Project 2

Application of
Derivatives

Chirag Jogi – 78
Nitika Budhrani
Pratik Matai – 90
Group 7 Eklavya Rathi -
Pooja Shah -
Kushal Shah -
Introduction

A derivative is a financial instrument that derives its value from an underlying

asset. This underlying asset can be stocks, bonds, currency, commodities, metals and
even intangible, pseudo assets like stock indices.

Derivatives can be of different types like futures, options, swaps, caps, floor,
collars etc. The most popular derivative instruments are futures and options.
There are newer derivatives that are becoming popular like weather derivatives
and natural calamity derivatives. These are used as a hedge against any
untoward happenings because of natural causes.

The phrase means is that the derivative on its own does not have any value.
It is considered important because of the importance of the underlying. When we
say an Infosys future or an Infosys option, these carry a value only because of
the value of Infosys.

Financial derivatives are instruments that derive their value from financial
assets.
These assets can be stocks, bonds, currency etc. These derivatives can be
forward rate agreements, futures, options swaps etc. As stated earlier, the most
traded instruments are futures and options.

Derivatives will find use for the following set of people:

• Speculators: People who buy or sell in the market to make profits. For
example, if you will the stock price of Reliance is expected to go upto Rs.400
in 1 month, one can buy a 1 month future of Reliance at Rs 350 and make
profits

• Hedgers: People who buy or sell to minimize their losses. For example, an
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importer has to pay US $ to buy goods and rupee is expected to fall to Rs 50
/$ from Rs 48/$, then the importer can minimize his losses by buying a
currency future at Rs 49/$

• Arbitrageurs: People who buy or sell to make money on price differentials in

different markets. For example, a futures price is simply the current price plus
the interest cost. If there is any change in the interest, it presents an arbitrage
opportunity. We will examine this in detail when we look at futures in a
separate chapter.
Basically, every investor assumes one or more of the above roles and derivatives
are a very good option for him.

Derivatives have been a recent development in the Indian financial markets.

But there have been derivatives in the commodities market. There is Cotton and
Oilseed futures in Mumbai, Soya futures in Bhopal, Pepper futures in Cochin,
Coffee futures in Bangalore etc. But the players in these markets are restricted to
big farmers and industries, who need these as an input to protect themselves
from the vagaries of agriculture sector.
Globally too, the first derivatives started with the commodities, way back in 1894.
Financial derivatives are a relatively late development, coming into existence
only in the 1970’s. The first exchange where derivatives were traded is the
Chicago Board of Trade (CBOT).

In India, the first derivatives were introduced by National Stock Exchange (NSE)
in June 2000. The first derivatives were index futures. The index used was Nifty.
Option trading was started in June 2001, for index as well as stocks. In
November 2001, futures on stocks were allowed. Currently, there are 30 stocks
on which derivative trading is allowed.

The 30 stocks on which trading is allowed currently are:

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Name of the Scrip Lot Size
ACC 1500
Bajaj Auto 800
BHEL 1200
BPCL 1100
BSES 1100
Cipla 200
Digital Global Soft 400
Dr Reddy Laboratories 400
Grasim 700
Gujarat Ambuja 1100
Hindalco 300
Hindustan Lever 1000
HPCL 1300
HDFC 300
Infosys 100
ITC 300
L&T 1000
MTNL 1600
M&M 2500
Ranbaxy 500
Reliance Industries 600
Reliance Petroleum 4300
Satyam Computers 1200
SBI 1000
Sterlite Opticals 600
TELCO 3300
TISCO 1800
Tata Power 1600
Tata Tea 1100
VSNL 700

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NIFTY 200
SENSEX 50
The trading is done on the exchange in the F&O (Futures and Option) segment.
Index F&O is also traded in the market. The indices traded are the Nifty and the
Sensex.

Since we have talked of hedging, can we compare derivatives to insurance: -

You buy a life insurance policy and pay a premium to the insurance agent for a
fixed term as agreed in the policy. In case you survive, you are happy insurance
company is happy. In case you don’t survive, your relatives are happy as the
insurance company pays them the amount for which you are insured.

Insurance is nothing but transfer of risk. An insurance company sells you risk
cover and buys your risk and you sell your risk and buy a risk cover. The risk
involved in life insurance is the death of the policyholder. The insurance
companies bet on your surviving and hence agree to sell a risk cover for some
premium.

There is a transfer of risk here for a financial cost, i.e. the premium. In this sense,
a derivative instrument can be compared to insurance, as there is a transfer of
risk at a financial cost.

What Does  Financial Derivative Mean?

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. 

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What dose Math Derivatives mean?

In calculus, a branch of mathematics, the derivative is a measure of how

a function changes as its input changes. Loosely speaking, a derivative can be
thought of as how much one quantity is changing in response to changes in
some other quantity.

Is there any connection with Math?

Yes there is connection with math, as math derivatives have two variables.
One depending on other. Thus if independent variable changes the
dependent variable also changes. The same is the Financial Derivatives
where a security whose price is dependent upon or derived from one or
more underlying assets. Its value is determined by fluctuations in the
underlying asset.

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