Unit 1 .

Introduction to Derivatives

Presented by-
Dr. Meera
Kalaskar.
Reference Books-
⚫Hull John C.- ‘Options, Futures and Other
Derivatives’
⚫S L Gupta- ‘Financial Derivatives-
Theory, Concepts and Problems’
⚫N R Parasuraman- ‘Fundamentals of
Financial Derivatives’
⚫Bhaskar P Vijaya, Mahapatra B-
‘Derivatives Simplified: An Introduction
to Risk Management’
Contents of the Unit
⚫Introduction to Derivatives
⚫Economic functions of derivatives,
⚫application of derivatives – for risk
management and speculation,
⚫basic terms and properties of options,
⚫futures and forwards.
Learning Objectives of the Session
⚫We are having this session on derivatives
with the core objective that students should
understand the basics of derivatives market.
⚫What is mean by derivative? What is
derivatives market?
⚫What are the other markets and how
derivatives market linked with those other
markets?
⚫To know about the historical background of
derivatives and some important concepts
related to it.
Derivatives??
⚫Welcome to the
fascinating world of
Derivatives!!
⚫Someone said that
‘well begun is half
done’
⚫To ensure we begin
right, this chapter is
designed to lay down
the foundations of
derivatives in a lucid
manner.
 How Derivatives comes into picture?
⚫ The source of derivatives
can be traced back to the
need of farmers to protect
themselves against
fluctuations in the price of
their crop from the time of
sowing to the time of crop
harvest.
⚫ Through the use of simple
derivative products, it was
F possible for the farmer to
Y O partially or fully transfer
INT
TA price risks by locking-in
E R asset prices.
C
UN CES
I
PR
⚫These were simple contracts developed to
meet the needs of farmers and were basically
a means of reducing risk.
⚫A farmer who sowed crop in the month of
June face uncertainty over the price and
farmer may receive harvest in the month of
September. In years of scarcity, farmer
probably obtains attractive prices. However,
during times of oversupply, farmer would
have to dispose off his harvest at a very low
price. Clearly this meant that the farmer was
exposed to a high risk of price uncertainty.
 ⚫On the other hand, a
merchant with ongoing
requirement of grains
too would face a price
risk - that of having to
pay exorbitant prices
during dearth, although
I CE S? favorable prices could
S I N PR be obtained during
T I ON
UC TUA periods of oversupply.
FL
⚫Under such circumstances, it clearly made sense
for the farmer and the merchant to come together
and enter into a contract where by the price of the
grain to be delivered in the month of September
could be decided earlier
⚫What they would then negotiate happened to be a
future-type contract, which would enable both
parties to eliminate the price risk.
⚫Financial markets are by nature extremely volatile
and hence, the risk factor is an important concern.
Derivatives have a significant place in finance and
risk management.
⚫Derivative indicates that the product or
contract has no independent value, which
means it derives value from some underlying
assets.
⚫These underlying assets can be securities,
commodities, bullion, currency, livestock and
so forth.
⚫To put it in simple words, derivative is a
product/contract of predetermined, fixed
duration, linked for the purpose of contract
fulfillment to the value of a specified asset.
Derivatives
⚫ If you are connected to any kind of financial market or
watch the financial news even for 5 minutes every
day, it is likely that you have heard the word, financial
derivatives many times. The media is flush with
articles wherein derivatives are criticized or
appreciated. Most of the times, commentators are in
awe of the mind-numbingly large amounts behind
these contracts.
⚫ It is often said that the total amount of derivatives
contracts in the worlds, is actually greater than the
total amount of money available in the world! How
can this happen? Well, to understand this we will have
to look into a little deeper into the subject of
derivatives. The features are-
Future Date

⚫A derivative contract is essentially a contract. The

contract specifies that some future commodity
may be exchanged at a later date at a price fixed
today. Notice the fact that the agreement would
basically be worthless if not for the time
difference between the setting of the price and the
actual execution of the trade.
⚫Since the price is set today, let’s say at $100 and
the transaction takes place a month from now
when the price could be any amount greater or
lower than $100, the derivative contract becomes
valuable. The derivative contract becomes a
license to purchase commodities at below market
prices and book an immediate gain.
Obligation vs. Option

⚫ Derivative contracts are characterized by the actual trade taking place at a

future date. However, there can two types of contracts. Some contracts are
symmetrical. This means that the buyer and seller are both bound to the
contract. In other words, there is an obligation for both of them to go
through with the trade. Consider a contract between a farmer and a
merchant wherein both of them are obligated to sell and buy (respectively)
a farm’s produce.
⚫ There are other derivative contracts which are asymmetrical. This means
that one party has the right to but not the obligation to follow through with
the contract. Consider the above mentioned case. Let’s suppose that a
contract is drawn up wherein the farmer has an option to sell the produce to
the merchant. This means that the farmer can decide whether or not he
wants to follow through with the transaction. The merchant on the other
hand is obligated to follow through with the transaction.
⚫ It must be noted, that there cannot be a contract wherein both parties hold
options. The option must be held by only one party. If both parties hold
options, then there isn’t a contract at all because no decision has been
made!
Time Restriction

⚫Since derivatives are contracts, they have an

expiration date. This means that after a
certain date they become completely
worthless. Hence they must be utilized
within a given time period or else they do not
hold any value. This is opposed to the
general notion of financial assets. Financial
assets like stocks and bonds usually hold
value for a much larger period of time.
Derivatives on the other hand hold value for
an extremely short period of time and this is
their defining feature.
Settlement

⚫Theoretically speaking, derivative contracts

can be settled in both cash as well as kind.
This means that the person executing the
contract has the right to ask for delivery of
the underlying commodity or the amount of
money which is equivalent to the underlying
commodity.
⚫However, in reality derivative contracts are
usually always settled in cash. Asking for
delivery of the underlying commodity is an
unheard of occurrence in the modern world.
Zero Sum Game

⚫Derivative contracts are a zero sum game.

This means that the parties in a derivative
contract are directly betting against each
other. If one party wins, the other party by
definition has to lose. This is opposed to
the stock market when a rising stock price
can be beneficial for everyone who is
holding that stock.
Why are Derivatives Useful?
⚫The key motivation for such instruments is that
they are useful in reallocating risk either across
time or among individuals with different risk
bearing preferences.
⚫One kind of passing on of risk is mutual
insurance between two parties who face the
opposite kind of risk. E.g. in the context of
currency fluctuations, exporters face losses if the
rupee appreciates and importers face losses if the
rupee depreciates. By forward contracting in the
dollar-rupee forward market, they supply
insurance to each other and reduce risk.
⚫Derivatives supply a method for people to do
hedging and reduce their risks. As compared with
an economy lacking these facilities, it is a
considerable gain.
⚫The ultimate importance of a derivatives market
hence hinges upon the extent to which it helps
investors to reduce the risks that they face.
⚫Some of the largest derivatives markets in the
world are on treasury bills (to help control interest
rate risk), the market index (to help control risk
that is associated with fluctuations in the stock
market) and on exchange rates (to cope with
currency risk).
 The Global Derivatives Industry:
Chronology of Instruments
Year Derivatives Introduced
1874 Commodity Futures
1972 Foreign Currency Futures
1973 Equity Options
1975 T-bond futures
1981 Currency Swaps
1982 Interest rate swaps, T-note futures, Eurodollar Futures, Equity
index futures, Options on T-bond futures, Exchange listed
currency options

1983 Options on equity index, options on T-note Futures, Options on

currency Futures

1985 Eurodollar Options, swaptions

1987 OTC Compound options, OTC average options

Year Derivatives Introduced

1989 Futures on Interest Rate Swaps, Quanto Options

1990 Equity Index swaps
1991 Differential Swaps
1993 Captions, Exchange-listed Flex options
1994 Credit Default Options
Why derivatives??
⚫ Risk is a characteristic feature of all commodity and capital
markets.
⚫ Prices of all commodities both agricultural and non-
agricultural commodities are subject to fluctuations overtime
keeping with the prevailing supply and demand conditions.
⚫ Similarly, the price of shares, debentures, and bonds and
other securities are also subject to continuous change.
⚫ Therefore, the sellers and buyers are constantly and
continuously exposed to the risk of losses on account of
fluctuations in the prices of such assets.
⚫ Thus, Derivatives came into picture primarily to deal with
and also to eliminate such price risks in commodity and
security market.
⚫ A Derivative is a financial instrument of Risk Management.
Why Derivatives in India??
Origin
Types of Derivative Contracts
⚫The basic purpose of these instruments is to
provide commitments to prices for future dates for
giving protection against adverse movements in
future prices, in order to reduce the extent of
financial risks.
⚫Not only this, they also provide opportunities to
earn profit for those persons who are ready to go
for higher risks.
⚫In other words, these instruments, facilitate to
transfer the risk from those who wish to avoid it
to those who are willing to accept the same.
Derivative
⚫A word formed by derivation. It means,
this word has been arisen by derivation.
Something derived, it means that some
things have to be derived or arisen out of
the underlying variables. For example,
financial derivative is an instrument
derived from the financial market.
⚫Derivatives are structurally related to
other substances.
Features of Derivatives
1. A derivative instrument relates to the future contract
between 2 parties. It means there must be a contract
binding on the underlying parties and the same to be
fulfilled in future. The future period may be short or
long depending upon the nature of contract. E.g, short
term interest rate futures and long term interest rate
futures contract.
2. Normally the derivative instruments have the value
which derived from the values of other underlying
assets, such as agricultural commodities, metals,
financial assets, intangible assets etc. Value of
derivatives depends upon the value of underlying
instrument and which changes as per the changes in
underlying assets, and sometimes, it may be nil or
zero. Hence they are closely related.
3. In general, the counter parties have specified
obligation under the derivative contract. So,
nature of the obligation would be different as per
the type of the instrument of a derivative. For
example, the obligation of the counter parties,
under the different derivatives, such as forward
contract, future contract, option contract and swap
contract would be different.
4. Derivatives are mostly secondary market
instruments and have little usefulness in
mobilizing fresh capital by the corporate world.
Warrants and convertibles are exception in this
respect.
Economic Functions of Derivatives
How can derivatives be used for Risk
Management?
⚫Derivatives can be used in risk management
to hedge a position, protecting against the
risk of an adverse move in an asset.
⚫A derivative is a contractual agreement
between two parties in which one party is
obligated to buy or sell the underlying
security and the other has the right to buy or
sell the underlying security. Hedging is the
act of taking an offsetting position in a
related security, which helps to mitigate
against opposite price movements.
Explanation with Example
⚫ Assume an investor bought 1,000 shares of Tesla Motors Inc. on May 9, 2015, for $65 a
share. He held onto his investment for over two years and is now afraid that Tesla will be
unable to meet its earnings per share (EPS)Assume an investor bought 1,000 shares of
Tesla Motors Inc. on May 9, 2015, for $65 a share. He held onto his investment for over
two years and is now afraid that Tesla will be unable to meet its earnings per share
(EPS) and revenue expectations.
⚫ Tesla's stock price opens at a price of $243.93 on May 15, 2018. The investor wants to
lock in at least $165 of profitsTesla's stock price opens at a price of $243.93 on May 15,
2018. The investor wants to lock in at least $165 of profits per share on his investment. To
hedge his position against the risk of any adverse price fluctuations the company may
have, the investor buys 10 put option contractsTesla's stock price opens at a price of
$243.93 on May 15, 2018. The investor wants to lock in at least $165 of profits per share
on his investment. To hedge his position against the risk of any adverse price fluctuations
the company may have, the investor buys 10 put option contracts on Tesla with a 
strike price of $230 and an expiration date on Sept. 7, 2018.
⚫ The put optionThe put option contracts, which are a type of derivative, give the investor
the right to sell his shares of Tesla for $230 a share. Since one stock optionThe put
option contracts, which are a type of derivative, give the investor the right to sell his
shares of Tesla for $230 a share. Since one stock option contract leverages 100 shares of
the underlying stock, the investor could sell 1,000 (100 x 10) shares with 10 put options.
⚫ Tesla is expected to report its earnings on Sept. 5, 2018. If Tesla misses its earnings
expectations and its stock price falls below $230, the investor has locked in a sell price of
$230 with his put options. So he could sell 1,000 shares, gaining a profit of $165 ($230 -
$65) per share.
Classification of Derivatives
Understanding basic terms of Derivatives
⚫The market is so large and so different from
the other markets that it has its own
language. A new person trying to trade
derivatives may not even understand the
information that is being offered to them. It
is therefore necessary to understand the
vocabulary of this market before making any
trades. 
⚫These terms are the most frequently used
ones and are therefore used for illustration
purpose.
⚫Long Position: When we trade stocks or
bonds, we are either on the buying side or on
the selling side. However, the terminology
used in the derivatives market is markedly
different. Here if you are the person buying
a derivative contract, then you are on the
long side of the contract. In the market, this
is simply referred to as going long.
⚫Hence, for example if you buy a contract
wherein you agree to exchange $1000 for
900 Euros, you are going long on the dollar.
⚫Short Position: The opposite of going long is
called going short. In simple words, this means
that you are the seller of a derivative contract.
In the derivatives market being a seller means
having a short term horizon and therefore you are
shorting the underlying financial instrument.
⚫Hence, in the same example, if you agree to
exchange $1000 for 900 Euros, then you are
going long on the dollar but short on the Euro.
Similarly, if you agree to deliver 100 bushels of
wheat to someone at a later date for a fixed price,
you are going short on the wheat.
⚫Expiration: Derivatives are time bound
financial instruments. This means that they
come with an expiration date. They have
intrinsic worth only up till that date and post
that date they are worthless. Expiration date is a
term usually used when we refer to options in
particular. When we talk about forwards, swaps or
futures, the expiration date is replaced by the
settlement date. However, the idea remains the
same. Expiration date is when the contract is
finally unwound and the profits and losses due
become a reality. Simply put that is the end of the
agreement.
⚫ Market Maker: A market maker is someone who provides
both buy and sell quotes for financial assets. In case of
derivatives market, these assets are derivatives. The purpose
of the market maker is to provide liquidity to the market.
Let’s say that you wanted to sell off a derivative security that
you had and you go to the market. Now, it is a real task to
find another buyer when you want to sell. Hence, instead
there is one party that is always willing to both buy as well as
sell. Hence, if you want to sell you go to the market maker
and also if you want to guy to buy, you go to the same market
maker. The market maker never holds the other side of the
bet. If they go long on a certain trade with you, they will
immediately find someone with whom they can go short with.
This cuts them out of the trade and in the end you are holding
the long end of the deal whereas the other party is holding the
short end.