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A derivative is a term that refers to a wide variety of financial instruments or "contract whose value is derived from the performance of underlying market factors, such as market securities or indices, interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof." [1] In practice, it is a contract between two parties that specifies conditions (especially the dates, resulting values and definitions of the underlying variables, the parties' contractual obligations, and the notional amount) under which payments are to be made between the parties.[2][3] The most common underlying assets include: commodities, stocks, bonds, interest rates and currencies. There are two groups of derivative contracts, the privately traded Over-the-counter (OTC) derivatives such as swaps that do not go through an exchange or other intermediary and Exchange-traded derivative contracts (ETD) that are traded through specialized derivatives exchanges or other exchanges.

Derivatives are more common in the modern era, but their origins trace back several centuries. One of the oldest derivatives is rice futures, which have been traded on the Dojima Rice Exchange since the eighteenth century.[4] Derivatives are broadly categorized by the relationship between the underlying asset and the derivative (such as forward, option, swap); the type of underlying asset (such as equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives, or credit derivatives); the market in which they trade (such as exchange-traded or over-the-counter); and their pay-off profile. Derivatives may broadly be categorized as lock or option products. Lock products (such as swaps, futures, or forwards) obligate the contractual parties to the terms over the life of the contract. Option products (such as interest rate caps) provide the buyer the right, but not the obligation to enter the contract under the terms specified. Derivatives can be used either for risk management (i.e. to hedge by providing offsetting compensation in case of an undesired event, insurance) or for speculation (i.e. making a financial "bet"). This distinction is important because the former is a legitimate, often prudent aspect of operations and financial management for many firms across many industries; the latter offers managers and investors a seductive opportunity to increase profit, but not without incurring additional risk that is often undisclosed to stakeholders. In December 2007 the Bank for International Settlements reported [5] that "derivatives traded on exchanges surged 27% to a record $681 trillion in the third quarter" (Stever et al. BIS 200712 Page 20) [5] of 2007 as "investors bet on losses linked to record U.S. mortgage foreclosures" and Federal Reserve and the European Central Bank policy changes intended to offset the credit slump. [6] Along with many other financial products and services, derivatives reform is an element of the DoddFrank Wall Street Reform and Consumer Protection Act of 2010. The Act delegated many rule-making details of regulatory oversight to the Commodity Futures Trading Commission and those details are not finalized nor fully implemented as of late 2012.

Definition of 'Derivative' A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. Investopedia explains 'Derivative' Futures contracts, forward contracts, options and

swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes. For example, a European investor purchasing shares of an American company off of an American exchange (using U.S. dollars to do so) would be exposed to exchange-rate risk while holding that stock. To hedge this risk, the investor could purchase currency futures to lock in a specified exchange rate for the future stock sale and currency conversion back into Euros. . What are Derivative Instruments? A derivative is an instrument whose value is derived from the value of one or more underlying, which can be commodities, precious metals, currency, bonds, stocks, stocks indices, etc. Four most common examples of derivative instruments are Forwards, Futures, Options and Swaps. Top 2. What are Forward Contracts? A forward contract is a customized contract between two parties, where settlement takes place on a specific date in future at a price agreed today. The main features of forward contracts are They are bilateral contracts and hence exposed to counter-party risk. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. The contract has to be settled by delivery of the asset on expiration date. In case the party wishes to reverse the contract, it has to compulsorily go to the same counter party, which being in a monopoly situation can command the price it wants. Top 3. What are Futures? Futures are exchange-traded contracts to sell or buy financial instruments or physical commodities for a future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument commodity in a designated future month at a price agreed upon by the buyer and seller.To make trading possible, BSE specifies certain

standardized features of the contract. Top 4. What is the difference between Forward Contracts and Futures Contracts? Sr.N o 1 2 3 4 5 6 Basis Nature Contract Terms Liquidity Margin Payments Futures Traded on organized exchange Standardized Forwards Over the Counter Customised Less liquid Not required At the end of the period. Contract can be reversed only with the same counter-party with whom it was entered into.

More liquid Requires margin payments Follows daily Settlement settlement Can be reversed with Squaring any member of the off Exchange.

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Derivatives Indian Scenario - 29 - Default/ credit risk of counterparty. This may be ignored, as the counterparty is a bank.This risk involves losses to the extent of the interest rate differential between fixed andfloating rate payments.- The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond10.75% will raise the cost of funds for the firm. Therefore it is very essential that the firmhold a strong view that MIBOR shall remain below 10.75%. This will require continuousmonitoring on the path of the firm.How does the bank benefit out of this transaction?The bank either goes for another swap to offset this obligation and in the process earn aspread. The bank may also use this swap as an opportunity to hedge its own floatingliability. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75%.Taking advantage of future views/ speculationIf a bank holds a view that interest rate is likely to increase and in such a case the returnon fixed rate assets will not increase, it will prefer to swap it with a floating rate interest.It may also swap floating rate liabilities with a fixed rate. 3.7 Factors to be looked at while doing a swap Though swaps can be used in the above conditions effectively, corporates need to look ata few factors before deciding to swap. The estimated net exposure They need to estimate the net exposure that they are likely to have i n t h e f u t u r e . Projecting the growth in exports/ imports, taking into account the changes in managementand government policies can do this. Expected range of exchange rates This can be determined by a fundamental and technical analysis. For f u n d a m e n t a l analysis one needs to keep track of the balance of payment condition, GDP growth rate,etc. of the country. The technical factors look at past trends and expected demand-supply position. Other factors like political stability also needs to be considered.

Derivatives Indian Scenario - 30 Expected interest rates Since currency swaps include exchange of interest payments, the interest rates also needt o b e t r a c e d . B y k e e p i n g a n e y e o n t h e y i e l d c u r v e o f l o n g t e r m b o n d s a n d t h e m a c r o economic variables of different countries, the interest rates can be estimated. Amount of cover to be taken Having estimated the amount of exposure, the expected exchange rates and the interestrates, the parties can determine the risks involved and can decide upon the amount of cover to be taken. This shall depend on the management policy whether they believe inminimizing the risk for a given level of return or maximizing the gain for a given level of risk. The risk taking capability of a corporate will depend upon the financial backup toa b s o r b t h e l o s s e s , i f a n y, t h e a v a i l a b i l i t y o f t i m e a n d r e s o u r c e s t o m o n i t o r t h e f o r e x market. 3.8 Market Report- Issues of Concern U n f o r t u n a t e l y, m o n e y m a r k e t s a s a w h o l e a r e n o t d e v e l o p e d . T h e b i g g e s t p r o b l e m continues to be the structure of the money market. Two-way quotes are a fundamentalnecessity for a proper yield curve to develop and a reference rate to be established. TheRBI does not encourage lend/borrow transaction on the same day. While foreign banksa n d s o m e o f t h e n e w b a n k s a r e p e r e n n i a l b o r r o w e r s i n t h e i n t e r- b a n k m a r k e t , s e v e r a l nationalised banks and institutions are perennial lenders. This leaves the primary dealersto do the trading. But their limited funds do not enable them to become large players.This gives rise to uni-directional players who are averse to two-way quotes. This detersthe development of a benchmark around which a term market can evolve.Right now, whatever trading is done is through the fixed rate. For IRS to happen thereshould be swaps in maturities. A benchmarking has to be done and for that we need acorrect reference rate, which will have to evolve beyond the overnight rate (MIBOR).That can happen only if a term money market is in place.In India fixed rates are aplenty with banks and institutions borrowing and lending at fixedrates. They also adopt floating rates (Prime Lending Rate or PLR) while lending. But thePLR has two crucial deficiencies compared to rates like LIBOR: PLR is not a marketrelated rate, but determined, somewhat arbitrarily, on the basis of the bank rate. Besides

Derivatives Indian Scenario - 31 there are no two-way quotes in PLR, in the absence of which swap deals virtually becomeinfructuous. Rates like LIBOR, Fed Funds Rate/ T.Bill Rate are those at which banks are prepared to lend and borrow in any currency.I n I n d i a t o o , s u c h a m a r k e t d o e s e x i s t f o r t h e r u p e e - t h e c a l l m o n e y m a r k e t . B a n k s borrow/lend at market determined rates. But where the Indian money market differs fromother major financial centers is that, in the latter money is available for periods rangingfrom 1 or 7 days to 3, 6 and 12 months, whereas in India, rupee is available for a day or t w o , u p t o

a maximum period of 13 days, as a general rule. The reason being t h e fortnightly reserve requirements.Another deficiency is the lack of integration with the foreign exchange (FX) markets. Inorder to protect and control the exchange rate of the rupee, strong silos have been created.Forward premium between the rupee and another foreign currency does not reflect theinterest rate differential. If anything, it reflects the estimated risk of depreciation of thelocal unit against the dollar. This gives rise to significant arbitrage opportunities betweent h e t w o m a r k e t s , w h i c h a r e p r o t e c t e d t h r o u g h t h e R B I d i k t a t . A t p r e s e n t , t h e t e n o r s available in the IRS market are short and the benchmark limited to only one, the MumbaiInter-bank Offer Rate (MIBOR). 3.9 Some swaps in near future 9 March 10 2001ICICI inks 5-year rupee IRS with Citibank ICICI has entered into a five-year rupee interest rate swap with Citibank. This is thef o u r t h l o n g - t e r m s w a p d e a l i n t h e I R S m a r k e t d u r i n g t h e f o r t n i g h t . The ICICI-Citibank swap deal has a notional amount of Rs 50 crore. The fixed portion of the swap is based on the yield on the four-year government security, while the floatingrate is based on the one-year Gsec yield. The floating rate will be reset on an annual b a s i s , f o r w h i c h f i v e s e c u r i t i e s h a v e b e e n i d e n t i f i e d t o p r o v i d e a p e r f e c t r e s i d u a l maturity, said an ICICI official. 9 Source: www.economictimes.com

Derivatives Indian Scenario - 32 11 MAY 2001Vysya Bank, L&T in Rs 10-cr overnight index swap deal VYSYA Bank and Larsen & Toubro have entered into an overnight index swap (OIS)transaction for Rs 10 crore. The one-year swap has Vysya Bank paying 8.75 per centagainst the compounded NSE Mibor to L&T. The deal, brokered by eMecklai, was doneover the internet. The verification of the swap differences will be carried out quarterlywith settlement at maturity. 17 FEBRUARYJet swaps $340-m floating loan with Credit Lyonnais George CherianCREDIT Lyonnais and Jet Airways have concluded the largest interest rate swap in thecountry. A total of $340m of the air tax operators outstanding foreign currency floatingrate loans has been swapped to fixed/ floating via a structured interest rate swap spreadover four years.It will insulate Jet Airways against rising interest rates. It will also give Jet Airways theopportunity to take advantage of falling interest rates in later years. The swap, which has b e e n e x e c u t e d i n t w o t r a n c h e s o f $ 2 0 0 m a n d $ 1 4 0 m , i s t h e l a rg e s t e v e r d e r i v a t i v e s transaction in the domestic market 4.0 Forward contracts & Futures & Options A forward contract is an agreement to buy or sell an asset on a specified

d a t e f o r a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price.The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated b i l a t e r a l l y b y t h e p a r t i e s t o t h e c o n t r a c t . T h e f o r w a r d c o n t r a c t s a r e n o r m a l l y t r a d e d outside the exchanges.The salient features of forward contracts are: They are bilateral contracts and hence exposed to counterparty risk. Each contract is custom designed, and hence is unique in terms of contract size,expiration date and the asset type and quality.

Contents
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Usage
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. 1 M e c h a n i c s a n d V a l u a t i o n B a s i c s
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. 2 H e d

Usage Derivatives are used by investors for the following:

hedge or mitigate risk in the underlying, by entering into a derivative contract whose

value moves in the opposite direction to their underlying position and cancels part or all of it out;[7] create option ability where the value of the derivative is linked to a specific condition or event (e.g. the underlying reaching a specific price level); obtain exposure to the underlying where it is not possible to trade in the underlying (e.g., weather derivatives);[8] provide leverage (or gearing), such that a small movement in the underlying value can cause a large difference in the value of the derivative;[9] speculate and make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level).

Mechanics and Valuation Basics Lock products are theoretically valued at zero at the time of execution and thus do not typically require an up-front exchange between the parties. Based upon movements in the underlying asset over time, however, the value of the contract will fluctuate, and the derivative may be either an asset (i.e. "in the money") or a liability (i.e. "out of the money") at different points throughout its life. Importantly, either party is therefore exposed to the credit quality of its counter party and is interested in protecting itself in an event of default. Option products have immediate value at the outset because they provide specified protection (intrinsic value) over a given time period (time value). One common form of option product familiar to many consumers is insurance for homes and automobiles. The insured would pay more for a policy with greater liability protections (intrinsic value) and one that extends for a year rather than six months (time value). Because of the immediate option value, the option purchaser typically pays an up front premium. Just like for lock products, movements in the underlying asset will cause the options intrinsic value to change over time while its time value deteriorates steadily until the contract expires. An important difference between a lock product is that, after the initial exchange, the option purchaser has no further liability to its counterparty; upon maturity, the purchaser will execute the option if it has positive value (i.e. if it is in the money) or expire at no cost (other than to the initial premium) (i.e. if the option is out of the money). Hedging Main article: Hedge (finance) Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because

of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk. From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk. Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market's current assessment of the future value of the asset.

Derivatives traders at the Chicago Board of Trade Derivatives can serve legitimate business purposes.[10] For example, a corporation borrows a large sum of money at a specific interest rate.[11] The rate of interest on the loan resets every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money.[12] If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings. Speculation and arbitrage Derivatives can be used to acquire risk, rather than to hedge against risk. Thus, some individuals and institutions will enter into a derivative contract to speculate on the value of the

underlying asset, betting that the party seeking insurance will be wrong about the future value of the underlying asset. Speculators look to buy an asset in the future at a low price according to a derivative contract when the future market price is high, or to sell an asset in the future at a high price according to a derivative contract when the future market price is low. Individuals and institutions may also look for arbitrage opportunities, as when the current buying price of an asset falls below the price specified in a futures contract to sell the asset. Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick Leeson, a trader at Barings Bank, made poor and unauthorized investments in futures contracts. Through a combination of poor judgment, lack of oversight by the bank's management and regulators, and unfortunate events like the Kobe earthquake, Leeson incurred a US$1.3 billion loss that bankrupted the centuries-old institution.[13] Proportion Used for Hedging and Speculation Unfortunately, the true proportion of derivatives contracts used for legitimate hedging purposes is unknown [14] (and perhaps unknowable), but it appears to be relatively small.[15][16] Also, derivatives contracts account for only 36% of the median firms total currency and interest rate exposure.[17] Nonetheless, we know that many firms derivatives activities have at least some speculative component for a variety of reasons.[17] Types OTC and exchange-traded In broad terms, there are two groups of derivative contracts, which are distinguished by the way they are traded in the market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately

negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options and other exotic derivatives are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, who first surveyed OTC derivatives in 1995, [5], reported that the "gross market value, which represent the cost of replacing all open contracts at the prevailing market prices, ...increased by 74% since 2004, to $11 trillion at the end of June 2007 (BIS 2007:24)." [5] Positions in the OTC derivatives market increased to $516 trillion at the end of June 2007, 135% higher than the level recorded in 2004. OTC derivatives were first surveyed by the BIS in 1995. "Gross market values, which represent the cost of replacing all open contracts at the prevailing market prices, ...increased by 74% since 2004, to $11 trillion at the end of June 2007. (BIS 2007:24)." [5] the total outstanding notional amount is US$708 trillion (as of June 2011).[18] Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts,

1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.
Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is

a market where individuals trade standardized contracts that have been defined by the exchange.[19] A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest[20] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange). According to BIS, the combined turnover in the world's derivatives exchanges totaled USD 344 trillion during Q4 2005. By December 2007 the Bank for International Settlements reported [5] they reported that "derivatives traded on exchanges surged 27% to a record $681 trillion."[5] Common derivative contract types Some of the common variants of derivative contracts are as follows:
1. Forwards: A tailored contract between two parties, where payment takes place at a 2.

3.

4. 5.

specific time in the future at today's pre-determined price. Futures: are contracts to buy or sell an asset on or before a future date at a price specified today. A futures contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing house that operates an exchange where the contract can be bought and sold; the forward contract is a non-standardized contract written by the parties themselves. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of a European option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction. Options are of two types: call option and put option. The buyer of a Call option has a right to buy a certain quantity of the underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Similarly, the buyer of a Put option has the right to sell a certain quantity of an underlying asset, at a specified price on or before a given date in the future, he however has no obligation whatsoever to carry out this right. Binary options are contracts that provide the owner with an all-or-nothing profit profile. Warrants: Apart from the commonly used short-dated options which have a maximum maturity period of 1 year, there exists certain long-dated options as well, known as

Warrant (finance). These are generally traded over-the-counter. 6. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of currencies exchange rates, bonds/interest rates, commodities exchange, stocks or other assets. Another term which is commonly associated to Swap is Swaption which is basically an option on the forward Swap. Similar to a Call and Put

option, a Swaption is of two kinds: a receiver Swaption and a payer Swaption. While on one hand, in case of a receiver Swaption there is an option wherein you can receive fixed and pay floating, a payer swaption on the other hand is an option to pay fixed and receive floating. Swaps can basically be categorized into two types:
Interest rate swap: These basically necessitate swapping only interest associated cash

flows in the same currency, between two parties. Currency swap: In this kind of swapping, the cash flow between the two parties includes both principal and interest. Also, the money which is being swapped is in different currency for both parties.[21] Some common examples of these derivatives are the following: CONTRACT TYPES UNDERLYIN Exchange-traded Exchange-traded G OTC swap futures options OTC option Stock Option on DJIA DJIA Index future Back-to-back option Index future Equity Single-stock Equity swap Repurchase Warrant Single-share future agreement Turbo option warrant Interest rate cap and Option on floor Eurodollar future Eurodollar future Interest rate Forward rate Interest rate Swaption Euribor future Option on Euribor swap agreement Basis swap future Bond option Credit default Credit Option on Bond Repurchase Credit Bond future swap default future agreement Total return option swap Foreign Option on Currency Currency Currency Currency future exchange currency future swap forward option Iron ore WTI crude oil Weather Commodity Gold Commodity forward futures derivative swap option contract OTC forward

Economic function of the derivative market Some of the salient economic functions of the derivative market include:
1. Prices in a structured derivative market not only replicate the discernment of the market participants about the future but also lead the prices of underlying to the professed future level. On the expiration of the derivative contract, the prices of derivatives congregate

2. 3.

4.

5.

with the prices of the underlying. Therefore, derivatives are essential tools to determine both current and future prices. The derivatives market relocates risk from the people who prefer risk aversion to the people who have an appetite for risk. The intrinsic nature of derivatives market associates them to the underlying Spot market. Due to derivatives there is a considerable increase in trade volumes of the underlying Spot market. The dominant factor behind such an escalation is increased participation by additional players who would not have otherwise participated due to absence of any procedure to transfer risk. As supervision, reconnaissance of the activities of various participants becomes tremendously difficult in assorted markets; the establishment of an organized form of market becomes all the more imperative. Therefore, in the presence of an organized derivatives market, speculation can be controlled, resulting in a more meticulous environment. Third parties can use publicly available derivative prices as educated predictions of uncertain future outcomes, for example, the likelihood that a corporation will default on its debts.[22]

In a nutshell, there is a substantial increase in savings and investment in the long run due to augmented activities by derivative Market participant.[23] Valuation

Total world derivatives from 1998 to 2007[24] compared to total world wealth in the year 2000[25]

Market and arbitrage-free prices Two common measures of value are:

Market price, i.e., the price at which traders are willing to buy or sell the contract; Arbitrage-free price, meaning that no risk-free profits can be made by trading in these contracts; see rational pricing.

Determining the market price For exchange-traded derivatives, market price is usually transparent, making it difficult to automatically broadcast prices. In particular with OTC contracts, there is no central exchange to collate and disseminate prices. Determining the arbitrage-free price See List of finance topics# Derivatives pricing. The arbitrage-free price for a derivatives contract can be complex, and there are many different variables to consider. Arbitrage-free pricing is a central topic of financial mathematics. For futures/forwards the arbitrage free price is relatively straightforward, involving the price of the underlying together with the cost of carry (income received less interest costs), although there can be complexities. However, for options and more complex derivatives, pricing involves developing a complex pricing model: understanding the stochastic process of the price of the underlying asset is often crucial. A key equation for the theoretical valuation of options is the BlackScholes formula, which is based on the assumption that the cash flows from a European stock option can be replicated by a continuous buying and selling strategy using only the stock. A simplified version of this valuation technique is the binomial options model. OTC represents the biggest challenge in using models to price derivatives. Since these contracts are not publicly traded, no market price is available to validate the theoretical valuation. Most of the model's results are input-dependent (meaning the final price depends heavily on how we derive the pricing inputs).[26] Therefore it is common that OTC derivatives are priced by Independent Agents that both counterparties involved in the deal designate upfront (when signing the contract). Criticism Derivatives are often subject to the following criticisms: Hidden Tail Risk According to Raghuram Rajan, a former chief economist of the International Monetary Fund (IMF), "... it may well be that the managers of these firms [investment funds] have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn

overnight to one a phenomenon they term phase lock-in. A hedged position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected."[27] Risk See also: List of trading losses The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as the following:
American International Group (AIG) lost more than US$18 billion through a subsidiary over the preceding three quarters on Credit Default Swaps (CDS).[28] The

US federal government then gave the company US$85 billion in an attempt to stabilize the economy before an imminent stock market crash. It was reported that the gifting of money, which came to be known as the "Back door bailout" of America's largest trading firms, was necessary because over the next few quarters the company was likely to lose more money. The loss of US$7.2 Billion by Socit Gnrale in January 2008 through mis-use of futures contracts. The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted. The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998. The loss of US$1.3 billion equivalent in oil derivatives in 1993 and 1994 by Metallgesellschaft AG.[29] The loss of US$1.2 billion equivalent in equity derivatives in 1995 by Barings Bank.[30] UBS AG, Switzerlands biggest bank, suffered a $2 billion loss through unauthorized trading discovered in September 2011.[31]

This comes to a staggering $39.5 billion, the majority in the last decade after the Commodity Futures Modernization Act of 2000 was passed. Counter party risk Some derivatives (especially swaps) expose investors to counter party risk, or risk arising from the other party in a financial transaction. Different types of derivatives have different levels of counter party risk. For example, standardized stock options by law require the party at risk to have a certain amount deposited with the exchange, showing that they can pay for any losses; banks that help businesses swap variable for fixed rates on loans may do credit checks on both parties. However, in private agreements between two companies, for example, there may not be benchmarks for performing due diligence and risk analysis.

Large notional value Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses for which the investor would be unable to compensate. The possibility that this could lead to a chain reaction ensuing in an economic crisis was pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report. Buffett called them 'financial weapons of mass destruction.' A potential problem with derivatives is that they comprise an increasingly larger notional amount of assets which may lead to distortions in the underlying capital and equities markets themselves. Investors begin to look at the derivatives markets to make a decision to buy or sell securities and so what was originally meant to be a market to transfer risk now becomes a leading indicator.(See Berkshire Hathaway Annual Report for 2002) Financial Reform and Government Regulation Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form to extend credit.[32] The strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency however, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks.[32] Indeed, the use of derivatives to conceal credit risk from third parties while protecting derivative counterparties contributed to the financial crisis of 2008 in the United States.[32][33] In the context of a 2010 examination of the ICE Trust, an industry self-regulatory body, Gary Gensler, the chairman of the Commodity Futures Trading Commission which regulates most derivatives, was quoted saying that the derivatives marketplace as it functions now "adds up to higher costs to all Americans." More oversight of the banks in this market is needed, he also said. Additionally, the report said, "[t]he Department of Justice is looking into derivatives, too. The departments antitrust unit is actively investigating 'the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries,' according to a department spokeswoman."[34] For legislators and committees responsible for financial reform related to derivatives in the United States and elsewhere, distinguishing between hedging and speculative derivatives activities has been a nontrivial challenge. The distinction is critical because regulation should help to isolate and curtail speculation with derivatives, especially for "systemically significant" institutions whose default could be large enough to threaten the entire financial system. At the same time, the legislation should allow for responsible parties to hedge risk without undulying tying up working capital as collateral that firms may better employ elsewhere in their operations and investment.[35] In this regard, it is important to distinguish between financial (e.g. banks) and non-financial end-users of derivatives (e.g. real estate development companies) because these firms derivatives usage is inherently different. More importantly, the reasonable collateral that secures these different counterparties can be very different. The distinction between these firms is not always straight forward (e.g. hedge funds or even some private equity firms do not neatly fit either category). Finally, even financial users must be differentiated, as large banks may classified as systemically significant whose derivatives activities must be more tightly monitored and restricted than those of smaller, local and regional banks.

Over-the-counter dealing will be less common as the DoddFrank Wall Street Reform and Consumer Protection Act comes into effect. The law mandated the clearing of certain swaps at registered exchanges and imposed various restrictions on derivatives. To implement DoddFrank, the CFTC developed new rules in at least 30 areas. The Commission determines which swaps are subject to mandatory clearing and whether a derivatives exchange is eligible to clear a certain type of swap contract. Nonetheless, the above and other challenges of the rule-making process have delayed full enactment of aspects of the legislation relating to derivatives. The challenges are further complicated by the necessity to orchestrate globalized financial reform among the nations that comprise the worlds major financial markets, a primary responsibility of the Financial Stability Board whose progress is ongoing.[36] In the U.S., by February 2012 the combined effort of the SEC and CFTC had produced over 70 proposed and final derivatives rules.[37] However, both of them had delayed adoption of a number of derivatives regulations because of the burden of other rulemaking, litigation and opposition to the rules, and many core definitions (such as the terms "swap," "security-based swap," "swap dealer," "security-based swap dealer," "major swap participant" and "major security-based swap participant") had still not been adopted.[37] SEC Chairman Mary Schapiro opined: "At the end of the day, it probably does not make sense to harmonize everything [between the SEC and CFTC rules] because some of these products are quite different and certainly the market structures are quite different."[38]

Country leaders at the 2009 G-20 Pittsburgh summit In November 2012, the SEC and regulators from Australia, Brazil, the European Union, Hong Kong, Japan, Ontario, Quebec, Singapore, and Switzerland met to discuss reforming the OTC derivatives market, as had been agreed by leaders at the 2009 G-20 Pittsburgh summit in September 2009.[39] In December 2012, they released a joint statement to the effect that they recognized that the market is a global one and "firmly support the adoption and enforcement of robust and consistent standards in and across jurisdictions", with the goals of mitigating risk, improving transparency, protecting against market abuse, preventing regulatory gaps, reducing the potential for arbitrage opportunities, and fostering a level playing field for market participants.[39] They also agreed on the need to reduce regulatory uncertainty and provide market participants with sufficient clarity on laws and regulations by avoiding, to the extent possible, the application of conflicting rules to the same entities and transactions, and

minimizing the application of inconsistent and duplicative rules.[39] At the same time, they noted that "complete harmonization perfect alignment of rules across jurisdictions" would be difficult, because of jurisdictions' differences in law, policy, markets, implementation timing, and legislative and regulatory processes.[39] Reporting Mandatory reporting regulations are being finalized in a number of countries, such as Dodd Frank Act in the US, the European Market Infrastructure Regulations (EMIR) in Europe, as well as regulations in Hong Kong, Japan, Singapore, Canada, and other countries.[40] The OTC Derivatives Regulators Forum (ODRF), a group of over 40 world-wide regulators, provided trade repositories with a set of guidelines regarding data access to regulators, and the Financial Stability Board and CPSS IOSCO also made recommendations in with regard to reporting.[40]
DTCC, through its "Global Trade Repository" (GTR) service, manages global trade repositories for interest rates, and commodities, foreign exchange, credit, and equity derivatives.[40] It

makes global trade reports to the CFTC in the U.S., and plans to do the same for ESMA in Europe and for regulators in Hong Kong, Japan, and Singapore.[40] It covers cleared and uncleared OTC derivatives products, whether or not a trade is processed electronically processed or bespoke.[40][41][42] Glossary
Bilateral netting: A legally enforceable arrangement between a bank and a counter-party

that creates a single legal obligation covering all included individual contracts. This means that a banks obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement. Counterparty: The legal and financial term for the other party in a financial transaction. Credit derivative: A contract that transfers credit risk from a protection buyer to a credit protection seller. Credit derivative products can take many forms, such as credit default swaps, credit linked notes and total return swaps. Derivative: A financial contract whose value is derived from the performance of assets, interest rates, currency exchange rates, or indexes. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof. Exchange-traded derivative contracts: Standardized derivative contracts (e.g., futures contracts and options) that are transacted on an organized futures exchange. Gross negative fair value: The sum of the fair values of contracts where the bank owes money to its counter-parties, without taking into account netting. This represents the maximum losses the banks counter-parties would incur if the bank defaults and there is no netting of contracts, and no bank collateral was held by the counter-parties. Gross positive fair value: The sum total of the fair values of contracts where the bank is owed money by its counter-parties, without taking into account netting. This represents the maximum losses a bank could incur if all its counter-parties default and there is no netting of contracts, and the bank holds no counter-party collateral.

 High-risk mortgage securities: Securities where the price or expected average life is highly sensitive to interest rate changes, as determined by the U.S. Federal Financial Institutions Examination Council policy statement on high-risk mortgage securities. Notional amount: The nominal or face amount that is used to calculate payments made on

swaps and other risk management products. This amount generally does not change hands and is thus referred to as notional. Over-the-counter (OTC) derivative contracts: Privately negotiated derivative contracts that are transacted off organized futures exchanges. Structured notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and / or have embedded forwards or options. Total risk-based capital: The sum of tier 1 plus tier 2 capital. Tier 1 capital consists of common shareholders equity, perpetual preferred shareholders equity with non-cumulative dividends, retained earnings, and minority interests in the equity accounts of consolidated subsidiaries. Tier 2 capital consists of subordinated debt, intermediate-term preferred stock, cumulative and long-term preferred stock, and a portion of a banks allowance for loan and lease losses. See also
Book: Finance Property derivatives Freight derivative Inflation derivative Weather derivative Interest rate derivative foreign exchange derivative Credit derivative equity derivative

References
1. ^ Derivatives (Report). Office of the Comptroller of the Currency, U.S. Department of 2. 3. 4. 5. 6. 7.

Treasury. Retrieved February 2013. ^ Rubinstein, Mark (1999). Rubinstein on derivatives. Risk Books. ISBN 1-899332-53-7. ^ Hull, John C. (2006). Options, Futures and Other Derivatives, Sixth Edition. Prentice Hall. p. 1. ^ Kaori Suzuki and David Turner (December 10, 2005). "Sensitive politics over Japan's staple crop delays rice futures plan". The Financial Times. Retrieved October 23, 2010. ^ a b c d e f g Ryan Stever; Christian Upper; Goetz von Peter (December 2007) (PDF). BIS Quarterly Review (Report). Bank for International Settlements. ^ Hamish Risk (December 10, 2007). Derivative Trades Jump 27% to Record $681 Trillion (Report). Bloomberg. ^ Khullar, Sanjeev (2009). "Using Derivatives to Create Alpha". In John M. Longo. Hedge Fund Alpha: A Framework for Generating and Understanding Investment Performance.

Singapore: World Scientific. p. 105. ISBN 978-981-283-465-2. Retrieved September 14,

2011. 8. ^ Don M. Chance; Robert Brooks (2010). "Advanced Derivatives and Strategies". Introduction to Derivatives and Risk Management (8th ed.). Mason, Ohio: Cengage Learning. pp. 483515. ISBN 978-0-324-60120-6. Retrieved September 14, 2011. 9. ^ Shirreff, David (2004). "Derivatives and leverage". Dealing With Financial Risk. USA: The Economist. p. 23. ISBN 1-57660-162-5. Retrieved September 14, 2011. 10.^ Peterson, Sam (2010). The Atlantic. "There's a Derivative in Your Cereal"
http://www.theatlantic.com/business/archive/2010/07/theres-a-derivative-in-your-cereal/60582/ 11.^ Chisolm, Derivatives Demystified (Wiley 2004) 12.^ Chisolm, Derivatives Demystified (Wiley 2004) Notional sum means there is no

actual principal. 13.^ News.BBC.co.uk, "How Leeson broke the bank BBC Economy" 14.^ Chernenko, Sergey and Faulkender, Michael. The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps
http://www.rhsmith.umd.edu/faculty/faulkender/swaps_JFQA_final.pdf 15.^ Knowledge@Wharton (2012). The Changing Use of Derivatives: More Hedging, Less Speculation http://knowledge.wharton.upenn.edu/article.cfm?articleid=709 16.^ Guay, Wayne R. and Kothari, S.P. (2001). "How Much do Firms Hedge with Derivatives?" http://papers.ssrn.com/sol3/papers.cfm?abstract_id=253036 17.^ a b Knowledge@Wharton (2006). The Role of Derivatives in Corporate Finances: Are Firms Betting the Ranch? http://knowledge.wharton.upenn.edu/article.cfm? articleid=1346 18.^ BIS survey: The Bank for International Settlements (BIS) semi-annual OTC [derivatives market report, for end of June 2008, showed US$683.7 trillion total notional amounts outstanding of OTC derivatives with a gross market value of US$20 trillion. See also Prior Period Regular OTC Derivatives Market Statistics. 19.^ Hull, J.C. (2009). Options, futures, and other derivatives . Upper Saddle River, NJ :

Pearson/Prentice Hall, c2009 20.^ Futures and Options Week: According to figures published in F&O Week October 10, 2005. See also FOW Website. 21.^ "Financial Markets: A Beginner's Module". 22.^ Michael Simkovic and Benjamin Kaminetzky (August 29, 2010). Leveraged Buyout Bankruptcies, the Problem of Hindsight Bias, and the Credit Default Swap Solution. Columbia Business Law Review, Vol. 2011, No. 1, p. 118, 2011. Retrieved March 5, 2013. 23.^ "Currency Derivatives: A Beginner's Module". 24.^ "Bis.org". Bis.org. May 7, 2010. Retrieved August 29, 2010. 25.^ "Launch of the WIDER study on The World Distribution of Household Wealth: 5 December 2006". Retrieved June 9, 2009. 26.^ Boumlouka, Makrem (2009),"Alternatives in OTC Pricing", Hedge Funds Review, 1030-2009. http://www.hedgefundsreview.com/hedge-funds-review/news/1560286/otc-pricingdeal-struck-fitch-solutions-pricing-partners 27.^ Raghuram G. Rajan (September 2006). "Has Financial Development Made the World Riskier?". European Financial Management (EUROPEAN FINANCIAL

MANAGEMENT) 12 (4): 499533. doi:10.1111/j.1468-036X.2006.00330.x. Retrieved January 17, 2012. 28.^ Kelleher, James B. (September 18, 2008). ""Buffett's Time Bomb Goes Off on Wall Street" by James B. Kelleher of Reuters". Reuters.com. Retrieved August 29, 2010. 29.^ Edwards, Franklin (1995). "Derivatives Can Be Hazardous To Your Health: The Case of Metallgesellschaft". Derivatives Quarterly (Spring 1995): 817 30.^ Whaley, Robert (2006). Derivatives: markets, valuation, and risk management. John Wiley and Sons. p. 506. ISBN 0-471-78632-2. 31.^ "UBS Loss Shows Banks Fail to Learn From Kerviel, Leeson". Businessweek. September 15, 2011. Retrieved March 5, 2013. 32.^ a b c Michael Simkovic, Secret Liens and the Financial Crisis of 2008. American Bankruptcy Law Journal, Vol. 83, p. 253. 2009. Retrieved March 5, 2013. 33.^ Michael Simkovic (January 11, 2011). "Bankruptcy Immunities, Transparency, and Capital Structure, Presentation at the World Bank". Ssrn.com. doi:10.2139/ssrn.1738539. Retrieved March 5, 2013. 34.^ Story, Louise, "A Secretive Banking Elite Rules Trading in Derivatives", The New York Times, December 11, 2010 (December 12, 2010, p. A1 NY ed.). Retrieved December 12, 2010. 35.^ Zubrod, Luke (2011). The Atlantic. "Will the 'Cure' for Systemic Risk Kill the Economy?" http://www.theatlantic.com/business/archive/2011/06/will-the-cure-for-systemicrisk-kill-the-economy/240600/ 36.^ Financial Stability Board (2012). OTC Derivatives Market Reforms Third Progress

Report on Implementation June 15, 2012

http://www.financialstabilityboard.org/publications/r_120615.pdf 37.^ a b Proskauer Rose LLP. "SEC and CFTC oversight of derivatives: a status report".

Lexology. Retrieved March 5, 2013. 38.^ Younglai, Rachelle. "INTERVIEW Not all SEC, CFTC rules must be harmonized". Reuters. Retrieved March 5, 2013. 39.^ a b c d "Joint Press Statement of Leaders on Operating Principles and Areas of Exploration in the Regulation of the Cross-Border OTC Derivatives Market; 2012-251". Sec.gov. December 4, 2012. Retrieved March 5, 2013. 40.^ a b c d e "DTCC's Global Trade Repository for OTC Derivatives ("GTR")". Dtcc.com. Retrieved March 5, 2013. 41.^ "U.S. DTCC says barriers hinder full derivatives picture". Reuters. February 12, 2013. Retrieved March 5, 2013. 42.^ Release, Press (August 5, 2010). "Derivatives trades will be tracked by Depository Trust". Futuresmag.com. Retrieved March 5, 2013. Further reading
Institute for Financial Markets (2011). Futures and Options (2nd ed.). Washington DC: Institute for Financial Markets. ISBN 978-0-615-35082-0. Hull, John C. (2011). Options, Futures and Other Derivatives (8th ed.). Harlow: Pearson Education. ISBN 9780132604604. Durbin, Michael (2011). All About Derivatives (2nd ed.). New York: McGraw-Hill.

ISBN 978-0-07-174351-8. Mattoo, Mehraj (1997). Structured Derivatives: New Tools for Investment Management:

A Handbook of Structuring, Pricing & Investor Applications. London: Financial Times. ISBN 0-273-61120-89. External links
BBC News Derivatives simple guide European Union proposals on derivatives regulation 2008 onwards

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LIMITAI TONS OF STUDY

1. LIMITED TIME: The time available to

conduct the study was only 2 months. It being a widetopic had a limited time. 2. LIMITED RESOURCES: Limited resources

are available to collect the information about thecommodity trading.

3.

VOLATALITY: Share market is so much volatile and

it is difficult to forecast any thing about itwhether you trade through online or offline 4. ASPECTS COVERAGE: Some of the

aspects may not be covered in my study.

22

MAIN TOPICS OF STUDY

1.

INTRODUCTIO N TO DERIVATIVE
The origin of derivatives can be traced back to the need of farmers to

protectthemselves against fluctuations in the price of their crop. From the time it wassown to the time it was ready for harvest,

farmers would face price uncertainty.Throu gh the use of simple derivative products, it was possible for the farmer topartially

or fully transfer price risks by locking-in asset prices. These were simplecontracts developed to meet the needs of farmers and were

basically a means of reducing risk.A farmer who sowed his crop in June faced uncertainty over the price hewould receive for his harvest in

September. In years of scarcity, he wouldprobably obtain attractive prices. However, during times of oversupply, he wouldhave to

dispose off his harvest at a very low price. Clearly this meant that thefarmer and his family were exposed to a high risk of price

uncertainty.On the other hand, a merchant with an ongoing requirement of grains toowould face a price risk that of having to

pay exorbitant prices during dearth,although favourable prices could be obtained during periods of oversupply.Under such

circumstances, it clearly made sense for the farmer and themerchant to come together and enter into contract whereby the price

of the grainto be delivered in September could be decided earlier. What they would thennegotiate happened to be

futures-type contract, which would enable both partiesto eliminate the price risk.In 1848, the Chicago Board Of Trade, or CBOT, was

established to bringfarmers and merchants together. A group of traders got together and created thetoarrive contract

that permitted farmers to lock into price upfront and deliver thegrain later. These to-arrive contracts proved useful as a device

for hedging and

23

speculation on price charges. These were eventually standardized, and in 1925the first futures clearing house came into

existence.Today derivatives contracts exist on variety of commodities such as corn,pepper, cotton, wheat, silver etc. Besides

commodities, derivatives contracts alsoexist on a lot of financial underlying like stocks, interest rate, exchange

rate, etc. 2. DERIVATIVE DEFINED A derivative is a product whose value is derived from the value of one or moreunderlying

variables or assets in a contractual manner. The underlying asset canbe equity, forex, commodity or any other asset. In our earlier

discussion, we sawthat wheat farmers may wish to sell their harvest at a future date to eliminate therisk of change in price by that

date. Such a transaction is an example of aderivative. The price of this derivative is driven by the spot price of wheat

whichis the underlying in this case.The Forwards Contracts (Regulation) Act, 1952, regulates theforward/future

s contracts in commodities all over India. As per this the ForwardMarkets Commission (FMC) continues to have

jurisdiction over commodityfutures contracts. However when derivatives trading in securities was introducedin 2001, the term

security in the Securities Contracts (Regulation) Act, 1956(SCRA), was amended to include derivative

contracts in securities.Conse quently, regulation of derivatives came under the purview of SecuritiesExchan

ge Board of India (SEBI). We thus have separate regulatory authoritiesfor securities and commodity derivative

markets.Derivativ es are securities under the SCRA and hence the trading of derivatives is governed by the regulatory

framework under the SCRA. TheSecurities Contracts (Regulation) Act, 1956 defines derivative to include-A

security derived from a debt instrument, share, loan whether secured or unsecured, risk instrument or contract

differences or any other form of security.A contract which derives its value from the prices, or index of prices,

of underlying securities.
24

DerivativesF u t u r e O p t i o n F o r w a r d S w a p s 3. TYPES OF DERIVATIVES MARKET Exchange Traded

Derivatives Over The Counter DerivativesNation al Stock Bombay Stock National Commodity &Exchange Exchange

Derivative ExchangeIndex Future Index option Stock option Stock future Figure.1 Types of Derivatives Market4. TYPES

OF DERIVATIVESFig ure.2 Types of Derivatives

25

(i)

FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specifieddate

for a specified price. One of the parties to the contract assumes a longposition and agrees to buy the underlying asset on a certain

specified futuredate for a certain specified price. The other party assumes a short positionand agrees to sell the asset on the same

date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterallyby the

parties to the contract. The forward contracts are normally tradedoutside the exchanges.

BASIC

FEATURES OF FORWARD CONTRACT

They are bilateral contracts and hence exposed to counter-party risk. Each contract is

custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is

generally not available in public domain. On the expiration date, the contract has to be settled by delivery of theasset. If the party wishes to

reverse the contract, it has to compulsorily go to thesame counterparty, which often results in high prices being charged.However

forward contracts in certain markets have become verystandardized, as in the case of foreign exchange, thereby reducingtransactio

n costs and increasing transactions volume. This process of standardization reaches its limit in the organized

futures market. Forwardcontracts are often confused with futures contracts. The confusion isprimarily because both

serve essentially the same economic functionsof allocating risk in the presence of future price uncertainty.

However futuresare a significant improvement over the forward contracts as theyeliminate counterparty risk

and offer more liquidity.

26

(ii)FUTURE CONTRACT
In finance, a futures contract is a standardized contract, traded on a futuresexchange,

to buy or sell a certain underlying instrument at a certain date in thefuture, at a pre-set price. The future date is called the

delivery date or finalsettlement date. The pre-set price is called the futures price. The price of theunderlying asset on the

delivery date is called the settlement price. Thesettlement price, normally, converges towards the futures price on

the deliverydate.A futures contract gives the holder the right and the obligation to buy or sell,which differs from an options contract,

which gives the buyer the right, but not theobligation, and the option writer (seller) the obligation, but not the right. To

exitthe commitment, the holder of a futures position has to sell his long position or buy back his short position,

effectively closing out the futures position and itscontract obligations. Futures contracts are exchange traded

derivatives. Theexchange acts as counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF

FUTURE CONTRACT
1. Standardization : Futures contracts ensure their liquidity by being highly

standardized, usually byspecifying: The underlying . This can be anything from a barrel of sweet

crude oil to ashort term interest rate. The type of settlement, either cash settlement or physical settlement. The

amount and units of the underlying asset per contract. This can be thenotional amount of bonds, a fixed number of barrels of oil, units

of foreigncurrency, the notional amount of the deposit over which the short terminterest rate is traded, etc.
27

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