DERIVATIVES AND

RISK
MANAGEMENT
OVERVIEW
An introduction to derivatives
History of Derivatives
Forwards and Futures
Economic Rationale
Futures Terminology
 Introduction

• Financial markets around the world can be divided into the spot market (or
cash markets) and the forward markets.
• In the spot market, the trade is normally settled within a day or two.
• In the forward market, the trade is settled at a future date, but the terms are
decided today.
• Derivatives markets, simply speaking are nothing but forward markets.
 Introduction

• A Derivative is a financial instrument whose value is derived from the value of an underlying
asset.
• Underlying asset can be equity shares or index, precious metals, commodities, currencies,
interest rates etc.
• A derivative instrument does not have any independent value.
• Its value is always dependent on the underlying assets.
• Derivatives can be used either to mitigate risk (hedging) or assume risk with the expectation
of some positive pay-off or reward (speculation).
 History

• Derivatives or Forward trading in one form or the other have been in

existence since time immemorial.
• In 18th century BC, the king of Babylon gave farmers the option of buying
protection in case of a crop failure.
• This is very similar to buying puts or protection in the options markets today.
 History

• In 6th century BC, a Greek mathematician, Thales, negotiated the right but
not the obligation to hire all olive presses in the region.
• This is similar to buying a call option in today’s options markets.
• In 13th century, Italian merchant cities issued Monti shares in order to raise
money.
• These shares represented sale of future government revenue to investors.
 History

• In 16th century Antwerp, traders used contracts for future delivery future in the form of
bills of exchange.
• In the 17th century, forward trading in rice was permitted in Dojima Rice Exchange in
Osaka.
• In 1848 the first derivative exchange in the world, the Chicago Board of Trade (CBOT) was
created in the United States.
• In 1865 CBOT standardized contracts in terms of quality, quantity and time/place of
delivery.
 History

• The Chicago Mercantile Exchange (CME) was established in 1919.

• In 1972, CME introduced currency futures.
• In 1973, Chicago Board of Options Exchange (CBOE) allowed trading
in equity call options.
• In 1975, CBOT introduced futures on T-Bills.
• In 1977, CBOE allowed trading in equity put options.
• In 1982, Equity IF were launched by the Kansas City Board of Trade.
 History of Derivatives

1982 Interest Rate Swaps and Currency Options are 1994 Options introduced on NASDAQ 100
launched.

1983 Options were introduced on broad based 1997 Options introduced on DJIA.
indices like S&P 100 and S & P 500.
2004 CBOE Futures exchange opens.
1984 Annual Exchange turnover exceeds 100 million
contracts.
2005 CBOE introduces weekly options.
1989 Options on Interest Rates allowed.
2006 VIX Options are launched.
1990 LEAPS introduced on equities.

1992 Options on Sectoral & International index. 2008 Annual Exchange Volume > 1 billion contracts.

1993 CBOE Volatility Index (VIX) is created. 2014 Trading in VIX futures expands to 24 hours.
 Global Derivatives

Factors leading to growth of Derivatives Market

• Increased fluctuations in underlying asset prices in financial markets.
• Integration of financial markets globally.
• Use of latest technology in communications has helped in reduction of
transaction costs.
• Enhanced understanding of market participants on sophisticated risk
management tools to manage risk.
• Frequent innovations in derivatives market and newer applications of
products.
 Derivatives in INDIA

• SEBI accepted most of the recommendations made by L.C. Gupta committee

report on regulatory framework for derivatives trading.
• The J.R. Varma committee recommended risk containment measures including
operational details of margining system, methodology for charging initial
margins, membership details and net-worth criterion, deposit requirements
and real time monitoring of positions requirements.
• The SCRA Act was amended to include “derivatives” within the domain of
“securities”.
• Index Futures and Index Options were introduced in 2000.
• Stock Futures and Stock Options were introduced in 2001.
• The Volumes in NSE F & O segment has grown by leaps and bounds.
 Forwards

• A forward contract is essentially a very simple derivative instrument.

• A forward contract is a customized contract between two entities where
settlement takes place on a specified future date at the terms decided
today.
• A forward contract is a private, bilateral contract and is usually traded in
the OTC market between two financial institutions or between a
financial institution and one of its clients.
 Forwards

• Both the parties in a forward contract assume opposite position.

• Buyer of the forward contract has a long position while the seller of the
forward contract has a short position.
• Buyer agrees to buy the underlying on a given future date at a specified price.
• Seller agrees to sell the underlying on a given future date at a specified price.
• Both buyer and seller have rights as well as the obligations to buy/sell the
underlying asset.
 Forwards

Let’s see how a forward contract is used.

• Bank A enters into a 2-month forward contract to buy USD 10,000 @ 81.00 from Bank B.
• At the end of two months, Bank A will get USD 10,000 by paying INR 810,000 to Bank B.
• BANK B is obliged to give USD 10,000 to Bank A @ 81.00 irrespective of the prevailing
USD/INR prices at the time of settling the contract.
• At the time of settlement, if USD/INR was 81.50, then Bank A makes profit of INR 5,000.
(81.50-81.00)*10,000 which will be the notional loss for Bank B.
• Conversely, Bank B will make a profit of INR 7,500 on this transaction if USD/INR is 80.25 at
settlement. (81.00-80.25)*(10,000).
 Forwards

• Bank A has a long position in the forward contract (long forward).

• Bank B has a short position in the forward contract (short forward).
• Forward contracts have been used extensively in the foreign exchange
market in India mainly to hedge the currency risk.
• Forward contracts offer tremendous flexibility in terms of price, quantity,
quality (for commodities), delivery time and place.
 Forwards

• Since forward contracts are customized products, they are plagued by poor
liquidity.
• Forward contracts carry the risk of counter party default.
• Price Discovery is very poor in the forward contracts.
• Forward contracts do not offer an easy exit option.
 Futures

• A futures contract is an exchange traded contract that is standardized in terms

of quantity, quality, delivery, time and place for settlement on a specified date.
• Futures are a significant improvement over forwards particularly with
reference to liquidity and counter party risk.
• Futures, by nature, are extremely liquid since they are traded in an organized
exchange.
 Futures

• All trades in the Futures market is guaranteed and settled by the Clearing
Corporation.
• The clearing corporation becomes the counter-party to all trades through a
process called as Novation .
• The action of the clearing house eliminates the risk of counter party default.
• The Price discovery mechanism in the futures markets are very efficient
because of huge liquidity.
 Forward v/s Futures
Features Forward Futures
Standardization Customised Standardized contracts
Liquidity Very Poor Highly Liquid
Default Risk Exists Assumed by C.C – Novation
Settlement Physical Settled in cash/Physical
Price Discovery Poor Very Efficient
Example Forex Market Futures and Options markets of
BSE and NSE.
 Derivatives In India
Years No of Contracts Turnover (Rs. crs.)
2000-01 90,580 2,365
2004-05 770,17,185 25,46,982
2009-10 6,792,93,922 176,63,665
2014-15 18,370,41,131 556,06,454
2019-20 51,372,28,372 3,453,91,355
2020-21 85,348,60,876 6,436,18,108
2021-22 186,601,40,821 16,952,33,134
2022-23 379,355,04,135 34,826,12,187
 TURNOVER VOLUMES

• Index Futures account for about 23.53 % of the total turnover.

• Index Options account for more than 26.59 % of the total turnover.
• Stock Futures account for about 47.51 % of the total turnover.
• Stock Options account for about 2.36 % of the total turnover.
 TURNOVER CONTRACTS

• Index Futures account for about 0.26 % of the total no of contracts.

• Index Options account for more than 96.96 % of the total no of contracts.
• Stock Futures account for about 0.70 % of the total no of contracts.
• Stock Options account for about 2.07 % of the total no of contracts.
 CHANGING MARKET DYNAMICS

• Trading in the Indian F and O markets is overwhelmingly dominated by

Index Futures and Index Options (primarily Nifty and Bank Nifty) in
terms of no of contracts.

• Index Options currently account for about 96-97% of the overall

notional Futures and Options volumes in terms of no of contracts.

• Derivatives Contracts are available on 191 stocks and 4 Indices.

 ECONOMIC RATIONALE

•Price Discovery
•Risk Transfer
•Market Completion
 ECONOMIC RATIONALE

Price Discovery
•Attracts individuals with better judgment and information.
•Faster dissemination of information.
•F & O markets are the first to react on account of lower transaction costs.
•F & O markets serve as an indicator and thus assist in better price discovery.
 ECONOMIC RATIONALE

Risk Transfer
• F & O markets redistribute risks among the market participants.
• It is similar to a gigantic insurance company.
• It provides the means to hedge against unfavorable or adverse price
movements for a premium.
• It provides opportunities for those who are willing to take risks.
 ECONOMIC RATIONALE

Market Completion
• Derivative instruments adds to the degree of completeness of markets.
• It provides the investors the ability to hedge against all possible odds in
the economy.
 FUTURES TERMINOLOGIES

Spot Price.
Futures Price.
Basis.
Cost of Carry.
Contract Cycle.
Expiration/Expiry Day.
Margins.
Open Interests.
 ACCOUNTING AND TAXATION
• Forward contracts used for Hedging,
then premium/discount will be
amortized over the life of the contract.
• Difference between value of settlement
date and value at inception of contract,
is recognized as P & L for the year.
• Profit/Loss on cancellation/renewal of
forward contract are recognized as P &
L for the year.
• Forward contracts used for Trading or
Speculation, then premium or discount is
not recognized.
• Difference between forward rate as per
previous year end valuation and year end
reporting date for remaining maturity, is
recognized as P & L for the year.
• Profit/Loss on cancellation/renewal of
forward contract are recognized as P & L
for the year.
 ACCOUNTING FOR INITIAL MARGIN
Deposit for Initial Margin (IM) kept.
Deposit for IM a/c debit to Bank A/c.

IM paid adjusted from Deposit.

IM a/c debit to Bank a/c deposit for IM a/c.

IM returned/released.
Bank a/c deposit for IM a/c debit to IM a/c.
 ACCOUNTING FOR INITIAL MARGIN
Mr. X purchases a Futures Contract on March 5, 2023. The IM calculated as per
SPAN, is 50,000. The margin for the subsequent days is as follows:
On March 6, Rs. 55,000, On March 7,Rs. 45,000 and on March 8, Rs. 47,000

On 5th Mar On 7th Mar:

IM a/c Dr 50,000. Bank a/c Dr 10,000

To Bank a/c 50,000. to IM a/c 10,000

On 6th Mar On 8th Mar

IM a/c Dr 5,000. IM a/c Dr 2,000.
to Bank a/c 5,000. to Bank a/c 2,000.
 ACCOUNTING FOR MTM MARGIN

Deposit for Mark-to-Market Margin (MTM) kept.

Deposit for MTM Margin a/c debit to Bank A/c.

MTM Margin paid/adjusted from Deposit.

MTM Margin a/c debit to Bank/Deposit for MTM Margin a/c.

MTM received.
Bank/Deposit for MTM a/c debit to MTM Margin a/c.
 Securities Transaction Tax

SR. NO Taxable Securities Transaction STT rate Payable By

1 Sale of an Option 0.050% Seller

2 Sale of an Option, where option is 0.125% Purchaser

exercised.

3 Sale of futures 0.010% Seller

THANK YOU