Unit-1:Introduction to

Derivatives Markets

Dr. C. Vijendra
M.Com, MBA, PhD.
 Learning Objectives
 Overview of the Derivative Market and Instruments.
 Evolutions of derivative markets in India since 2000 in Equity market,
commodities, Foreign exchange and Interest Rates.
 OTC and Exchange-traded markets.
 Types of Traders: Hedgers-Arbitrageurs- speculators.
 What is Derivative?
Derivative is a financial instrument which derives its value from an
underlying asset
Financial instruments include shares, bonds, debentures
Derivatives are based on wide range of underlying assets such as
(a) metals like gold, silver, copper, etc
(b) Energy sources like crude oil, coal, electricity, natural gas, etc.
(c ) Agricultural commodities like Wheat, Maize, Coffee, Sugar, etc
 EXAMPLE -1

Therefore, this payback card

is deriving its value from the
underlying asset i.e. Credit
card
The more you swipe the credit card,
more points is gained and added to
pay back card.
The payback card
is what ? Not a debit card nor a credit card, but linked toThe value of the pay back
Credit card increases when the underlying
asset i.e. card spent increases
A DERIVATIVE
However, you redeem your points later on.
EXAMPLE-2
If value of the
Reliance Industries Stock underlying asset
5 increases, the value
4.5 of the derivative
4
also increases.
3.5
If value of the
3 underlying asset
2.5 decreases, the value
2
of the derivative
also decreases
1.5

1 The underlying asset

0.5 for this example-2 is
0
Reliance Industries
STOCK DERIVATIVE Stock
Series 1 Column1
 EXAMPLE-3 COMMODITY
DERIVATIVE
Wheat Derivative
5

4.5

4
If value of the underlying
3.5 asset increases, the value of
3 the derivative also increases.
2.5
If value of the underlying
2 asset decreases, the value of
1.5 the derivative also decreases
1
The underlying asset for this
0.5 example-3 is WHEAT
0
Wheat Derivative
Wheat
 CURRENCY DERIVATIVES
EXAMPLE-4

If value of the underlying

US DOLLAR DERIVATIVE asset becomes stronger, then
5 the value of the derivative
4.5 also becomes stronger in FX
4
market.
3.5
If value of the underlying
3 becomes weake, the value of
2.5 the derivative also becomes
2
weake in FX market
1.5
The underlying asset for this
1
example-4 is US Dollar
0.5

0
US DOLLAR DERIVATIVE

US $ DERIVATIVE
 Example -5
Nifty Derivative
5

4.5 If value of the

underlying asset
4
increases, the value
3.5 of the derivative also
increases.
3

2.5 If value of the

underlying asset
2 decreases, the value
of the derivative also
1.5
decreases
1
The underlying asset
0.5
for this example-5 is
0
Nifty
Nifty Derivative
 WHY DERIVATIVES ?

Primary for two

reasons

A. Speculate B. Hedge
 A. Speculation
To speculate or bet on something or trying to gauge the direction of the market
 Ex: Market goes up or down
 For example if market goes down then the trader shall make a Short sale :
Sell first and buy later
 Top to bottom (sell first and buy later) or bottom up approach (buy first sell
later).
 Top to bottom is correct approach and that is where the derivative comes
into play.
 If the market goes up or down, the position is not closed. It means after
selling the shares/nifty the position is still existing.
 Hedge
 Enter into the position to reduce the loss
 Bought stock worth Rs. 10 crores when market was at 11,600.
 If market is going down, the value of the stock is reduced to Rs. 5
crores
 Know the value of the stock in the portfolio is going down, in order to
reduce the loss, the trader takes a position to compensate the loss
 The trader enter into derivative contract with an intention to hedge,
but how?
Over the Counter Exchange Traded

Forward Market Future Market

Swaps Options
 Forwards
 It is a contractual agreement between two parties to buy/sell an underlying asset at a certain
future date for a particular price that is pre-decided on the date of contract.
 Both the contracting parties are committed and are obliged to honor the transaction
irrespective of price of underlying asset at the time of delivery.
 Since forwards are negotiated between two parties, the terms and conditions of contract are
customized.
 These are Over-the- Counter (OTC) contracts.
 Example of Forwards contract:
Mr. Andrew (A) Mr. Balla (B)

A and B Forex traders from Mumbai. They

know each other. A Want to sell 9950 US
dollars and B want to purchase the same
quantity from A. They entered in to a ₹-$
forward contract at the price of ₹73.15 per
US Dollar to be exchanged at A’s house in
Mumbai on 6th August, 2021.
 Futures contract
 A contract between two parties to buy or sell
an asset at a certain fixed time in the future
at a certain traded price on a recognized
exchange.

 Futures contacts are special types of forward

contracts in the sense that they are
standardized exchange-traded contracts.
 Example of Futures contract:

A and B Forex traders. A sold 10 lots of ₹-$

contract maturing in the month of August 2021 @
price of ₹76.50 per dollar through their broker on
NSEIL. Each lot represents 1000 us dollars.
B has purchased10 lots of ₹-$ contract maturing in
August 2021 on NSEIL at same price. The
settlement date Forex Futures is on 28th September,
2021.
 Difference between forwards and futures
Features Forward Contracts Future Contracts
Operational mechanism It is not traded in exchanges. It is exchange traded contract.

Contract Specification Terms of the contracts differ from trade to trade (tailor Terms of the contracts are standardize.
made contract) according to the need of the participants.

Counter party risk Exists, but at times gets reduced by guarantor. Exists but the clearing agreement associated with
exchanges becomes the counter party to all trades assuming
guarantee on their settlement.

Liquidity Profile Low, as contract are tailor made catering to the needs of the High, as contracts are standardized exchange traded
parties involve. Further, contract are not easily accessible to contracts.
other market participants.

Price discovery Not efficient, as markets are scattered. Efficient centralized trading platform helps all buyers and
sellers to come together and discover the price through
common order book.

Quality of information and its dissemination Quality of information may be poor. Speed of information Futures are traded national wide. Every bit of decision
dissemination is weak. related information is distributed very fast

Examples Currency markets are examples of forwards. Though Commodities futures, currency futures, index futures and
currency futures are introduced in India but yet a market for individual stock futures in India
currency forwards exists through banks
Options
Options are of two types – Call and Put.

Call option give the buyer the right but not the
obligation to buy a given quantity of the underlying
asset, at a given price on or before a given future
date.

Put option give the buyer the right, but not

obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.
 SWAPS
Swaps are customized contracts traded in the over-the-counter (OTC)
market privately, versus options and futures traded on a public
exchange.
In the case of companies, these derivatives or securities help limit or
manage exposure to fluctuations in interest rates or acquire a lower
interest rate than a company would otherwise be able to obtain. 
Hedging purpose
Interest rate swaps, currency swaps, commodity swaps, credit default
swaps, zero coupon swaps
*Example on interest rate and currency swaps.
Market Participants
 Speculators

 They try to predict the future movements in prices of underlying assets and based on the view, take position in
derivative contract.
 Derivatives are preferred over underlying asset for trading purpose, as they offer leverage, are less expensive (cost of
transaction is generally lower than that of underlying) and are faster to execute in size (high volume market).
 Hedgers

 They face risk associated with the prices of underlying assets and use derivatives to reduce the risk.
 Companies, investing institutions and banks all use derivative products to hedge or reduce their exposures to market variables
such as
 Interest rates
 Share values
 Bond prices
 Currency rates
 Commodity prices
Example: A farmer who sells future contracts to lock into a price for delivering a crop on future date
News paper clipping
 Arbitrageurs
 Arbitrage is a deal that produces profit by exploiting a price difference in a product in two different markets.
 Arbitrage originates when a trader purchases a asset cheaply in one location and simultaneously sells them at a higher price
in another location.
 Such opportunities are unlikely to persist for very long, since arbitrageurs would rush in to these transactions, thus closing
the price gap at different locations.
 History of Derivative Market

6th Century Greek Philosopher Aristotle

 Predicted demand for olive oil before Autumn

 Entered agreement with press owners before Autumn for exclusive use of their presses

 Deposited advance with agreement that he will not demand money if harvest is not good

 His predication came perfect

 Since he had rights to use them, he hired them and sold the olive oil at high prices and made big money.

 He knew well in advance that his maximum losses will be the advance he paid while his profit depend on what he demand
 History of Derivative Markets contd-2
Credit risk remained problem for US market.
In 1848 Chicago Board Of Trade (CBOT) was constituted to bring buyer
and seller of commodities to a common platform to negotiate forward
contracts.
In 1865 CBOT was listed as first exchange traded derivative in US, which
also called as “Futures Contract”.
Chicago Butter and Egg Board spined off from CBOT to Chicago
Mercantile Exchange to deal with future trading.
Therefore CBOT & CME are two largest future exchange in the world
The first stock index was traded at Kansas City Board of Trade.
During mid 80’s financial future became active derivatives and
generated volumes as compared to commodity futures.
Currently popular index futures contract is S&P 500
 International exchanges that trade in derivatives
 London International Financial Future Exchange (LIFFE), UK
 Deutsche Borse (DTB), Germany
 Singapore Exchange (SGX), Singapore
 Tokyo International Financial Future Exchange (TIFFE), Japan
 MAITIF - France
 Indian Scenario

1996 – Dr. LC Gupta Committee – for regulatory framework for derivatives

1998 – Prof. JR Verma Committee – for Risk containment measures in derivatives
1999 – SCR Act amended to include Derivative as Security
June 2000 – Trading In Index Futures started in NSE Nifty and BSE Sensex.
June 2001 – Trading in Index options commenced
July 2001 – Trading in stock options commenced
2008 – currency futures commenced
Feb. 2013 – Multi Commodity Exchange –Stock Exchange MCX-SX ( renamed now as
Metropolitan Stock Exchange of India MSEI) started trading in stock and index options and
futures. Its index is SX40
Futures contracts on Volatility Index were launched in 2014.