Chapter 1: An introduction to derivatives

1.1 Derivatives

Derivatives are one of the most complex instruments. The word derivative comes from the
word “to derive”. It indicates that it has no independent value. A derivative is a contract
whose value is derived from the value of another asset, known as the underlying asset, which
could be a share, a stock market index, an interest rate, a commodity, or a currency. The
underlying is the identification tag for a derivative contract. When the price of the underlying
changes, the value of the derivative also changes. Without an underlying asset, derivatives do
not have any meaning. For example, the value of a gold futures contract derives from the
value of the underlying asset i.e., gold. The prices in the derivatives market are driven by the
spot or cash market price of the underlying asset, which is gold in this example.
Derivatives are very similar to insurance. Insurance protects against specific risks, such as
fire, floods, theft and so on. Derivatives on the other hand, take care of market risks -
volatility in interest rates, currency rates, commodity prices, and share prices. It offers a
sound mechanism for insuring against various kinds of risks arising in the world of finance.
They offer a range of mechanisms to improve redistribution of risk, which can be extended to
every product existing, from coffee to cotton and live cattle to debt instruments.
Theoretically, Derivatives are financial instruments whose values depend on the values of
other, more basic underlying assets. They do not have value of their own & they derive their
values from another asset or multiple of assets. Derivatives are useful in reallocating risk
either across time or across individuals with different risk bearing preferences. The
underlying asset can be equity, forex, commodity or any other asset class.
Derivative products, several centuries ago, emerged as hedging devices against fluctuations
in commodity prices. Commodity futures and options have had a lively existence for several
centuries. Financial derivatives came into the limelight in the post-1970 period; today they
account for 75 percent of the financial market activity in Europe, north America, and east
Asia. The basic difference between commodity and financial derivatives lies in the nature of
the underlying instrument. In commodity derivatives, the underlying asset is a commodity; it
may be wheat, cotton, pepper, turmeric, corn, orange, soya beans, rice, crude oil, natural gas,
gold, silver, and many more. In financial derivatives, the underlying includes treasuries,
bonds, stocks, stock index, foreign exchange, and euro dollar deposits. The market for
financial derivatives has grown tremendously both in terms of variety of instruments and
turnover. Presently, most major institutional borrowers and investors use derivatives.
Derivatives market is a recent development in India. The stock exchanges in India have been
in existence for more than a century now. Bombay stock exchange (BSE) is a stock exchange
located in Mumbai, Maharashtra and was established in 1875. Subsequently, the national
stock exchange (NSE) was set up in November 1992. The road for stock exchange traded
derivatives contracts was cleared with the removal of prohibition of options on securities by
way of amendment to securities laws through securities laws (amendment) ordinance, 1995.
A bill was introduced on October 28, 1999 and was converted into an act on December 16,
1999 making way for derivatives trading in India.
Since the introduction of derivatives market in India in 2000, the market has grown at a very
fast rate. The NSE has improved its ranking since then in terms of traded volumes in futures
and options taken together, improving its worldwide ranking from 15th in 2006 to eighth
position in 2008, seventh in 2009, and fifth in 2010. In 2010, the national stock exchange
(NSE) stood at rank 9 in terms of market capitalization with the market capitalization of 1597
billion USD. In terms of the number of single stock futures contracts traded in 2010, the NSE
has held the second position globally. It was second in terms of the number of stock index
options contracts traded and third in terms of the number of stock index futures contracts
traded globally in 2010. Now in 2022, national stock exchange (NSE) is world's largest
derivatives exchange for 3rd consecutive year in 2021 in terms of number of contracts traded,
according to the futures industry association (FIA). Which means NSE has dominated from
2019.
In addition, the bourse has been ranked fourth in the world in cash equities by number of
trades by the world federation of exchanges for calendar year 2021. At the instrument level,
NSE ranks first in index options and currency options by number of contracts traded. The
index options contracts on nifty bank index ranks 1st and nifty 50 index ranks 2nd globally
within the index options category by number of contracts traded. The us dollar – Indian rupee
options contract ranks 1st by number of contracts traded in the currency options category.

In the last 10 years, the equity derivatives daily average turnover increased by 4.2 times, from
₹33,305 crore in 2011 to over ₹1.41 lakh crore in 2021. During the same period, the cash
market daily average turnover increased by 6.2 times, from ₹11,187 crore in 2011 to ₹69,644
crore in 2021. NSE is ranked fourth in the world in cash equities by the number of trades per
the world federation of exchanges (WFE) statistic for the year 2021.

NSE recently got approval from securities exchange board of India (SEBI) to launch
derivatives on nifty mid-cap select index and will start from January 24(2022). The segment
has come into focus due to a rally in equities with broad based participation from all classes
of investors resulting in improved liquidity in these stocks. The year 2021 witnessed total
registered investor base on NSE surpassing the 5-crore mark to reach a count of 5.5 crore
investors. In the last 10 years, the equity derivatives daily average turnover increased by 4.2
times to Rs.1,41,267 crores. During the same period, the cash market daily average turnover
increased by 6.2 times to Rs.69,644 crores. In currency derivatives, the daily average
turnover increased by 83% to Rs.26,017 crores.
1.2 Definition of Derivatives

The most common definition of a derivative reads approximately as follow: a derivative is a

contract between two parties which derives its value/price from an underlying asset. The most
common types of derivatives are futures, options, forwards and swaps. For example, It can
also describe mutual funds and exchange-traded funds, which would never be viewed as
derivatives even though they derive their values from the values of the underlying securities
they hold. Perhaps the distinction that best characterizes derivatives is that they usually
transform the performance of the underlying asset before paying it out in the derivatives
transaction.
In contrast, with the exception of expense deductions, mutual funds and exchange-traded
funds simply pass through the returns of their underlying securities. This transformation of
performance is typically understood or implicit in references to derivatives but rarely makes
its way into the formal definition. In keeping with customary industry practice, this
characteristic will be retained as an implied, albeit critical, factor distinguishing derivatives
from mutual funds and exchange-traded funds and some other straight pass-through
instruments. Also, note that the idea that derivatives take their performance from an
underlying asset encompasses the fact that derivatives take their value and certain other
characteristics from the underlying asset. Derivatives strategies perform in ways that are
derived from the underlying and the specific features of derivatives.
Derivative is a product whose value is derived from the value of one or more basic variables,
called bases (underlying asset, index, or reference rate), in a contractual manner. The
underlying asset can be equity, forex, commodity or any other asset.
According to securities contracts (regulation) act, 1956 {SC(R)A}, derivatives is

A security derived from a debt instrument, share, loan, whether secured or unsecured, risk
instrument or contract for differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of underlying
securities.

Derivatives are securities under the securities contract (regulation) act and hence the trading
of derivatives is governed by the regulatory framework under the securities contract
(regulation) act.
1.3 History of Derivatives

The history of derivatives is considered to be longer than what many people believe.
Derivatives have been around in the global market for a very long time. The evidence of
characteristics of derivative contracts can even be found in incidents that date back to the
ages before Jesus Christ. However, the beginning of modern-day derivative contracts is
ascribed to the requirement of farmers to protect themselves from any decline in the price of
their crops due to delayed monsoon, or over production etc. The first recorded instance of
futures trading appears to have been occurred with Yodoya rice market in Osaka, Japan
around 1650. In the ancient age, merchants used to store rice in warehouses to use the same
in future and to raise cash. The warehouse holders used to sell the receipts against the stored
rice. These were the earliest known form of forward contracts whereby the landlords were
protected against any future economic losses due to falling prices. These were evidently
standardized contracts, which made them much like today's futures. It is said that there may
also have been rice futures traded in China as long as 6000 years ago.
The evolution of markets in commodities and financial assets may be viewed as a worldwide
long-term historical process. In this process, the emergence of futures has been recognized in
economic literature as a financial development of considerable significance. A vast economic
literature has been built around this subject. From “forward” trading in commodities emerged
the commodity “futures”. The emergence of financial futures is a more recent phenomenon
and represents an extension of the idea of organized futures markets.
However, modern origin of futures/forwards as an exchange -based industry lies in the
productive fields of the grain belt of USA. In the first half of the 19th century. This evolution
was supported by the exigencies of supply and demand where price fluctuations for grain
were violently volatile and consequently had a serious and noticeable effect on the economy
by causing an increase in food prices. At harvest time in the 19th century, when farmers
hauled their grain filled wagons to Chicago and with so many sellers looking for a buyer, the
price went firmly down and farmers were forced to accept whatever was offered or worse, he
was forced to watch it spoil or dumped in a lake. And the wise grain merchant made money
in later months when the supply was short and demand was high
A group of Chicago businessmen to do something and in 1848, 82 merchants representing
every important business interest in Chicago met above a flour store on south water street and
founded the Chicago board of trade (CBOT) which till today remains foremost in commodity
futures trading. The primary intention of the CBOT was to provide a centralized location
known in advance for buyers and sellers to negotiate forward contracts. Thus, the Chicago
board of trade (CBOT), the largest derivative exchange in the world, was established in 1848
in united states of America where forward contracts on various commodities were
standardized around 1865. In 1865, the CBOT went further and listed the first “exchange
traded” derivatives contract in the US. These contracts were called “futures contracts”. Since
then, futures contracts have remained more or less in the similar form, as we know them
today. There were many other exchanges that came into existence in the late 19th century.
The New York coffee, cotton and produce exchanges came into existence in the United States
of America in 1870s and 1880s. In 1919, Chicago butter and egg board, a spin-off of CBOT,
was reorganized to allow futures trading and renamed as Chicago mercantile exchange
(CME). The first stock index futures contract was traded at Kansas City board of trade.
Today, there exist several other commodity exchanges such as the New York mercantile
exchange, the New York commodity exchange, and the New York coffee, sugar and cocoa
exchanges in the United States of America.
Development of derivative market in UK can be traced back to the arrival of a centralized
commodities market, founded in 1565 by sir Thomas Gresham and opened by queen
Elizabeth 1. It was based in the royal exchange (which in 1982 became the first home to the
London international financial futures exchange) and was run along similar lines to the 33
Amsterdam trade centre in the Netherlands which had opened a few years earlier. Each
commodity had a different part of the exchange from which to trade. These markets were
using spot trading methods and it is from these origins that the more complicated forward
markets arose. Derivatives are intended for the purpose of facilitating the hedging of price
risks of the underlying asset which may be in the form of inventory holdings or a financial/
commercial transaction over a certain period. When the asset prices are locked in, derivative
products help in minimizing or neutralizing the impact of fluctuations in asset prices on the
profitability and cash flow situation and serves as an important tool for risk management.
Due to growing instability in the financial markets, the financial derivatives gained
prominence after 1970. The pace of innovation in derivatives markets increased remarkably
in the 1970s. The first major innovation occurred in February 1972, when the Chicago
mercantile exchange (CME) began trading futures on currencies. The biggest increase in
derivatives trading activity was observed subsequently in the 1970s when futures on financial
instruments started trading in CME. This was the first time any futures contract was written
on anything other than a physical commodity. There are now many futures trading exchanges
established all over the world. Foreign currencies such as the Swiss franc and the Japanese
yen were first. In the 1980s, futures began trading on stock market indexes such as the S&P
500.
Subsequently, in October 1975, the CBOT introduced the first futures contract on an interest
rate instrument - government national mortgage association futures. In January 1976, CME
launched treasury bill futures and in august 1977, the CBOT launched treasury bond futures.
In 1980s, the use of cash settlement came in. In December 1981, the IMM launched cash
settlement contracts, the 3-month Eurodollar futures. Cash settlement made feasible the
introduction of derivatives on stock index futures. In February 1982, the Kansas City board of
trade (KCBT) listed futures on the value line composite stock index and in April 1982, the
CME listed futures on the S&P 500. These contract introductions marked the launch of
futures contracts on stock indexes.
In 1980s, the exchange-traded option contracts were also written on "underlying" other than
individual common stocks. The CBOE and Amex listed interest rate options in October 1982
and the Philadelphia stock exchange (PHLX) listed currency options in December 1982 as
also options and gold futures. In January 1983, the CME and the New York futures exchange
(NYFE) began to list options directly on stock index futures and in march 1983, the CBOE
began to list options on stock indexes. Since 1970, the introductions of new products
completely transformed the nature of derivatives trading activity on the exchanges. While
derivatives exchanges were originally developed to help the participants of market to manage
the price risk of physical commodities, today's trading activity is focused on hedging the
financial risks associated with unanticipated price movements in various underlying such as
commodities, stocks, bonds, and currencies.
Options are as old as futures. Their history also dates back to ancient Greece and Rome.
Options are very popular with speculators in the tulip craze of seventeenth century holland.
Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand,
tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was
so much speculation that people even mortgaged their homes and businesses. These
speculators were wiped out when the tulip craze collapsed in 1637 as there was no
mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an American financier, Russell sage, in 1872.
These options were traded over the counter. Agricultural commodities options were traded in
the nineteenth century in England and the us. Options on shares were available in the us on
the over the counter (OTC) market only until 1973 without much knowledge of valuation. A
group of firms known as put and call brokers and dealers association was set up in early
1900s to provide a mechanism for bringing buyers and sellers together.
On April 26, 1973, the Chicago board options exchange (CBOE) was set up at CBOT for the
purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes
invented the famous black-Scholes option formula. This model helped in assessing the fair
price of an option which led to an increased interest in trading of options. With the options
markets becoming increasingly popular, the American stock exchange (AMEX) and the
Philadelphia stock exchange (PHLX) began trading in options in 1975.
The market for futures and options grew at a rapid pace in the eighties and nineties. The
collapse of the Bretton woods regime of fixed parties and the introduction of floating rates for
currencies in the international financial markets paved the way for development of a number
of financial derivatives which served as effective risk management tools to cope with market
uncertainties.
The CBOT and the CME are two largest financial exchanges in the world on which futures
contracts are traded. The CBOT now offers 48 futures and option contracts with the annual
volume at more than 454 million in 2003. The CBOE is the largest exchange for trading stock
options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The
Philadelphia stock exchange is the premier exchange for trading foreign options.
The most traded stock indices include S&P 500, the Dow jones industrial average, the
Nasdaq 100, and the Nikkei 225. The us indices and the Nikkei 225 trade almost round the
clock. The n225 is also traded on the Chicago mercantile exchange.
National stock exchange ranks first in index options and currency options by number of
contracts traded. NSE is dominating derivate market since 2019.
1.4 Derivatives in India

In India, derivatives markets have been functioning since the nineteenth century, with
organized trading in cotton through the establishment of the cotton trade association in 1875.
Derivatives, as exchange traded financial instruments were introduced in India in june 2000.
The national stock exchange (NSE) is the largest exchange in India in derivatives, trading in
various derivatives contracts. The first contract to be launched on NSE was the nifty 50 index
futures contract. In a span of one and a half years after the introduction of index futures,
index options, stock options and stock futures were also introduced in the derivatives segment
for trading. NSE's equity derivatives segment is called the futures & options segment or f60
segment. NSE also trades in currency and interest rate futures contracts under a separate
segment.
The Bombay securities control act, 1925 was passed after the Atlay committee
recommendations to regulate activities in stock exchanges. It empowered the government to
grant and withdraw recognition to a stock exchange and provided that rules of a recognized
stock exchange could be made or amended only after prior approval of the government.
Though the stock exchanges were in operation, there was no legislation for their regulation
till this act was enacted in 1925. This was, however, deficient in many respects. Under the
constitution which came into force on January 26, 1950, stock exchanges and forward
markets came under the exclusive authority of the central government.
However, the commodity market activities remained unregulated. With a view to restricting
speculative activity in cotton market, the government of Bombay issued an ordinance in
September 1939 prohibiting option business. Bombay options in cotton prohibition act, 1939,
later replaced the ordinance. In 1943, the defence of India act was utilized on large scale for
the purpose of prohibiting forward trading in some commodities and regulating such trading
in others on all India basis. In the same year oilseeds forward contracts prohibition order was
issued and forward contracts in oilseeds were banned. Like-wise orders were issued banning
forward trading in food-grains, spices, vegetable oils, sugar and cloth. These orders were
retained with necessary modifications in the essential supplies’ temporary powers act 1946,
after the defence of India act had lapsed. Government with a view to evolving the unified
systems of Bombay enacted the Bombay forward contract control act 1947. The Bombay
forward contracts (control) act, 1947 which was applied on cotton, bullion and seeds but still
the operations was not extended to stocks and shares because of BSE objected.
After independence, the constitution of India adopted by parliament on 26th January, 1950
placed the subject of "stock exchanges and futures market" in the union list and therefore the
responsibility for regulation of forward contracts devolved on government of India. The
parliament passed forward contracts (regulation) act, 1952 which presently regulated forward
contracts in commodities all over India and banned cash settlement and options trading.
Hence, derivatives trading subsequently shifted to informal forwards markets.

A series of reforms in the financial markets paved way for the development of exchange
traded equity derivatives markets in India. In 1993, the NSE was established as an electronic,
national exchange and it started operations in 1994. It improved the efficiency and
transparency of the stock markets by offering a fully automated screen-based trading system
with real-time price dissemination. A report on exchange traded derivatives, by the l.c. Gupta
committee, set up by the securities and exchange board of India (SEBI), recommended a
phased introduction of derivatives instruments with bi-level regulation (i.e., self-regulation by
exchanges, with SEBI providing the overall regulatory and supervisory role). Another report,
by the J. Varma committee in 1998, worked out the various operational details such as
margining and risk management systems for these instruments. In 1999, the securities
contracts (regulation) act of 1956, or SC(R)A, was amended so that derivatives could be
declared as "securities". This allowed the regulatory framework for trading securities, to be
extended to derivatives. The act considers derivatives on equities to be legal and valid, but
only if they are traded on exchanges.
At present, the equity derivatives market, is the most active derivatives market in India.
Trading volumes in equity derivatives are, on an average, more than three and a half times the
trading volume in the cash equity market. National stock exchange (NSE) is world's largest
derivatives exchange for 3rd consecutive year in 2021 in terms of number of contracts traded.
Milestone of derivative market in India
Year Milestone
1988-1999 L c. Gupta committee submits its report on the policy framework for introducing
derivatives.
2000-2001 NSE launched index options based on the nifty 50 index for trading.
2000-2001 NSE launched single stock future and options on listed securities.
2004-2005 NSE launched nifty bank index derivatives.
2007-2008 NSE became the first exchange in India to offer trading in currency futures.
2009-2010 NSE launched trading in currency options.
2010-2011 NSE commenced trading in index futures and options on global indices, namely
the S&P 500 and the Dow jones industrial average.
2011-2012 NSE commenced trading in index futures and options contracts on the FTSE 100
index.
2013-2014 NSE launched trading on India VIX futures.
2015-2016 NSE launched nifty5o index futures on TAIFEX.
2017-2018 NSE launched currency derivatives on non-FCYINR pairs.
2018-2019 NSE launched weekly option on nifty50.
2018-2019 NSE derivatives access was extended to US clients.
2019-2020 NSE was declared world’s largest derivatives exchange by WFE.
2021-2022 NSE launched derivatives on nifty midcap select index.

1.4.1 Equity derivatives trading in India

In the decade of 1990s revolutionary changes took place in the institutional infrastructure in
India’s equity market. It has led to wholly new ideas in market design that has come to
dominate the market. These new institutional arrangements, coupled with the widespread
knowledge and orientation towards equity investment and speculation, have combined to
provide an environment where the equity spot market is now India’s most sophisticated
financial market. One aspect of the sophistication of the equity market is seen in the levels of
market liquidity that are now visible. The market impact cost of doing program trades of rs.5
million at the nifty index is around 0.2%. This state of liquidity on the equity spot market
does well for the market efficiency, which will be observed if the index futures market when
trading commences. Indian equity spot market is dominated by a new practice called, futures
– style settlement or account period settlement. In its present scene, trades on the largest
stock exchange (NSE) are netted from Wednesday’s morning till Tuesday evening, and only
the net open position as of Tuesday evening is settled. The future style settlement has proved
to be an ideal launching pad for the skills that are required for futures trading.
Stock trading is widely prevalent in India hence it seems easy to think that derivatives based
on individual securities could be very important. The index is the counter piece of portfolio
analysis in modern financial economies. Index fluctuations affect all portfolios. The index is
much harder to manipulate. This is particularly important given the weaknesses of law
enforcement in India, which have made numerous manipulative episodes possible. The
market capitalisation of the NSE-50 index is rs.2.6 trillion. This is six times larger than the
market capitalisation of the largest stock and 500 times larger than stocks such as Sterlite, bpl
and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a
stock with a 10% weight in the nifty, this yields a 1% in the nifty. Cash settlements, which is
universally used with index derivatives, also helps in terms of reducing the vulnerability to
market manipulation, in so far as the, short-squeeze is not a problem. Thus, index derivatives
are inherently less vulnerable to market manipulation.
A good index is a sound trade of between diversification and liquidity. In India the traditional
index- the BSE – sensitive index was created by a committee of stockbrokers in 1986. It
predates a modern understanding of issues in index construction and recognition of the
pivotal role of the market index in modern finance. The flows of this index and the
importance of the market index in modern finance, motivated the development of the nifty50
index in late 1995. Many mutual funds have now adopted the nifty as the benchmark for their
performance evaluation efforts. Membership in the NSE-50 index appeared to be a fair test of
liquidity. The 50 stocks in the nifty are assuredly the most liquid stock in India.
The choice of futures vs. Options is often debated. The difference between these instruments
is smaller than, commonly imagined, for a futures position is identical to an appropriately
chosen long call and short put position. Hence, futures position can always be created once
options exist. Individuals or firms can choose to employ positions where their downside and
exposure is capped by using options. Risk management of the futures clearing is more
complex when options are in the picture. When portfolios contain options, the calculation of
initial price requires greater skill and more powerful computers. The skills required for
pricing options are greater than those required in pricing futures.
Futures contracts are available on 199 securities stipulated by the securities & exchange
board of India (SEBI). These securities are traded in the capital market segment of the
exchange. The most traded derivatives stocks in India are IDFC, NBCC, RELIANCE, TATA
STEEL, INFYSOS, AXISBANK, NMDC, PNB, HDFCBANK, ITC.
1.4.2 Commodity derivatives trading in India

In India, the futures market for commodities evolved by the setting up of the “Bombay cotton
trade association ltd.”, in 1875. A separate association by the name "Bombay cotton
exchange ltd” was established following widespread discontent amongst leading cotton mill
owners and merchants over the functioning of the Bombay cotton trade association. With the
setting up of the, Gujarati yapari mandali in 1900, the futures trading in oilseed began.
Commodities like groundnut, castor seed and cotton etc began to be exchanged.
Raw jute and jute goods began to be traded in Calcutta with the establishment of the
“Calcutta hessian exchange ltd.” In 1919. The most notable centres for existence of futures
market for wheat were the chamber of commerce at Hapur, which was established in 1913.
Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala
and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras,
Ghaziabad, Sikenderabad and Bareilly in U.P. The bullion futures market began in Bombay
in 1990. After the economic reforms in 1991 and the trade liberalization, the govt. Of India
appointed in June 1993 one more committee on forward markets under chairmanship of prof.
K.N. Kabra. The committee recommended that futures trading be introduced in basmati rice,
cotton, raw jute and jute goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed,
sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them, rice
bran oil, castor oil and its oilcake, linseed, silver and onions.
All over the world commodity trade forms the major backbone of the economy. In India,
trading volumes in the commodity market have also seen a steady rise - to RS. 5,71,000
crores in FY-05 from RS. 1,29,000 crores in FY-04. In the current fiscal year, trading
volumes in the commodity market have already crossed RS. 3,50,000 crores in the first four
months of trading. Some of the commodities traded in India include agricultural commodities
like rice wheat, soya, groundnut, tea, coffee, jute, rubber, spices, cotton, precious metals like
gold & silver, base metals like iron ore, aluminium, nickel, lead, zinc and energy
commodities like crude oil, coal. Commodities form around 50% of the Indian GDP. Though
there are no institutions or banks in commodity exchanges, as yet, the market for
commodities is bigger than the market for securities. Commodities market is estimated to be
around RS. 44,00,000 crores in future. Assuming a future trading multiple is about 4 times
the physical market, in many countries it is much higher at around 10 times.
In India most traded commodity are Gold, Silver, Crude oil, Copper, etc.
1.5 Factors contributing to the growth of derivatives
Factors contributing to the explosive growth of derivatives are price volatility, globalisation
of the markets, technological developments and advances in the financial theories.

 Price volatility - The most-simple definition of volatility is a reflection of the degree

to which price moves. A stock with a price that fluctuates wildly—hits new highs and
lows or moves erratically—is considered highly volatile. A stock that maintains a
relatively stable price has low v0latility. A highly volatile stock is inherently riskier,
but that risk cuts both ways. When investing in a volatile security, the chance for
success is increased as much as the risk of failure. For this reason, many traders with
a high-risk tolerance look to multiple measures of volatility to help inform their trade
strategies.
A price is what one pays to acquire or use something of value. The objects having value
maybe commodities, local currency or foreign currencies. The concept of price is clear to
almost everybody when we discuss commodities. There is a price to be paid for the purchase
of food grain, oil, petrol, metal, etc. The price one pays for use of a unit of another person’s
money is called interest rate. And the price one pays in one’s own currency for a unit of
another currency is called as an exchange rate.
Prices are generally determined by market forces. In a market, consumers have „demand‟ and
producers or suppliers have, supply, and the collective interaction of demand and supply in
the market determines the price. These factors are constantly interacting in the market
causing changes in the price over a short period of time. Such changes in the price are known
as, price volatility. This has three factors namely the speed of price changes, the frequency of
price changes and the magnitude of price changes.
The changes in demand and supply influencing factors culminate in market adjustments
through price changes. These price changes expose individuals, producing firms and
governments to significant risks. The breakdown of the Bretton woods agreement brought an
end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars.
The globalisation of the markets and rapid industrialisation of many underdeveloped
countries brought a new scale and dimension to the markets. Nations that were poor suddenly
became a major source of supply of goods. The Mexican crisis in the south east-Asian
currency crisis of 1990’s has brought the price volatility factor on the surface. The advent of
telecommunication and data processing bought information very quickly to the markets.
Information which would have taken months to impact the market earlier can now be
obtained in matter of moments.
Even equity holders are exposed to price risk of corporate share fluctuates rapidly. These
price volatility risk pushed the use of derivatives like futures and options increasingly as
these instruments can be used as hedge to protect against adverse price changes in
commodity, foreign exchange, equity shares and bonds.
  Globalisation of markets - Earlier, managers had to deal with domestic economic
concerns, what happened in other part of the world was mostly irrelevant. Now
globalisation has increased the size of markets and as greatly enhanced
competition .it has benefited consumers who cannot obtain better quality goods at a
lower cost. It has also exposed the modern business to significant risks and, in many
cases, led to cut profit margins in Indian context, south east Asian currencies crisis of
1997 had affected the competitiveness of our products via depreciated currencies.
Export of certain goods from India declined because of this crisis. Steel industry in
1998 suffered its worst set back due to cheap import of steel from south east Asian
countries. Suddenly Blue-chip companies had turned in to red. The fear of China
devaluing its currency created instability in Indian exports. Thus, it is evident that
globalisation of industrial and financial activities necessarily gave rise to use of
derivatives to guard against future losses. This factor alone has contributed to the
growth of derivatives to a significant extent.

 Technological advances - A significant growth of derivative instruments has been

driven by technological break-through. Advances in this area include the
development of high-speed processors, network systems and enhanced method of
data entry. Closely related to advances in computer technology are advances in
telecommunications. Improvement in communications allow for instantaneous
worldwide conferencing, data transmission by satellite. At the same time there were
significant advances in software programmes without which computer and
telecommunication advances would be meaningless. These facilitated the more rapid
movement of information and consequently its instantaneous impact on market price.
Although price sensitivity to market forces is beneficial to the economy as whole resources
are rapidly relocated to more productive use and better rationed overtime the greater price
volatility exposes producers and consumers to greater price risk. The effect of this risk can
easily destroy a business which is otherwise well managed. Derivatives can help a firm
manage the price risk inherent in a market economy.

 Advances in financial theories

Advances in financial theories gave birth to derivatives. Initially forward contracts in its
traditional form, was the only hedging tool available. Option pricing models developed by
black and schools in 1973 were used to determine prices of call and put options. In late
1970‟s, work of Lewis Edington extended the early work of Johnson and started the hedging
of financial price risks with financial futures. The work of economic theorists gave rise to
new products for risk management which led to the growth of derivatives in financial
markets.

The above factors in combination of lot many factors led to growth of derivatives
instruments.
1.6 Types of derivatives

There are mainly four types of derivatives i.e., Forwards, futures, options and swaps

Derivatives

Forward Futures Options Swaps

1.6.1 Forwards
A forward contract is an agreement to buy or sell an asset on a specified date for 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 bilaterally by the
parties to the contract. The forward contracts are normally traded outside the exchanges.
A forward contract is a customized contract between two parties to buy or sell an asset at a
specified price on a future date. A forward contract can be used for hedging or speculation,
although its non-standardized nature makes it particularly apt for hedging.
No margins are generally payable by any of the parties to the other. Forwards contracts are
traded over-the- counter and are not dealt with on an exchange unlike futures contract. Lack
of liquidity and counter party default risks are the main drawbacks of a forward contract.
Forward contracts are customized. In other words, the terms of forward contracts are
individually agreed between two counter-parties.
Now, let us take an example to furthermore explain this: suppose you are a farmer and you
want to sell wheat at the current rate of Rs.18 per kg, but you know that wheat prices will fall
in the coming months ahead.
In this case, you enter a contract with a grocery for selling them a particular amount of wheat
at rs.18 in three months. By entering into the said contract, you are able to eliminate the
uncertainties of your revenues on account of prices of wheat in futures. Now, if the price of
wheat falls to rs.16 after three months, then you are protected from the potential losses since
you will still be able to sell the wheat at the agreed price of rs.18 per kg. However, on the
other hand, if the price of wheat rises to Rs.20 after three months, then you will be devoid of
the potential profits because you will still sell the wheat at the agreed price of rs.18 per kg as
per the forward contract.
Forward contracts are very useful in hedging and speculation. The classic hedging application
would be that of an exporter who expects to receive payment in three months later. He is
exposed to the risk of exchange rate fluctuations. By using the currency forward market to
sell forward, he can lock on to a rate today and reduce his uncertainty. Thus, an importer who
is required to make a payment in two months hence can reduce his exposure to exchange rate
fluctuations by buying forward. If a speculator has information or analysis, which forecasts
an upturn in a price, then he can go long on the forward market instead of the cash market.
The speculator would go long on the forward, wait for the price to rise, and then take a
reversing transaction to book profits. Speculators may well be required to deposit a margin
upfront. However, this is generally a relatively small proportion of the value of the assets
underlying the forward contract. The use of forward markets here supplies leverage to the
speculator.
The market for forward contracts is huge since many of the world’s biggest corporations use
it to hedge currency and interest rate risks. However, since the details of forward contracts
are restricted to the buyer and seller—and are not known to the general public—the size of
this market is difficult to estimate.
The large size and unregulated nature of the forward contracts market mean that it may be
susceptible to a cascading series of defaults in the worst-case scenario. While banks and
financial corporations mitigate this risk by being very careful in their choice of counterparty,
the possibility of large-scale default does exist.
Another risk that arises from the non-standard nature of forward contracts is that they are
only settled on the settlement date and are not marked-to-market like futures. What if
the forward rate specified in the contract diverges widely from the spot rate at the time of
settlement?
In this case, the financial institution that originated the forward contract is exposed to a
greater degree of risk in the event of default or non-settlement by the client than if the
contract were marked-to-market regularly.
1.6.2 Futures
A futures contract is an agreement to either buy or sell an asset on a publicly-traded
exchange. The contract specifies when the seller will deliver the asset, and what the price will
be. The underlying asset of a futures contract is commonly either a commodity, stock, bond,
or currency.
Futures markets are exactly like forward markets in terms of basic economics. However,
contracts are standardized and trading is centralized (on a stock exchange). There is no
counterparty risk in the futures markets, unlike in forward markets, increasing the time to
expiration does not increase the counter party risk. Futures markets are highly liquid as
compared to the forward markets.
Futures contracts are standardized. In other words, the parties to the contracts do not decide
the terms of futures contracts; but they merely accept terms of contracts standardized by the
exchange.
A futures contract represents a contractual agreement to purchase or sell a specified asset in
the future for a specified price that is determined today. The underlying asset could be foreign
currency, a stock index, a treasury bill or any commodity. The specified price is known as the
future price. Each contract also specifies the delivery month, which may be nearby or more
deferred in time.

The undertaker in a future market can have two positions in the contract:
A) long position is when the buyer of a future contract agrees to purchase the underlying
asset.
B) short position is when the seller agrees to sell the asset. Futures contract represents an
institutionalized, standardized form of forward contracts.
They are traded on an organized exchange, which is a physical place of trading floor where
listed contracts are traded face to face.
A futures trade will result in a futures contract between 2 sides- someone going long at a
negotiated price and someone going short at that same price. Thus, if there were no
transaction costs, futures trading would represent a 'zero sum game' what one side wins,
which exactly match what the other side loses.

The most important distinctive characteristic of futures contracts is the daily settlement of
gains and losses and the associated credit guarantee provided by the exchange through its
clearinghouse. When a party buys a futures contract, it commits to purchase the underlying
asset at a later date and at a price agreed upon when the contract is initiated. The counterparty
(the seller) makes the opposite commitment, an agreement to sell the underlying asset at a
later date and at a price agreed upon when the contract is initiated. The agreed-upon price is
called the futures price. Identical contracts trade on an ongoing basis at different prices,
reflecting the passage of time and the arrival of new information to the market. Thus, as the
futures price changes, the parties make and lose money. Rising (falling) prices, of course,
benefit (hurt) the long and hurt (benefit) the short. At the end of each day, the clearinghouse
engages in a practice called mark to market, also known as the daily settlement. The
clearinghouse determines an average of the final futures trades of the day and designates that
price as the settlement price. All contracts are then said to be marked to the settlement price.
For example, if the long purchases the contract during the day at a futures price of rs.120 and
the settlement price at the end of the day is rs.122, the long’s account would be marked for a
gain of rs.2. In other words, the long has made a profit of rs.2 and that amount is credited to
his account, with the money coming from the account of the short, who has lost rs.2.
Naturally, if the futures price decreases, the long loses money and is charged with that loss,
and the money is transferred to the account of the short seller.
Futures are widely used in various markets to hedge against price volatility, and by
speculators who want to take advantage of price movements. A futures contract gives a buyer
or seller the right to buy or sell a particular asset at a specific future price.
There are many types of futures, in both the financial and commodity segments. Some of the
types of financial futures include stock, index, currency and interest futures. There are also
futures for various commodities, like agricultural products, gold, oil, cotton, oilseed, and so
on.
The different types of futures are
1)Stock futures – Stock futures index first appeared in India in the year 2000. These were
followed by individual stock futures a couple of years later. There are several advantages of
trading in stock futures. The biggest one is leverage. Before trading in stock futures, you need
to deposit an initial margin with the broker. If the initial margin is, say, 10 per cent, you can
trade in RS. 50 lakh worth of futures by paying just RS. 5lakh to the broker. The larger the
volume of transactions, the higher your profit. But the risks are also more significant. You
can trade stock futures on stock exchanges like the BSE and NSE. However, they are
available only for a specified list of stocks. Some of stock futures are HDFC, HINDPETRO,
RELIANCE, COALINDIA, SAIL, BHEL, etc.
2)index futures - index futures can be used to speculate on the movements of indices, like the
SENSEX or nifty, in the future. Let’s say you buy BSE SENSEX futures at rs 40,000 with an
expiry date of the month. If the SENSEX rises to 45,000, you stand to make a profit of RS.
5,000. If it goes down to RS. 30,000, your losses, in that case, would be RS. 5,000. Index
futures are used by portfolio managers to hedge their equity positions should share prices fall.
Some of the index futures in India include SENSEX, nifty 50, nifty bank, nifty it etc.
3)currency futures - one of the different types of financial futures is currency futures.
This futures contract allows you to buy or sell a currency at a specific rate vis-à-vis another
currency (EURO vs USD, etc.) At a predetermined date in the future. These are used by those
who want to hedge risks, and by speculators. For example, an importer in India may purchase
USD futures to guard against any appreciation in the currency against the rupee.
4)commodity futures - commodity futures allow hedging against price changes in the future
of various commodities, including agricultural products, gold, silver, petroleum etc.
Speculators also use them to bet on price movements. Currency markets are highly volatile
and are generally the domain of large institutional players, including private companies and
governments. Since initial margins are low in commodities, players in commodity futures can
take significant positions. Of course, the profit potential is enormous, but the risks tend to be
high. In India, these futures are traded on commodity exchanges like the multi commodity
exchange (mcx) and the national commodity and derivatives exchange.
5) interest rate futures - an interest rate future is one of the different types of futures. It’s a
contract to buy or sell a debt instrument at a specified price on a predetermined date. The
underlying assets are government bonds or treasury bills. You can trade these on the NSE and
the BSE.
Thus, futures contracts allow traders to speculate in the direction of the market. Trading in
futures contracts involves several advantages such as easy pricing, high liquidity, and risk
hedging. These are highly leveraged instruments which allow you to increase your profit
potential with margin investment. The futures market is linear, and unlike options, the margin
requirement is well-defined, following a simple pricing model determined based on the cost
of carrying of the spot price.

Futures markets were designed to solve the problems that exist in forward markets. A futures
contract is an agreement between two parties to buy or sell an asset at a certain time in the
future at a certain price. But unlike forward contracts, the futures contracts are standardized
and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies
certain standard features of the contract. It is a standardized contract with standard underlying
instrument, a standard quantity and quality of the underlying instrument that can be delivered,
(or which can be used for reference purposes in settlement) and a standard timing of such
settlement. A futures contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of futures transactions are offset this way.

Difference between Forwards and Futures

Basis for comparison Forward contract Futures contract

Forward contract is an A contract in which the

Meaning agreement between parties to parties agree to exchange the
buy and sell the underlying asset for cash at a fixed price
asset at a specified date and and at a future specified
agreed rate in future date, is known as future
contract

What is it? It is a tailor-made contract It is a standardized contract

Traded on Over the counter i.e. There is Organized stock exchange

no secondary market
Settlement On a maturity date On a daily basis
Risk High Low
 Default As they are private No such probability
agreement, the chance of
defaults is relatively high
Size of contract Depends on the contract Fixed
terms
Collateral Not required Initial margin required

Maturity As per the terms of contract Predetermined date

Regulation Self-regulated By stock exchange

Liquidity Low High

Major specifications of a Futures contract

1. Expiration - Expiration (also known as maturity or expiry date) refers to the last
trading day of the futures contract. After the expiry of a futures contract, final
settlement and delivery is made according to the rules laid down by the exchange in
the contract specifications document.
2. Contract size - Contract size, or lot size, is the minimum tradable size of a contract. It
is often one unit of the defined contract.
3. Initial margin - Initial margin is the minimum collateral required by the exchange
before a trader is allowed to take a position. Initial margins can be paid in various
forms as laid down by the exchange and varies from assets to assets as well as from
time to time. The level of initial margin is dependent on the price volatility of the
contract. More volatile commodities generally have higher margin requirements.
4. Price quotation - Price quotation is the units in which the traded price of a contract is
displayed. It can be different from the trading size of a contract and is often based on
industry practices and conventions.
5. Tick value - Tick value refers to the minimum profit or loss that can arise from
holding a position of one contract. Tick value depends on the size of the contract and
its tick size. While it is often explicitly mentioned in contract specifications, it can be
calculated by the formula:
Tick value = Contract size x tick size
6. Mark to market - Mark to market refers to the process by which the exchange
calculates and values all open positions according to pre-defined rules and
regulations. Mark-to-market is an essential feature of exchange-traded futures
contracts whereby the exchange ensures that all profit and losses are recognized by
pricing them according to accurate market conditions. It is also an important feature
for the risk management of positions of participants.
7. Delivery date - Delivery date or delivery period refers to the time specified by the
exchange during or by which the seller has to make delivery according to contract
 specifications and regulations. Delivery date is often later than expiry date of a
contract, especially in case of physically delivered commodities.
8. Daily settlement - Daily settlement refers to the process whereby the exchange debits
and credits all accounts with daily profits and losses as calculated by the mark-to-
market process. Daily settlement is necessary in order to recover losses and pay
profits to respective accounts.
9. Position - One can take long and short positions in futures contract.
1. Long position - Having a long position in a security means that you intend to buy the
security in future. Investors maintain long security positions in the expectation that
the stock will rise in value in the future.
2. Short position - A short position means that you intend to sell the security in future.
Investors maintain short position in an expectation that the price of the stock will
decrease in value in future.

 Payoffs and profits for a long futures holder

A payoff is the likely profit loss that would accrue to a market participant with change in the
price of the underlying asset. Futures contracts have linear payoffs. In simple words, it means
that the losses as well as profits, for the buyer and the seller of futures contracts, are
unlimited. Further, the profits of one party is exactly equivalent to the losses of the other
party.
Let’s take a case of a speculator who buys a two-month nifty index futures contract when the
nifty stands at 11600.
The underlying asset in this case is the nifty portfolio. When the index moves up, the long
futures position starts making profits, and when the index moves down it starts making
losses.

The figure above shows the profits/losses for a long futures position. The investor who
bought futures when the index was at 11600. If the index goes up, his futures position starts
making profit. If the index falls, his futures position starts showing losses.
  Payoffs and profits for a short futures holder
The payoff for a person who sells a futures contract is similar to the payoff for a person who
shorts an asset. He has a potentially unlimited upside as well as a potentially unlimited
downside. Take the case of a speculator who sells a two-month nifty index futures contract
when the nifty stands at 11600. The underlying asset in this case is the nifty portfolio. When
the index moves down, the short futures position starts making profits, and when the index
moves up, it starts making losses.

The figure shows the profits/losses for a short futures position. The investor sold futures
when the index was at 11600. If the index goes down, his futures position starts making
profit. If the index rises, his futures position starts showing losses.

1.6.3 Options

CALL
OPTIONS
PUT
Options are fundamentally different from forward and futures contracts. An option gives the
holder of the option the right to do something. The holder does not have to exercise this right.
In contrast, in a forward or futures contract, the two parties have committed themselves to
doing something. Whereas it costs nothing (except margin requirements) to enter into a
futures contract, the purchase of an option requires an up-front payment.
An option on a future is the right, but not the obligation, to buy or sell a specified number of
underlying futures contracts or a specified amount of a commodity, currency, index or
financial instrument at an agreed upon price on or before a given future date. Options are a
right available to the buyer of the same, to purchase or sell an asset, without any obligation. It
means that the buyer of the option can exercise his option but is not bound to do so.
Normally, options on futures are traded on the same exchanges that trade the underlying
futures contracts and are standardized with respect to the quantity of the underlying futures
contracts (by custom, one futures contract), expiration date, and exercise or strike price (the
price at which the underlying futures contract can be bought or sold).
All options contracts on indices are settled in cash on the expiration date. Whereas for single
stock contracts, the option contracts are settled via delivery.
Options in India, except for long-dated contracts, options have a maximum of the 3-month
trading cycle - 1 month, 2 months and 3 months. New option contracts are introduced on the
next trading day of the expiration of the monthly contracts. The expiration day is the last
trading Thursday of the month. So, at any time, buyers have the option to choose from 3
contracts with different expiry dates. For example, on Jan 14, 2022, there would be 3 option
contracts i.e., Contracts expiring on Jan 27, Feb 24 and march 31. On April 1st, new contracts
with the expiry of June 29 would be available for trading
Options are of two types: Call options (calls) and Put options (puts).
1. Call option - A call option gives the holder (buyer/ one who is long call), the right to
buy a specified quantity of the underlying asset at the strike price on the expiration
date. The seller (one who is short call) however, has the obligation to sell the
underlying asset if the buyer of the call option decides to exercise his option to buy.
Example: An investor buys a call option on HDFC at the strike price of RS. 2500 at a
premium of RS. 100. If the market price of HDFC on the day of expiry is more than RS.
2500, the option will be exercised. The investor will earn profits once the share price crosses
RS. 2600 (strike price + premium i.e., 2500+100). Suppose stock price is RS. 2800, the
option will be exercised and the investor will buy 1 share of HDFC from the seller of the
option at RS. 2500 and sell it in the market at RS. 2800 making a profit of RS. 200 {(spot
price - strike price) - premium}.
In another scenario, if at the time of expiry stock price falls below RS. 2500 say suppose it
touches RS. 2000, the buyer of the call option will choose not to exercise his option. In this
case the investor loses the premium (RS. 100), paid which shall be the profit earned by the
seller of the call option.
2. Put option - a put option gives the holder (buyer/ one who is long put), the right to sell
a specified quantity of the underlying asset at the strike price on or the expiry date.
The seller of the put option (one who is short put) however, has the obligation to buy
the underlying asset at the strike price if the buyer decides to exercise his option to
sell.
Example: An investor buys one put option on TCS at the strike price of RS. 3000, at a
premium of RS. 250. If the market price of TCS, on the day of expiry is less than RS. 3000,
the option can be exercised as it is 'in the money'. The investor's break-even point is RS. 2750
(strike price - premium paid) i.e., the investor will earn profits if the market falls below 2750.
Suppose stock price is RS. 2600, the buyer of the put option immediately buys TCS from the
market @ RS. 2600 & exercises his option selling TCS at Rs.3000 to the option writer thus
making a net profit of RS. 150 {(strike price - spot price) - premium paid}.
In another scenario, if at the time of expiry, market price of TCS is RS. 3200; the buyer of the
put option will choose not to exercise his option to sell as he can sell in the market at a higher
rate. In this case the investor loses the premium paid (i.e., Rs 250), which shall be the profit
earned by the seller of the put option.
The biggest advantage of option trading is that investment amount is very low. It also acts as
an insurance if you are holding any stock for long term. While you are investing less in
options, the profit percentage is higher in short term. With options, we can make a profit in
all scenarios bullish, bearish or neutral. We can execute option strategies as per the market
outlook and may earn profit from it.
Option terminology
 Option premium – Option premium is the price paid by the buyer to the seller to
acquire the right to buy or sell. The option premium paid is the maximum loss a
buyer can ever make and represents the maximum profit the seller can ever make. In
simpler terms, the price of options contract is known as option premium.
 Strike price - The strike or exercise price of an option is the specified/ predetermined
price of the underlying asset at which the same can be bought or sold if the option
buyer exercises his right to buy/ sell on or before the expiration day. Suppose you
buy a call of nifty at the strike of Rs. 17,500 at a premium of Rs. 50. Nifty is
currently trading at 17,300. You believe that the nifty will cross 17,500 before expiry.
So, at the point when it crosses 17500, you will exercise your right. Also, since you
have paid a premium of Rs. 50 for buying the call, you start making profits when
nifty crosses 17,550 (17,500 + 50).
 Expiration date - The date on which the option expires is known as the expiration
date. On the expiration date, either the option is exercised or it expires worthless.
 American option - An American option is an option contract that can be exercised
i.e., Bought or sold at any time until the expiry date.
 European option - A European option is an option contract that can only be exercised
on its expiry date.
 In the money option - A call option is said to be in the money when the strike price of
the option is less than the underlying asset price. For example, HDFC call option
with a strike of 2500 is in the money, when the spot price of HDFC is at 2800 as the
call option has a positive exercise value. The call option holder has the right to buy
HDFC at 2500, no matter by what amount the spot price exceeded the strike price.
With the spot price at 2800, selling HDFC at this higher price, one can make a profit.
An option is said to be in the money when,
Strike price< spot price (call option)
Strike price > spot price (put option)
  At the money - An option is said to be at-the-money, when the option's strike price is
equal to the underlying asset price. This is true for both puts and calls. For example,
HDFC call option with a strike of 2500 is at the money, when the spot price of HDFC
is at 2500 as the call option has a positive exercise value and put option will also
remain the same.
An option is said to be at the money when,
Strike price = spot price (for both call option and put option)
 Out of the money - When a call option expires out of the money: a call option is said
to be out of the money (OTM) if the strike price is higher than the current market
price of the underlying instrument. In such a case, the buyer loses the premium paid
to buy the contract and the seller earns the profit. When a put option expires out of
the money
A put option is said to be out of the money (OTM) if the strike price is lesser than the
current market price of the underlying security. In such a case, the buyer loses the
premium paid to buy the contract and the seller earns the profit.
For example, HDFC call option with a strike of 2500 is out of the money, when the
spot price of HDFC is at 2400. For put option of HDFC when strike price is 2500 and
spot price of HDFC is 2600.
An option is said to be out of the money when,
Strike price > spot price (call option)
Strike price< spot price (put option)
 Put/call ratio (PCR) - PCR is a popular derivative indicator, specifically designed
to help traders gauge the overall sentiment (mood) of the market. The ratio is
calculated either on the basis of options trading volumes or on the basis of the open
interest for a particular period. If the ratio is more than 1, it means that more puts
have been traded during the day and if it is less than 1, it means more calls have
been traded. The PCR can be calculated for the options segment as a whole, which
includes individual stocks as well as indices.

Factors that affect the value of an option premium

 Current price of the underlying asset - When the market price begins to approach the
strike price the options start becoming more and more expensive. When the strike
price moves away from the market price the options start becoming cheaper. Option
price depends on where the underlying is trading with respect to the strike price.
 Exercise price of the option – In the money call and put options will be more
expensive than at-the-money options. At-the-money call and put options will be more
expensive than out-of-the-money options. Out of the money call or put options will
always have lesser value compared to the other two types of options.
 Interest rates - When interest rates rise in the economy, call options start becoming
expensive. When interest rates rise in the economy, put options start becoming less
and less expensive.
 Time to expiry - Options with longer time to maturity will have greater values than
options with shorter time frame. INFY SEP 1800 CE/PE will have a greater value
than INFY SEP 1800 CE/PE. Options have large time values at the beginning of the
 series. Option gradually loses its value because of time value decay. The time value
decay is very sharp or exponential as we approach expiry.
 Volatility of prices of the underlying asset - Volatility plays a very important role in
options pricing. The value of both the call and put options rises with increase in
volatility. Option prices can fluctuate wildly under different volatility condition in the
markets.
 Dividend - Dividends have the effect of reducing the stock price on the ex-dividend
date. This is bad news for the value of call options and good news for the value of put
options. Consider a dividend whose ex-dividend date is during the life of an option.
The value of the option is negatively related to the size of the dividend if the option is
a call and positively related to the size of the dividend if the option is a put.

Factor Effect on call option Effect on put option price

Increase in the value of the Increase Decrease
underlying asset

Increase in intrinsic vale Decrease Increase

Increase in time value Increase Increase
Increase in volatility Increase Increase
Increase in interest rates Increase Decrease
Increase in dividends Decrease Increase

Option chain
An option chain chart is a listing of call and put options available for an underlying for a
specific expiration period. The listing includes information on premium, volume, open
interest etc., for different strike prices.

Below is the option chain of national aluminium company (NATIONALUM) limited as on

17/02/2022 which will expire on 24/02/2022
The current market price of national aluminium company (NATIONALUM)
 BSE – 117.50
 NSE - 117.40
(Source - https://www.NSEIndia.com/)
The chart is divided into call and put options. On the left side, we have data for call options
and put options on the right side. At the middle of the chart, we have various strike prices. On
both sides of the strike prices, we have various data like oi, change in OI, volume, IV, LTP,
net change, bid qty, bid price, ask price and ask qty. We also see a part of data on both sides
are highlighted in the pinkish shade and the rest is in white.

Important terminology for option chain

 OI: OI is an abbreviation for open interest. It is a data that signifies the interest of
traders in a particular strike price of an option. OI tells you about the number of
contracts that are traded but not exercised or squared off. The higher the number, the
more is the interest among traders for the particular strike price of an option. And
hence there is high liquidity for you to able to trade your option when desired.
  Change in OI: It tells you about the change in the open interest within the expiration
period. The number of contracts that are closed, exercised or squared off. A
significant change in oi should be carefully monitored.

 Volume: it is another indicator of trader’s interest in a particular strike price of an

option. It tells us about the total number of contracts of an option for a particular
strike price are traded in the market. It is calculated on a daily basis. Volume can help
you understand the current interest among traders.

 IV: IV is an abbreviation for implied volatility. It tells us about what the market thinks
on the price movement of the underlying. A higher iv means the potential for high
swings in prices and low iv means no or fewer swings. Iv doesn't tell you about the
direction, whether upward or downward, movement of the prices.

 Net change: It is the net change in the LTP. The positive changes, means rise in price,
are indicated in green while negative changes, decrease in price, are indicated in red.

 Bid qty: Bid qty is the number of buy orders for a particular strike price. This tells you
about the current demand for the strike price of an option.

 Bid price: It is the price quoted in the last buy order. So, a price higher than the LTP
may suggest that the demand for the option is rising and vice versa.

 Ask price: It is the price quoted in the last sell order.

 Ask qty: It is the number of open sell orders for a particular strike price. It tells you
about the supply for the option.

Summary of option chain

Resistance and support level keeps on changing. Resistance and support levels are found with
the help of OI. On call side the maximum, OI will act as resistance and for put side maximum
oi will act as support. Since it keeps on changing as of the option chain provided above
maximum oi is at 125 so 125 will act as crucial resistance and maximum oi for put option is
at 110 that would a crucial support.

So, we can say that with the help of option chain we can quickly find the support and
resistance for few minutes as it changes after every 5 mins.

Difference between selling a put option and buying a call option

Put option (sell) Call option (buy)

Premium is received for selling a put option. Premium is paid to buy a call option
Profit is limited to the premium received. Profit is unlimited
Losses are unlimited Losses are limited to the premium paid plus
brokerage paid.
Difference between selling a call option and buying a put option

Call option(sell) Put option(buy)

Premium is received Premium is paid
Profit is limited to the premium Profit unlimited
Loss is unlimited Loss is limited to the premium
Difference between futures and options.

Basis for comparison Futures Options

Meaning In case of futures, both the buyer In case of options the buyer
and seller are obligated to enjoys the right & not the
buy/sell the underlying asset. obligation, to buy or sell the
underlying asset.

Risk profile Futures contracts have a Options have an asymmetric risk

symmetric risk profile for both profile.
the buyer as well as the seller

Volatility For futures volatility is low For options volatility is very high

Price affected The futures contracts prices are The prices of options are
affected mainly by the prices of however; affected by prices of
the underlying asset. the underlying asset, time
remaining for expiry of the
contract, interest rate & volatility
of the underlying asset

Cost Futures are expensive (minimum Options are cheaper (minimum

amount is more than 1 lakh) amount required is as small as
rs.50)

Example Futures are denoted by Options are denoted by

TCS FEB FUT TCS FEB 3800CE/PE

1.6.4 Swaps
Swaps are transactions which obligates the two parties to the contract to exchange a series of
cash flows at specified intervals known as payment or settlement dates. They can be regarded
as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)
payments, based on some notional principal amount is called as a ‘swap’. In case of swap,
only the payment flows are exchanged and not the principal amount.
Types of swaps
 1. Interest rate swaps - Interest rate swaps is an arrangement by which one party agrees
to exchange his series of fixed rate interest payments to a party in exchange for his
variable rate interest payments. The fixed rate payer takes a short position in the
forward contract whereas, the floating rate payer takes a long position in the forward
contract.
2. Commodity swaps - Commodity swaps involve the exchange of a floating commodity
price, such as the brent crude oil spot price, for a set price over an agreed-upon
period. Commodity swaps most commonly involve crude oil.
3. Currency swaps - In a currency swap, the parties exchange interest and principal
payments on debt denominated in different currencies. Unlike an interest rate swap,
the principal is not a notional amount, but it is exchanged along with interest
obligations. Currency swaps can take place between countries. For example, China
has used swaps with Argentina, helping the latter stabilize its foreign reserves,
the U.S. Federal reserve engaged in an aggressive swap strategy with
European central banks during the 2010 European financial crisis to stabilize the euro,
which was falling in value due to the Greek debt crisis.
4. Debt-equity swaps - A debt-equity swap involves the exchange of debt for equity—in
the case of a publicly-traded company, this would mean bonds for stocks. It is a way
for companies to refinance their debt or reallocate their capital structure.
5. Total return swaps - In a total return swap, the total return from an asset is exchanged
for a fixed interest rate. This gives the party paying the fixed-rate exposure to the
underlying asset—a stock or an index. For example, an investor could pay a fixed rate
to one party in return for the capital appreciation plus dividend payments of a pool of
stocks.
6. Credit default swap (CDS) - A credit default swap (CDS) consists of an agreement by
one party to pay the lost principal and interest of a loan to the CDS buyer if a
borrower defaults on a loan. Excessive leverage and poor risk management in the
CDS market were contributing causes of the 2008 financial crisis.
The other kind of derivatives, which are not, much popular are as follows:
1. Baskets - Baskets options are option on portfolio of underlying asset. Equity index
options are most popular form of baskets.
2. Leaps normally option contracts are for a period of 1 to 12 months. However,
exchange may introduce option contracts with a maturity period of 2-3 years. These
long-term option contracts are popularly known as leaps or long-term equity
anticipation securities.
3. Warrants - Options generally have lives of up to one year, the majority of options
traded on options exchanges having a maximum maturity of nine months. Longer-
dated options are called warrants and are generally traded over-the-counter.
4. Swaptions - Swaptions are options to buy or sell a swap that will become operative at
the expiry of the options. Thus, a swaption is an option on a forward swap. Rather
than have calls and puts, the swaptions market has receiver swaptions and payer
swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer
swaption is an option to pay fixed and receive floating.
1.7 Participants in the derivatives market:
As equity markets developed, different categories of investors started participating in the
market. In India, equity market participants currently include retail investors, corporate
investors, mutual funds, banks, foreign institutional investors etc. Each of these investor
categories uses the derivatives market to as a part of risk management, investment strategy or
speculation.
The participants in the derivatives market are as follows

Participants

Trading Intermediary Institutional

Participants participants framework

Hedgers Speculators Arbitrageurs Brokers Exchange

Market maker Clearing

Long hedge
and jobber house

Short hedge Custodian

Bank for fund

movements

1.7.1 Trading participants

 Hedgers
 Speculators
  Arbitrageurs

Hedgers - These investors have a position (i.e., have bought stocks) in the underlying market
but are worried about a potential loss arising out of a change in the asset price in the future.
Hedgers participate in the derivatives market to lock the prices at which they will be able to
transact in the future. Thus, they try to avoid price risk through holding a position in the
derivatives market. Different hedgers take different positions in the derivatives market based
on their exposure in the underlying market. A hedger normally takes an opposite position in
the derivatives market to what he has in the underlying market. Hedging in futures market
can be done through two positions, via. Short hedge and long hedge.
1. Short hedge
A short hedge involves taking a short position in the futures market. Short hedge position is
taken by someone who already owns the underlying asset or is expecting a future receipt of
the underlying asset.
For example, an investor holding reliance shares may be worried about adverse future price
movements and may want to hedge the price risk. He can do so by holding a short position in
the derivatives market. The investor can go short in reliance futures at the NSE. This protects
him from price movements in reliance stock. In case the price of reliance shares falls, the
investor will lose money in the shares but will make up for this loss by the gain made in
reliance futures. Note that a short position holder in a futures contract makes a profit if the
price of the underlying asset falls in the future. In this way, futures contract allows an
investor to manage his price risk.
Similarly, a sugar manufacturing company could hedge against any probable loss in the
future due to a fall in the prices of sugar by holding a short position in the futures/ forward’s
market. If the prices of sugar fall, the company may BSE on the sugar sale but the loss will be
offset by profit made in the futures contract.

2. Long hedge
A long hedge involves holding a long position in the futures market. A long position holder
agrees to buy the underlying asset at the expiry date by paying the agreed futures/ forward
price. This strategy is used by those who will need to acquire the underlying asset in the
future.
For example, a chocolate manufacturer who needs to acquire sugar in the future will be
worried about any loss that may arise if the price of sugar increases in the future. To hedge
against this risk, the chocolate manufacturer can hold a long position in the sugar futures. If
the price of sugar rises, the chocolate manufacture may have to pay more to acquire sugar in
the normal market, but he will be compensated against this loss through a profit that will arise
in the futures market. Note that a long position holder in a futures contract makes a profit if
the price of the underlying asset increases in the future.
Long hedge strategy can also be used by those investors who desire to purchase the
underlying asset at a future date (that is, when he acquires the cash to purchase the asset) but
wants to lock the prevailing price in the market. This may be because he thinks that the
prevailing price is very low.

For example, Suppose the current spot price of WIPRO ltd. Is RS. 650 per stock. An investor
is expecting to have RS. 650 at the end of the month. The investor feels that WIPRO ltd. Is at
a very attractive level and he may miss the opportunity to buy the stock if he waits till the end
of the month. In such a case, he can buy WIPRO ltd. In the futures market. By doing so, he
can lock in the price of the stock. Assuming that he buys WIPRO ltd.
In the futures market at RS. 650 (this becomes his locked in price), there can be three
probable scenarios:
Scenario 1: Price of WIPRO ltd. In the cash market on expiry date is RS. 700.
As futures price is equal to the spot price on the expiry day, the futures price of WIPRO
would be at RS. 700 on expiry day. The investor can sell WIPRO ltd in the futures market at
RS. 300. By doing this, he has made a profit of 700-650= RS. 50 in the futures trade. He can
now buy WIPRO ltd in the spot market at RS. 300. Therefore, his total investment cost for
buying one share of WIPRO ltd equals RS.700 (price in spot market) 50 (profit in futures
market) = RS.650. This is the amount of money he was expecting to have at the end of the
month. If the investor had not bought WIPRO ltd futures, he would have had only RS. 650
and would have been unable to buy WIPRO ltd shares in the cash market. The futures
contract helped him to lock in a price for the shares at RS. 650.

Scenario 2: Price of WIPRO ltd in the cash market on expiry day is RS. 650.
As futures price tracks spot price, futures price would also be at RS. 650 on expiry day. The
investor will sell WIPRO ltd in the futures market at RS. 650. By doing this, he has made RS.
0 in the futures trade. He can buy WIPRO ltd in the spot market at RS. 650. His total
investment cost for buying one share of WIPRO will be = RS. 650 (price in spot market) + 0
(loss in futures market) = RS. 650.

Scenario 3: Price of WIPRO ltd in the cash market on expiry day is RS. 600.
As futures price tracks spot price, futures price would also be at RS. 600 on expiry day. The
investor will sell WIPRO ltd in the futures market at RS. 200. By doing this, he has made a
loss of 600-650 RS. 50 in the futures trade. He can buy WIPRO in the spot market at RS.
600. Therefore, his total investment cost for buying one share of WIPRO ltd will be = 600
(price in spot market) + 50 (loss in futures market) RS. 650.

Thus, in all the three scenarios, he has to pay only RS. 250. This is an example of a long
hedge.
Speculators - A speculator is one who bets on the derivatives market based on his views on
the potential movement of the underlying stock price. Speculators take large, calculated risks
as they trade based on anticipated future price movements. They hope to make quick, large
gains; but may not always be successful. They normally have shorter holding time for their
positions as compared to hedgers. If the price of the relying moves as per their expectation,
they can make large profits. However, if the price moves in the opposite direction of their
assessment.
For E.g. - Currently HDFC bank (HDFC) is trading at, say, RS. 1500 in the cash market and
also at RS. 1500 in the futures market. A speculator feels that post the RBI policy
announcement, the share price of HDFC will go up. The speculator can buy the stock in the
spot market or in the derivatives market. If the derivatives contract size of ICICI is 500 and if
the speculator buys one futures contract of HDFC, he is buying HDFC futures worth RS.
1500 x 500 RS. 750,000. For this he will have to pay a margin of say 20% of the contract
value to the exchange. The margin that the speculator needs to pay to the exchange is 20% of
RS. 750,000 = RS. 150,000. This RS. 150,000 is his total investment for the futures contract.
If the speculator would have invested RS. 150,000 in the spot market, he could purchase only
150,000/1500= 100 shares.
Let us assume that post RBI announcement price of HDFC share moves to RS. 1520. With
one lakh and fifty thousand investment each in the futures and the cash market, the profits
would be:
(1520-1500) x 500 RS. 10,000 in case of futures market and
(1520-1500) x 100 = Rs. 2000 in the case of cash market.
It should be noted that the opposite will result in case of adverse movement in stock prices,
where in the speculator will be losing more in the futures market than in the spot market. This
is because the speculator can hold a larger position in the futures market where he has to pay
only the margin money.

Arbitrageurs - Arbitrageurs attempt to profit from pricing inefficiencies in the market by

making simultaneous trades that offset each other and capture a risk-free profit. An
arbitrageur may also seek to make profit in case there is price discrepancy between the stock
price in the cash and the derivatives markets.
For example, if SBI share is trading at Rs. 580 in the cash market and the futures contract of
SBI is trading at Rs. 590, the arbitrageur would buy the SBI shares (i.e., Make an investment
of Rs. 580) in the spot market and sell the same number of SBI futures contracts. On expiry
day, the price of SBI futures contracts will close at the price at which SBI closes in the spot
market. In other words, the settlement of the futures contract will happen at the closing price
of the SBI shares and that is why the futures and spot prices are said to converge on the
expiry day. On expiry day, the arbitrageur will sell the SBI stock in the spot market and buy
the futures contract, both of which will happen at the closing price of SBI in the spot market.
Since the arbitrageur has entered into off-setting positions, he will be able to earn Rs. 10
irrespective of the prevailing market price on the expiry date.
There are three possible price scenarios at which SBI can close on expiry day. Let us
calculate the profit/ loss of the arbitrageur in each of the scenarios where he had initially
purchased SBI shares in the spot market at Rs 580 and sold the futures contract of SBI at Rs.
590:

Scenario 1: SBI shares closes at a price greater than 580 (say Rs. 700) in the spot market on
expiry day
SBI futures will close at the same price as SBI in spot market on the expiry day i.e., SBI
futures will also close at Rs. 700.
Profit/ loss (-) in spot market 700-580 = Rs. 120
Profit/ loss (-) in futures market = 590- 700 Rs. (-) 110
Net profit/ loss (-) on both transactions combined = 120-110 = Rs. 10profit.

Scenario 2: SBI shares close at Rs 580 in the spot market on expiry day.
SBI futures will close at the same price as SBI in spot market on expiry day i.e., SBI futures
will also close at Rs 580. The arbitrageur reverses his previous transaction.
Profit/ loss (-) spot market 580-580 = Rs.0
Profit/ loss (-) in futures market 590- 580 = Rs. 10
Net profit/ loss (-) on both transactions combined=0+ 10 = Rs. 10profit.

Scenario 3: SBI shares close at Rs. 500 in the spot market on expiry day.
Here also, SBI futures will close at Rs. 500. The arbitrageur reverses his previous transaction
entered into on 1 august 2009.
Profit/ loss (-) in spot market = 500- 580 = Rs. (-) 80
Profit/ loss (-) in futures market 590-500 = Rs. 90
Net profit/ loss (-) on both transactions combined = (-) 80 +90 Rs.10 profit.

Thus, in all three scenarios, the arbitrageur will make a profit of Rs. 10, which was the
difference between the spot price of SBI and futures price of SBI, when the transaction was
entered into. This is called a "risk less profit" since once the transaction is entered (due to the
price difference between spot and futures), the profit is locked.
irrespective of where the underlying share price closes on the expiry date of the contract, a
profit of Rs. 10 is assured. The investment made by the arbitrageur is Rs. 580 (when he buys
SBI in the spot market). He makes this investment and gets a return of Rs. 10 on this
investment in 23 days. This means a return of 0.56% in 23 days. If we annualize this, it is a
return of nearly 9% per annum. One should also note that this opportunity to make a risk less
return of 9% per annum will not always remain. The difference between the spot and futures
price arises due to some inefficiency (in the market), which was exploited by the arbitrageur
by buying shares in spot and selling futures. As more and more such arbitrage trades take
place, the difference between spot and futures prices would narrow thereby reducing the
attractiveness of further arbitrage.
1.7.2 Intermediary participants
1. Brokers
2. Market maker and jobber

Brokers - For any purchase and sale, brokers perform an important function of bringing
buyers and sellers together. As a member in any futures exchanges, may be any commodity
or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a
commodity or financial futures exchange one can get a right to transact with other members
of the same exchange. This transaction can be in the pit of the trading hall or on online
computer terminal. All persons hedging their transaction exposures or speculating on price
movement, need not be and for that matter cannot be members of futures or options
exchange. A non-member has to deal in futures exchange through member only. This
provides a member the role of a broker. His existence as a broker takes the benefits of the
futures and options exchange to the entire economy all transactions are done in the name of
the member who is also responsible for final settlement and delivery. This activity of a
member is price risk free because he is not taking any position in his account, but his other
risk is clients default risk. He cannot default in his obligation to the clearing house, even if
client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more
involvement of non-members in hedging and speculation in futures and options market will
increase brokerage business for member and more volume in turn reduces the brokerage.
Thus, more and more participation of traders other than members gives liquidity and depth to
the futures and options market. Members can attract involvement of other by providing
efficient services at a reasonable cost. In the absence of broking houses, the futures exchange
can only function as a club
Market maker and jobber - Even in organised futures exchange, every deal cannot get the
counter party immediately. It is here the jobber or market maker plays his role. They are the
members of the exchange who takes the purchase or sale by other members in their books and
then square off on the same day or the next day. They quote their bid-ask rate regularly. The
difference between bid and ask is known as bid-ask spread. When volatility in price is more,
the spread increases since jobber’s price risk increases. In less volatile market, it is less.
Generally, jobbers carry limited risk. Even by incurring loss, they square off their position as
early as possible. Since they decide the market price considering the demand and supply of
the commodity or asset, they are also known as market makers. Their role is more important
in the exchange where outcry system of trading is present. A buyer or seller of a particular
futures or option contract can approach that particular jobbing counter and quotes for
executing deals. In automated based trading best buy and sell rates are displayed on screen,
so the role of jobber to some extent. In any case, jobbers provide liquidity and volume to any
futures and option market.
1.7.3 Institutional framework
1. Exchange
2. Clearing house
3. Custodian
4. Bank for fund movements

Exchange - Exchange provides buyers and sellers of futures and option contract necessary
infrastructure to trade. In outcry system, exchange has trading pit where members and their
representatives assemble during a fixed trading period and execute transactions. In online
trading system, exchange provide access to members and make available real time
information online and also allow them to execute their orders. For derivative market to be
successful exchange plays a very important role, there may be separate exchange for financial
instruments and commodities or common exchange for both commodities and financial
assets.
Clearing house - A clearing house performs clearing of transactions executed in futures and
option exchanges. Clearing house may be a separate company or it can be a division of
exchange. It guarantees the performance of the contracts and for this purpose clearing house
becomes counter party to each contract. Transactions are between members and clearing
house. Clearing house ensures solvency of the members by putting various limits on him.
Further, clearing house devises a good managing system to ensure performance of contract
even in volatile market. This provides confidence of people in futures and option exchange.
Therefore, it is an important institution for futures and option market.
Custodian - Futures and options contracts do not generally result into delivery but there has to
be smooth and standard delivery mechanism to ensure proper functioning of market. In stock
index futures and options which are cash settled contracts, the issue of delivery may not arise,
but it would be there in stock futures or options, commodity futures and options and interest
rates futures. In the absence of proper custodian or warehouse mechanism, delivery of
financial assets and commodities will be a cumbersome task and futures prices will not reflect
the equilibrium price for convergence of cash price and futures price on maturity, custodian
and warehouse are very relevant.
Bank for fund movements - Futures and options contracts are daily settled for which large
fund movement from members to clearing house and back is necessary. This can be smoothly
handled if a bank works in association with a clearing house. Bank can make daily
accounting entries in the accounts of members and facilitate daily settlement a routine affair.
This also reduces a possibility of any fraud or misappropriation of fund by any market
intermediary.
1.8 Risks involved in Derivatives trading
Risk is defined in financial terms as the chance that an outcome or investment's actual gains
will differ from an expected outcome or return. Risk includes the possibility of losing some
or all of an original investment. Each investor has a unique risk profile that determines their
willingness and ability to withstand risk. In general, as investment risks rise, investors expect
higher returns to compensate for taking those risks. A fundamental idea in finance is the
relationship between risk and return.
The major risks involved in derivative trading are
1. Counterparty risk
2. Price risk
3. Agency risk
4. Systemic risk
5. Liquidity risk
6. Interconnection risk

1. Counterparty risk – It is about three quarters of the derivatives contracts across the
world are entered over the counter. This means that there is no exchange involved and
hence there is a probability that the counterparty may not be able to fulfil its
obligations. This gives rise to the most obvious type of risk associated with
derivatives market i.e., counterparty risk. Counterparty risks are sometimes called
legal risk, default risk, settlement risk etc. Essentially all these risks refer to the same
risk. Parties not following through with their commitments could happen at various
stages. For instance, if the contract is not drafted then it would be called legal risk. On
the other hand, if the other party defaults on the day of the settlement, then it would
be called settlement risk.

2. Price risk - Derivatives trading is a new phenomenon due to which pricing of the
derivatives is a little unclear to all participants. There is always a risk that the majority
of the market may be mispricing these derivatives and may cause large scale default.
For example, long term capital management (ITCM) became part of a trillion dollars
default and became a prime example as to how even the smartest management may
end up wrongly guessing the price of derivatives.

3. Agency risk - Agency risk simply means that if there is a principal and an agent, the
agent may not act in the best interest of the principal because their objectives are
different from that of the principal. In this scenario it would mean that if a derivative
trader is acting on behalf of a client, the interests of the client and that of the trader
who is authorized to make decisions may be different.
4. System risk- System risk refers to the probability of widespread default in all financial
markets because of a default that initially started in derivative markets. In simple
words, this is the belief that because derivatives are so volatile, one major default can
cause cascading defaults throughout the derivatives market. These cascading defaults
will then spin out of control and enter the financial domain in general threatening the
existence of the entire financial system. Systemic risk pertaining to derivatives is not
faced by any particular party. It is faced by the entire system.

5. Liquidity risk - Liquidity risk applies to investors who plan to close out a derivative
trade prior to maturity. Liquidity risk is also important for investors interested in
derivatives trading. Such investors need to consider if it is difficult to close out the
trade or if existing bid-ask spreads are so large as to represent a significant cost.

6. Interconnection risk - Interconnection risk refers to how the interconnections between

various derivative instruments and dealers might affect an investor's particular
derivative trade. Some analysts express concern over the possibility that problems
with just one party in the derivatives market, such as a major bank that acts as a
dealer, might lead to a chain reaction or snowball effect that threatens the stability of
financial markets overall.