FINANCIAL DERIVATIVES

SUNDAR B. N.
ASSISTANT PROFESSOR
COORDINATOR OF M.com
HISTORY OF DERIVATIVES
The word derivatives originated in mathematics and refers to a variable that has been derived
from another variable. For example, a measure of distance in KM could be derived from a measure of
distance in miles by dividing by 1.61, or Similarly a measure of temperature in Celsius could be derived from a
measure of temperature in Fahrenheit. In sense, a derivative is a financial product which had been derived
from a market for another product.
Derivative market can be traced back to the middle ages. They were originally developed meet the
needs of farmers and merchants.
The Chicago Board of Trade was the first derivatives market established in 1848 to bring farmers
and merchants together.
In 1874, the Chicago Produce Exchange was established. In 1919, this was renamed the Chicago
Merchantile Exchange (CME) and was reorganized for futures trading. In India it is trading on
Multicommodity Exchange (MCX), National Commodity and Derivatives Exchange (NCDEX).
CHARACTERISTICS OF DERIVATIVES

 It has one or more underlying assets

 Requires negligible initial
investment compared to other types
of financial contracts
 Should provide net settlement I.e.,
offsetting of initial contract position
FEATURES OF DERIVATIVES

 The instrument relates to the future contract and

settlement of terms between parties involved,
normally called maturity period in case of Forward
contract.
 The parties involved may be obliged to exercise their
contracts or offset them (Forwards, Futures) or may
have rights (like option buyers).
 The contracts are fulfilled or transacted through a
recognized exchange (Futures contracts) through the
clearing house or they may be private bi-lateral
contracts (Forwards, Swaps) or OTC contracts
(Options)
 The value of derivatives depends on their underlying
FUNCTIONS OF DERIVATIVES MARKET

 Risk management- Stop loss

 Transfer of risk

 Price discovery

 Transitional efficiency - low transaction cost

compare to rest like, brokerage, commission,
regulatory costs and margin requirements
 Financial Engineering- as it is new field
creating calls, puts, futures and other
derivatives
USES OF DERIVATIVES

Derivatives are used by companies and individuals wanting to

cover their risks. This is facilitated by a counter party who has the
motivation to make profits out of the Premium, or is holding a mirror-image
opposite position.
Example for derivatives use;
An exporter to the US expects to get $50,000 in 3 months from
now. She will be happy to have this converted at around Rs. 45 per $.
However, there is great uncertainty in the foreign exchange market as to
the nature of the possible movement after 3 months.
Fortunately for the exporter a bank is willing to enter into a
Forwards contract with her for paying Rs. 45 per $ after 3 months on her
surrounding $50,000 then. If the exporter enters into this Forward contract,
she makes sure that she will be able to get 22,50,000 ($50,000*Rs.45) after
3 months.
However if the rates change to her favor say to Rs. 48 per $ she
will not be able to make advantage of the favorable movement since she is
already committed to the Forward Contract/agreement
 DIFFERENCE BETWEEN SHARES AND DERIVATIVES
SHARES DERIVATIVES
Shares are assets Derivatives are usually contracts

Share are primary Derivatives are secondary ( underlying )

Risks limited within the company and Risks are diversified through speculation,
unable to stop Arbitrages and Hedging
Shares are main products Derivatives are by-product

Independent
Profits are limited or unlimited
Equity derives its values on market
conditions like demand and supply
Dividend income
Dependent
Profit will be locked
Derivatives derives its value from the
movement performance of one or more
underlying assets underlying assets
Price fluctuations

Generally long term ( 1 year ) Short term ( maximum 3 months)

No expiry Last Thursday of any month

DEFINITION OF UNDERLYING ASSET?
 The underlying is a fundamental concept in derivatives
trading because it allows investors to speculate risk and
purchase options to limit the downside risk of future stock
price movements. In addition, it represents the
component of the agreement that provides value to the
contract.
 For instance, an investor who buys an option contract on
a stock has the right to buy or sell the underlying asset (in
this case the stock) at the strike price at maturity to
realize a profit. Therefore, the UA represents the stock
involved in a derivatives contract, which the parties agree
to exchange. An UA can be stock, index, commodity or
currency, and the price may be directly correlated (call
option) or inversely correlated (put option) to the price of
the derivative
HOW IT WORKS (EXAMPLE):

 For example, options are derivative instruments, meaning that their

prices are derived from the price of another security. More specifically,
options prices are derived from the price of an underlying stock. For
example, let's say you purchase a call option on shares of Intel (INTC)
with a strike price of $40 and an expiration date of April 16.
This option would give you the right to purchase 100 shares of Intel at a
price of $40 on April 16 (the right to do this, of course, will be
valuable only if Intel is trading above $40 per share at that point in time).
 The seller (writer) has the obligation to either buy or sell the
underlying asset (depending on what type ofoption he or she sold --
either a call option or a put option) to the buyer at a specified price by a
specified date. Meanwhile, the buyer of an options contract has the right,
but not the obligation, to complete the transaction by a specified date.
When an option expires, if it is not in the buyer's best interest to exercise
the option, then he or she is not obligated to do anything. The buyer has
purchased the option to carry out a certain transaction in the future --
hence the name.
UNDERLYING ASSETS

 Commodities ( Castor seed, Grain, Coffee,

Gur, Pepper, Potato's)
 Precious metals (Gold, Silver)

 Interest rate

 Common shares/ stock

 Stock index value ( NSE, Nifty, Sensex)

 Currency
 Lifespan- as each day passes and the expiration date approaches,
more and more time premium lose and option’s value decreases
 Sophistication- Potential for huge losses and huge gains,
appropriate for only sophisticated investors with a high tolerance of
risk
 Direction and market timing- Investors must accurately predict the
direction in which the market or index will move during a set period of
time
 Derivatives are too illiquid
 Derivatives are linked to Gambling
 Counter party risk
 Hidden tail risk- a hedge position can become unhedged at the
worst times, inflicting substantial losses on those who mistakenly
believe they are protected
 Risks- Derivatives allow investors to earn large returns from small
movements in the underlying assets prices. Investors could lose large
amounts if the price of the underlying moves against them
significantly.
Americal International Group lost > US $ 18 Bn
In Jan 2008 Societe Generale Lost > US $ 7.2 Bn
Totally in last decade $ 39.5 Bn lost from derivatives
DERIVATIVES ADVANTAGES AND DISADVANTAGES

Derivatives are the most important

innovation which has happened in the past few
years when it comes to financial markets. It
has changed the whole way of operations of
stock, commodities and currency market.
Given below are some of the advantages and
disadvantages of derivatives –
 ADVANTAGES OF DERIVATIVES
 Since all transactions related to derivatives take place in
future it provides individuals with better opportunities
because an individual who want to short some stock for
long time can do it only in futures or options hence the
biggest benefit of this is that it gives numerous options to
an investor or trader to execute all sorts of strategies.
 In derivatives market people can transact huge
transactions with small amounts and therefore it gives the
benefit of leverage and hence even people who have less
amount of money can enter into this market.
 Intraday traders get the benefit of liquidity as these
contracts are very liquid and also the costs such as basis
expense, brokerage are less as compared to cash
market.
 It is a great risk management tool and if applied
judiciously it can produce good results and benefit its
user.
 DISADVANTAGES OF DERIVATIVES
 Leverage is a double edged sword and therefore if you do
not get it right chances are you wound end up losing huge
amount of money because these contracts have specific
maturities and on that date they get expired unlike cash
market where you can hold on to stocks for long period of
time.
 Since its inception many critics have been blaming
derivatives for huge fall which keeps happening frequently
after the introduction of derivatives and many people say
that it increases unnecessary speculation in the market
which is not good for the small retail investors who are the
backbone of stock market.
 It is quite complex and various strategies of derivatives
can be implemented only by an expert and therefore for a
layman it is difficult to use this and therefore it limits its
usefulness.
 PARTICIPANTS/ TRADERS IN DERIVATIVES MARKET
SPECULATORS
When a securities are brought with a sole object of selling
them in future at higher price or these are sold now with the
intension of buying at a lower price in future are called Speculation
transactions. The main objective of such transactions is to take
advantage of price differential at different times.
For example; Ramu bought 200 shares of Tata Steel Limited
at Rs. 235 per share. He does not take and give delivery of shares
but settles the transactions by receiving the difference in prices
amounting to Rs. 5,000 plus brokerage .
Example 2; manu bought 200 shares of ONGC Limited at Rs.
87# per share and sold them at Rs. 69 per share. He settles these
transaction by simply paying the difference amounting to Rs. 3,600
plus brokerge.
However, nowadays stock exchanges have a system of
rolling settlement. Such transactions of purchase and sale made
on the same day, as no carry forward is allowed.
Speculation; Settlement by paying difference in price
without delivery of securities.
 ARBITRAGEURS
Arbitrage signifies the existence of a riskless
profit. ‘Person actively engaged in seeking out minor
price discrepancies are called Arbitrageurs. Arbitrage is
simultaneous purchase and sale of equivalent assets at
prices which guarantee a fixed profit at the time of the
transactions, although the life of the assets and hence
the consumption of the profit may be delayed until some
future date.
Example: Arbitrageurs are in business to take
advantage of a discrepancy between prices in two
different markets (NSE and BSE)
 HEDGER
Hedge is a strategy intended to protect an
investment or portfolio against loss. It usually
involves buying securities that move in the
opposite direction than the asset being
protected. Hedging is like buying insurance. It
is protection against unforeseen events. It is
usually involves balance any gains and losses
to the underlying assets.