You are on page 1of 4

Introduction: Derivatives are a type of financial instrument that few of us understand and fewer still fully appreciate, although

many of us have invested indirectly in derivatives by purchasing mutual funds or participating in a pension plan whose underlying assets include derivative products. In a way, derivatives are like electricity. Properly used, they can provide great benefit. If they are mishandled or misunderstood, the results can be catastrophic. Derivatives are not inherently "bad". When there is full understanding of these instruments and responsible management of the risks, financial derivatives can be useful tools in pursuing an investment strategy. This project attempts to familiarize with financial derivatives, their use and the need to appreciate and manage risk. Or

Introduction to derivatives The emergence of the market for derivative products, most notably forwards, futures and options, can be traced back to the willingness of risk-averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, the financial markets are marked by a very high degree of volatility. Through the use of derivative products, it is possible to partially or fully transfer price risks by locking-in asset prices. As instruments of risk management, these generally do not influence the fluctuations in the underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors. Derivative products initially emerged, as hedging devices against fluctuations in commodity prices and commodity-linked derivatives remained the sole form of such products for almost three hundred years. The financial derivatives came into spotlight in post1970 period due to growing instability in the financial markets. However, since their emergence, these products have become very popular and by 1990s, they accounted for about two-thirds of total transactions in derivative products. In recent years, the market for financial derivatives has grown tremendously both in terms of variety of instruments available, their complexity and also turnover. In the class of equity derivatives, futures and options on stock indices have gained more popularity than on individual stocks, especially among institutional investors, who are major users of index-linked derivatives. Even small investors find these useful due to high correlation of the popular indices with various portfolios and ease of use. The lower costs associated with index derivatives vis-vis derivative products based on individual securities is another reason for their growing use.

INTRODUCTION : 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. Derivatives offer 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. In this era of globalisation, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk averse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk averse individuals by offering a mechanism for hedging risks. 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, oats, Soya beans, rice, crude oil, natural gas, gold, silver, and so on. 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. Similarly, many act as intermediaries dealing in derivative transactions. Derivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding, quantifying and managing financial risk. Derivatives contracts are used to counter the price risks involved in assets and liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk averse to those who are risk neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off-balance sheet activity for traditional lines of business. The exposure to derivatives by banks have implications not only from the point of capital adequacy, but also from the point of view of establishing trading norms, business rules and settlement process. Trading in derivatives differ from that in equities as most of the derivatives are market to the market. DEFINITION 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.

The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O): Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system. On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips. Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market. 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.
Table of Contents of Project Report: 1.Acknowledgement 2.Preface 3.Introduction - What is a derivative 4.History of Derivatives 5.Characteristics of derivatives 6 Types of derivatives 7.Forward contract 8. Future contract 9.Swaps 10.Options 11.Function of derivatives 12.Advantages of Derivatives 13.Disadvantages of derivatives 14.Risks associated with derivatives

15. Derivatives in Indian Market 16.How derivatives are actually traded 17. How derivatives are traded in Indian 18. Capital market 19.Recommendations 20. Annexure