History of Derivative:

The history of derivatives is quite colourful and surprisingly a lot longer than most people
think. Forward delivery contracts, stating what is to be delivered for a fixed price at a
specified place on a specified date, existed in ancient Greece and Rome. Roman emperors
entered forward contracts to provide the masses with their supply of Egyptian grain. These
contracts were also undertaken between farmers and merchants to eliminate risk arising out
of uncertain future prices of grains. Thus, forward contracts have existed for centuries for
hedging price risk.
The first organized commodity exchange came into existence in the early 1700s in Japan.
The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in
1848 in the US to deal with the problem of credit risk and to provide centralised location to
negotiate forward contracts. From forward trading in commodities emerged the commodity
futures. The first type of futures contract was called to arrive at. Trading in futures
began on the CBOT in the 1860s. In 1865, CBOT listed the first exchange traded
derivatives contract, known as the futures contracts. Futures trading grew out of the need
for hedging the price risk involved in many commercial operations. The Chicago Mercantile
Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874
under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter Board
(CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first
foreign currency futures were traded on May 16, 1972, on International Monetary Market
(IMM) a division of CME.
Options

are

as

old

as

futures.

Their

history

also

dates

back

to

ancient

Greeceand Rome. Options are very popular with speculators in the tulip craze of seventeenth
century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to
a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb
options. There was so much speculation that people even mortgaged their homes and
businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there
was no mechanism to guarantee the performance of the option terms.
The first call and put options were invented by an American financier, Russell Sage, in 1872.
These options were traded over the counter. Options on shares were available in the US on
the over the counter (OTC) market only until 1973 without much knowledge of valuation. A

group of firms known as Put and Call brokers and Dealers Association was
setup in early 1900s to provide a mechanism for bringing buyers and sellers together.
The market for futures and options grew at a rapid pace in the eighties and nineties. The
collapse of the Brett on Woods regime of fixed parties and the introduction of floating rates
for currencies in the international financial markets paved the way for development of a
number of financial derivatives which served as effective risk management tools to cope with
market uncertainties.
History of Derivative in Pakistan:
The Financial Derivatives Business Regulations have been formulated in exercise of the
power derived by State Bank of Pakistan under Banking Companies Ordinance 1962 and
Foreign Exchange Regulations Act 1947, to permit, regulate, and supervise financial
institutions entering into derivative transactions.
State Bank of Pakistan (SBP) is the supervisory authority for all banks and Development
Finance Institutions (DFIs) engaging in Derivative Business. Financial institutions engaging
in derivative business shall obtain the approval of the State Bank of Pakistan and be subject
to the supervision and scrutiny of the State Bank of Pakistan.
Derivative:
As referred to in the Regulations means a type of financial contract the value of which is
determined by reference to one or more underlying assets or indices. The major categories of
such contracts include forwards, futures, swaps and options. Derivative also includes
structured financial products that have one or more characteristics of forwards, futures, swaps
and options.
Types of Derivative:
Following are the types of derivative;

1.

Forward contract
Future contract
Options
Swap
Forward Contact:

A forward contract is an agreement to buy or sell an asset on a specified for a specified price.
One of the parties to the contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified price. The other party assumes a
short position and agrees to sell the asset on the same date for the same price. Other contract

details like delivery date, price and quantity are negotiated bilaterally by the parties to the
contract. The forward contracts are normally traded outside the exchange.
Forward Rate Agreement:
A Forward Rate Agreement (FRA) is an over-the-counter agreement between two parties in
which one party (the seller of the FRA) agrees to lend a specified amount of money for a
specified period to the other party (the buyer of the FRA) in a specific currency at a fixed
interest rate. In practice, actual lending or borrowing of the underlying principal does not take
place; only interest rate is locked in. An FRA removes all uncertainty from cost of borrowing
or rate of return on investment.
Foreign Currency Forward:
A foreign currency forward is an agreement between two parties to exchange some amount of
one currency for another at a specified time in the future. The exchange rate is fixed at the
time the contract is entered into. The market in which such forward transactions in foreign
currencies are carried out is called forward exchange market. The cash flow in the foreign
currency forwards takes place at the time of maturity.
2. Future Contract:
In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy
or sell a certain underlying instrument at a certain date in the future, at a pre-set price.
The future date is called the delivery date or final settlement date. The pre-set price is called
the futures price. The price of the underlying assets on the delivery date is called the
settlement price.
A futures contract gives the holder the right and the obligation to buy or sell, which differs
from an options contract, which gives the buyer the right, but not the obligation, and the
option writer (seller) the obligation, but not the right. To exit the commitment, the holder of a
futures position has to sell his long position or buy back his short position, effectively closing
out the futures position and its contract obligations. Future contracts are exchange traded
derivative. The exchange act as counterparty on all contracts set margin requirements.
Interest Rate Future Contract:
It is one of the significant financial futures instruments. Both borrowers and lenders face
interest rate risk. The borrower, for example, has to notch up a heavy loss if the interest rate
increases whereas the lender has to incur a loss in decreasing trend of interest rate. This

instrument assists to reduce interest rate risk of lenders and borrowers. There are some
interest-based securities like treasury bills, notes, bonds, debentures, euro-dollar deposits and
municipal bonds.
Foreign Currency Future:
This kind of financial futures, as the name indicates, is traded in foreign currencies. Therefore
it is also known as exchange rate futures. The rate of exchange changes continuously;
different firms are exposed to the exchange rate risk. The assets, liabilities or cash flow of a
firm undergo a change in value with the passage of time due to variation in exchange rates.
So, exporters, importers, bankers, financial institutions and large companies use foreign
currency futures as a hedge against the exchange rate risk.
3. Options:
A derivative transaction that gives the option holder the right but not theobligation to buy or
sell the underlying asset at a price, called the strike price, during a period or on a specific date
in exchange for payment of a premium is known as option. Underlying asset refers to any
asset that is traded. The price at which the underlying is traded is called the strike price.
There are two types of options i.e. Call Option and Put Option
Call Option:
A contract that gives its owner the right but not the obligation to buy anunderlying

asset-

stock or any financial asset, at a specified price on or before a specified date is known as
a Call option. The owner makes a profit provided he sells at a higher current price and buys
at a lower future price.
Put Option:
A contract that gives its owner the right but not the obligation to sell an underlying assetstock or any financial asset, at a specified price on or before a specified date is known as
a Put option. The owner makes a profit provided he buys at a lower current price and sells
at a higher future price. Hence, no option will be exercised if the future price does not
increase.
Put and calls are almost always written on equities, although occasionallypreference
bonds and warrants become the subject of options.
4. Swap:

shares,

Swaps are transactions which obligates the two parties to the contract toexchange a series of
cash flows at specified intervals known as payment or settlement dates. They can be regarded
as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap)
payments, based on some notional principle amount is called as a SWAP. In case of swap,
only the payment flows are exchanged and not the principle amount. The two commonly used
swaps are;
Interest Rate Swap:
Interest rate swaps is an arrangement by which one party agrees to exchange his series of
fixed rate interest payments to a party in exchange for his variable rate interest payments. The
fixed rate payer takes a short position in the forward contract whereas the floating rate payer
takes a long position in the forward contract.
Currency Swap:
Currency swaps is an arrangement in which both the principle amount and the interest on
loan

in

one

currency

are

swapped

for

the

principle

and

the

interest

payments on loan in another currency. The parties to the swap contract of currency generally
hail from two different countries. This arrangement allows the counter parties to borrow
easily and cheaply in their home currencies. Under a currency swap, cash flows to be
exchanged are determined at the spot rate at a time when swap is done. Such cash flows are
supposed to remain unaffected by subsequent changes in the exchange rates.
Financial Swap:
Financial swaps constitute a funding technique which permits a borrower toaccess

one

market and then exchange the liability for another type of liability. It also allows the investors
to exchange one type of asset for another type of asset with a preferred income stream.