Derivatives:

• Derivatives are those Assets whose value is determined

from the value of some underlying Assets. The underlying
Assets may be Equity, Commodity or Currency.
• The list of Derivative assets is long. The Derivatives are
the most modern financial instruments in hedging risk.
• The individuals & firms who wish to avoid or reduce risk
can deal with others who are willing to accept the risk for a
price.
• A common place where such transactions take place is
called the ‘Derivative Market’.
• As the financial products commonly traded in the
Derivatives market are themselves not primary loans or
securities but can be used to change the risk
characteristics of underlying Asset or Liability position,
they are referred to as ‘Derivative Financial Instruments or
simply Derivatives.’
• These instruments are so called because they derive their
value from some underlying instrument and have no intrinsic
value of their own.
• Derivative products can be classified into the following main
types:

1. Forwards
2. Futures
3. Options
4. Swaps
5. Warrants
6. Leaps &
7. Baskets
• Out of these Futures & Options are actively traded on
organized stock exchanges whereas Forwards are traded in
OTC Exchanges
1. Forward Contract:
A forward contract is the simplest of the Derivative
products.
• It is a mutual agreement made today between two
parties (Buyer & Seller), in which the buyer agrees to
buy a quantity of an asset / instrument for cash at a
predetermined future date at the specific price agreed
upon today from the seller.
• The agreed upon price is called as ‘Forward price’ with
a forward market the transfer of ownership occurs on
the spot, but delivery of the commodity or instrument
doesn’t occur until some future date.
• Here, 2 parties agree to do a trade at some future date,
at a stated price & quantity. No money changes hands
at the time the deal is signed.
• The Price of the contract does not change before
delivery.
• These type of contracts are binding, which means both the buyer and
seller must stay committed to the contract. This means they are bound
to deliver or take delivery of the product on which the forward contract
was agreed upon. Forwards contracts are very useful in hedging.
E.g.
• A wheat farmer may wish to contract to sell their harvest at a future
date to eliminate the risk of change in prices by that date. Such a
transaction will take place through a Forward market.
• Forward contracts are not traded on an exchange, they are said to
trade over the counter exchange (OTC ).
• The quantities of the underlying asset & terms of agreement are fully
negotiable. The secondary market doesn’t exist for the Forward
contracts & faces the problem of Liquidity & Negotiability.
• Important Characteristics of Forwards Contracts:

1. They are Over the counter (OTC) contracts.

2. Both the buyer and seller are bound by the contractual
terms.
3. The Price remains fixed.

• Limitations of Forwards contracts:

1. Lack of centralized trading. Any two individuals can enter
into a forwards contract.

2. Lack of Liquidity.

3. Counterparty risk - The case wherein either the buyer or

seller does not honour his end of the contract.
• In a forward contract, a user (holder) who promises to
buy the specified asset at an agreed price at a fixed
future date is said to be in ‘Long position’.
• While a user (holder) who promises to sell the specified
asset at an agreed price at a fixed future date is said to
be in ‘Short position’.
• Thus, Long & Short position take the form of Buy & Sell
in FC.
2. Futures Contract:
• It is traded on a futures exchange as a standardized contract,
subject to the rules & regulations of an Exchange.
• It is the standardization (Specified quantity, grade, coupon rate,
maturity) of the Futures contract facilitates the secondary
market trading.
• It relates to a given quantity of the underlying asset & only
whole contracts can be executed /traded and trading of
fractional contracts are not allowed.
• The terms of the futures contracts are not negotiable.
• A futures contract is a financial security, issued by an
organized exchange to buy or sell a commodity , security
or currency at a predetermined future date at a price
agreed upon today.
• The Contractual terms of the futures contracts are very clear.
The Futures market was designed to solve the shortcomings in
the forwards contracts.
•
• Unlike forwards, futures are traded in organized
exchanges. They also use a clearing house (Futures
Exchange) that provides the necessary protection to both
the buyer and the seller.
• The price of the futures contract can change prior to
delivery. Hence, both participants must settle daily price
changes as per the contract values.
• Over the Counter Trading ( OTC) : Forward contracts
are purely privately arranged agreements & hence, the
are not at all standardized ones. They are traded Over
the Counter & not in exchanges.
• There is much flexibility since the contract can be
modified according to the requirements of the parties to
the contract.
• Parties enter into this kind of contract on the basis of
custom & hence it is called ‘customized contracts.’
• Characteristics of Futures contract:

1. They are traded in organized exchanges.

2. Credit risk is eliminated with the margin system. Both

parties deposit a portion of the contract with the clearing
house.

3. Both the buyer and seller are bound by the contract terms
and are expected to honour their end of the contract.
4. Settlement : Though Future contracts can be held till
maturity , they are not so in actual practice. Future
instruments are marked to the market & the exchange
records profit & loss on them on daily basis. i.e. once a FC is
entered into, profits or losses to both the parties are
calculated on a daily basis.
• The difference between the Spot price & future price on
that day constitutes either profit or losses depending upon
the prevailing Spot prices.
• The Spot price is the market price prevailing then.
• E.g. on Monday morning A enters into a futures agreement
with B to buy 50 bales of cotton at Rs. 100 per bale on
Friday afternoon. At the close of the trading day on
Monday, the futures price goes up by Rs. 10 per bale.
Now, X will get a cash profit of Rs. 500 ( 50 bales @ Rs. 10
per bale). X can also cancel the existing FC with the price
Rs. 100 per bale or he can enter into a new FC @Rs.110
per bale.
• Generally these profits or losses are accumulated in the
margin A/cs of the parties. But, if there are continuous
losses, & if the initial margin falls below a minimum level
called ‘maintenance margin’, then the exchange authorities
will interfere.
• In such a situation, the contract automatically lapses.
The default risk due to such lapse is limited to the profit
or loss booked during the day.
• Since, the exchange guarantees the performance of the
contract by both the counter parties, the default risk is
borne by the exchange.
• The delivery of the asset in question is not essential on
the maturity date of the FC. Generally, parties simply
exchange the difference between the Spot & Future
prices on the date of maturity.
• The standardization of the FCs fetches the potential
buyers & sellers & increases the marketability and
liquidity of the contracts.
• Hedging: The classic Hedging application would be
that of a wheat farmer futures selling his harvest at a
known price in order to eliminate price risk.
• Conversely, a bread factory may want to buy wheat
futures in order to assist production planning without
the risk of price fluctuations.
• The main feature of FC is Hedging against the price
fluctuations. The buyers of a FC hope to protect
themselves from future spot price increases & the
sellers from future spot price decreases.
• Parties enter into future agreements on the basis of
their expectations of the future price in the Spot market
for the Asset in question.
• Speculation:
if a speculator has information or analysis which
forecasts an upturn in a price, then he can go long on
the futures/forward market instead of cash market, wait
for the price rise & then take a reversing transaction.
• The use of Futures/ forwards market here gives leverage
to the speculator.