Derivatives

By,
Hitesh Jain
 What are derivative
instruments?

A derivative is an instrument whose value is

derived from the value of one or more
underlying asset, which can be
commodities, precious metals, currency,
bonds, stocks, indices, etc.
 Why Derivatives?

There are several risks inherent in

financial transactions. Derivatives allow you
to manage these risks more efficiently by
unbundling the risks and allowing either
hedging or taking only one (or more if
desired) risk at a time.
 Four most common derivative
instruments

• Forwards

• Futures

• Options

• Swaps.
 What are forwards ?

• A: A forward contract is a contract between two people who agree to

buy/sell a specified quantity of a financial instrument/commodity at a
certain price at a certain date in future.

For example, Mr X and Mr Y. Mr X is a wholesale sugar dealer and Mr Y

is the prospective buyer. Mr Y agrees to buy 30 kg of sugar at Rs 15 per
kg after three months. The price is arrived at on the basis of prevailing
market conditions and future perceptions about the price of sugar .

If after three months, the market price of sugar is Rs 20 per kg, then Mr
Y is a gainer. and if the price of sugar is Rs 10 per kg, then Mr X is a
gainer.
 What are futures?

Futures are exchange traded contracts to

sell or buy financial instruments or physical
commodities for Future delivery at an
agreed price..
 How are futures different from
forwards?
• A The basic difference is that while forward contracts are customised, futures contracts are
standardised.

A customised contract means that Mr X and Mr Y can enter into it on the basis of mutual
needs, and there is no one else to determine the terms of their contract.

In futures, on the other hand, the stock exchange offers certain fixed/standardised contracts
for investors to pick up and trade. Thus, unlike Mr X and Mr Y, who have the freedom to enter
into a contract for any length of time, in futures investors have to choose from the series of
contracts offered for various durations. For example, one month, two months, three months.

In a forward market, both buyer and seller deal with each other, while in futures market, both
buyers and sellers are faceless. Both deal with the exchange and exchange in turn assures
performance of the contract.

Default risk is very high in forward contracts while in futures contracts the exchange ensures
performance of the contract.
 OPTIONS

• An option is the right but not the obligation, to buy

or sell something at a stated date at a stated price.
As the word suggests option is a contract that gives you
an option, but not the obligation to buy or sell
something. Unlike futures, there is an option writer who
initiates the contract. An option writer is treated as the
seller of the contract.

– A “ Put option ” gives the right to Sell.

– A “ Call option ” gives the right to Buy
 SWAPS
• Swap is an agreement between two counterparties to
exchange two streams of cash flows—the parties "swap" the
cash flow streams. Those cash flow streams can be defined in
almost any manner.

• A swap can be defined as barter or an exchange. A swap is

contract whereby parties agree to exchange obligations that
each of them have under their respective underlying contracts
or we can say a swap is an agreement between two or more
parties to exchange sequence of cash flows over a period in
future . The parties that agree to swap are known as
counterparties.
 What is the scene on the
domestic front?

Futures' trading was launched on the BSE

on June 9, 2000, and on the NSE on June
12, 2000.
 Suppose I want to trade in
futures, what should I do?

To trade in futures, the person will first have to

approach a broker who is authorised to trade in
derivatives. Then the broker will tell him the
different series that are available. In India, both
the BSE and NSE offer futures on the Sensex
and Nifty respectively, and these are popularly
called as index futures.
 Risk in Derivatives
• Derivatives transactions allow investors to take large
price position in the market while committing a small
amount of capital.
• Taking these greater risks raises the likelihood that
investor makes or loses large amount of money.
• If they suffer losses, they are then threatened with
bankruptcy.
• If they go bankrupt, then the people, banks and other
institutions that invested in them or lent money to them
will face possible losses.