracts. The two commonly used swaps are:

Interest rate swaps

: These entail swapping only the interest related cash flowsbetween the parties in the same currency.

Currency swap

: These entail swapping both principal and interest between theparties, with the cash flows in one direction

being in a different currency than those in theopposite direction.


: Options generally have lives of upto one

year, the majority of options traded onoptions exchanges having a maximum maturity of nine months. Longerdated options

arecalled warrants and are generally traded over-thecounter.


: The acronym LEAPS means Long-Term Equity

Anticipation Securities. These areoptions having a maturity of upto three years.


: Basket options are options on portfolios of

underlying assets. The underlying assetis usually a moving average or a basket of assets. Equity index options are

a form of basketoptions.

: Swaptions are options to buy or sell a swap that will become operative at theexpiry of the

options. Thus a swaption is an option on a forward swap. Rather than havecalls and puts, the swaptions market

has receiver swaptions and payer swaptions. A receiverswaption is an option to receive fixed and pay floating. A

payer swaption is an option to payfixed and receive floating.


Participants and Functions

Three broad categories of participants hedgers, speculators, and arbitrageurs trade in

thederivatives market.

face risk associated with the price of an

asset. They use futures


Source: Options Futures & Other Derivatives John C Hull

or options markets to reduce or eliminate this risk.


wish to bet on futuremovements in the price of an asset. Futures and

options contracts can give them an extraleverage; that is, they can increase both the potential gains and potential losses in

aspeculative venture.

are in business to take advantage of a discrepancybetwe en prices in two different markets.

If, for example, they see the futures price of anasset getting out of line with the cash price, they will take offsetting

positions in the twomarkets to lock in a profit.The derivative market performs a number of economic

functions. First, prices in anorganized derivatives market reflect the perception of market participants about

the futureand lead the prices of underlying to the perceived future level. The prices of derivativesconver ge with the prices

of the underlying at the expiration of derivative contract. Thusderivatives help in discovery of future as well as current prices.

Second, the derivativesmarket helps to transfer risks from those who have them but may not like them to thosewho have appetite for

them. Third, derivatives, due to their inherent nature, are linked tothe underlying cash markets. With the introduction of

derivatives, the underlying marketwitnesses higher trading volumes because of participation by more players who would

nototherwise participate for lack of an arrangement to transfer risk. Fourth, speculative tradesshift to a

more controlled environment of derivatives market. In the absence of anorganized derivatives market,

speculators trade in the underlying cash markets. Margining,monito ring and surveillance of the activities of various

participants become extremelydifficult in these kind of mixed markets. Fifth, an important incidental benefit

that flowsfrom derivatives trading is that it acts as a catalyst for new entrepreneurial activity. Thederivatives

have a history of attracting many bright, creative, well-educated people with anentrepreneurial attitude. They often energize

others to create new businesses, newproducts and new employment opportunities, the benefit of which are immense. Sixth,derivatives

markets help increase savings and investment in the long run. Transfer of riskenables market participants to

expand their volume of activity. Derivatives thus promoteeconomic development to the extent the later depends on the

rate of savings andinvestment.

Development of exchangetraded derivatives

Derivatives have probably been around for as long as people have been trading with oneanother. Forward contracting dates

back at least to the 12th century, and may well havebeen around before then. Merchants entered into contracts with one another

for futuredelivery of specified amount of commodities at specified price. A primary motivation forprearranging a

buyer or seller for a stock of commodities in early forward contracts was tolessen the possibility that large swings

would inhibit marketing the commodity after aharvest. Although early forward contracts in the US addressed merchants

concerns about ensuring

that there were buyers and sel lers for commodities, credit risk remained a serious

problem. To deal with this problem, a group of Chicago businessmen formed the
Chicago Board of Trade

(CBOT) in 1848. The primary intention of the CBOT was to provide acentralized location known in advance for

buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step further and listed the first exchange traded derivatives

contract in the US; these contracts were called futures contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT,

was reorganized to allow futures trading. Its name waschanged to

Chicago Mercantile Exchange

(CME). The CBOT and the

CME remain the twolargest org anized futures exchanges, indeed the two largest financial exchanges of any kind in the world today.The first

stock index futures contract was traded at

Kansas City Board of Trad

e. Currentlythe most popular index futures contract in the

world is based on S&P 500 index, traded onChicago Mercantile Exchange. During the mid eighties, financial futures became the

mostactive derivative instruments generating volumes many times more than the commodityfutures

. Index futures, futures on T-bills and Euro-Dollar futures are the three most popularfutures contracts traded today. Other

popular international exchanges that trade derivatives