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1 Derivatives – Introduction
Risk takes a prime place in the financial system. There is
always an exposure to risk because of variations / fluctuations in
prices of commodities, interest rates, foreign exchange rates, etc.
arising due to demand and supply conditions. Financial
instruments (Shares, Bonds, Debentures, Other securities) are
always under a threat of continuous price change. Hence, all the
participants in financial system are constantly exposed to the risk
of losses. In order to overcome risk in financial system,
‘Derivatives’ have been introduced. Derivatives facilitate to control
volatility in prices. It helps to minimize the impact of these
fluctuations, by locking-in asset prices.
A) Financial Assets:
(i) Equity Instruments – Equity shares (Raymond Ltd,
ICICI etc.); Indices (Sensex, Nifty etc.)
(ii) Debt-market Instruments – Interest Rates, Bonds etc.
(iii) Other Instruments – Forex, Currency, Temperature,
Carbon Credits etc.
B) Non-Financial Assets:
Commodities, Cereals, Pulses, Dairy Products, Metals,
Derivatives themselves etc.
Definition of Derivative:
“A derivative is a financial instrument whose value depends on (or
derives from) the values of other, more basic underlying variables”
- John C. Hull
3) XYZ, an Indian company sell its products across the globe. They
may earn in various currencies. Ultimately theses earnings in
other currencies have to be converted in INR. There can be a risk
of changes in the foreign exchange rates which may lead to
reduction in net earnings after conversion. In order to avoid this
risk, XYZ can get into a derivatives contract for locking-in the
exchange rate.
1) Hedgers: The term ‘hedge’ means ‘to reduce the risk’. Hedgers
are the participants / investors who look at reducing their risks
in the market. They use derivatives for mitigating risk
associated with price movement of a financial asset. All the
participants of financial markets (corporates, banks, financial
institutes etc.) may use derivative products to hedge their risk
exposures. Hedgers use futures markets to mitigate risk because
of the price movements of assets, exchange rates, commodities,
interest rates, etc. Hedgers try to hedge price of the assets by
getting in to an exactly opposite deal in the derivatives market.
Hence, they pass over the risk to participants willing to bear it.
Before settlement, futures and spot prices need not be the same.
The difference between the prices is called the basis of the futures
contract. It converges to zero as the contract approaches maturity.
The basis is defined as the difference between the spot and futures
price.
B=S–F
Where;
B is basis points
S is Spot Price
F is Futures Price
Example:
If the spot price on 1st July 2017 is 72 cents, calculate the basis for the
following futures contract:
Settlement Aug 2017 Sept 2017 Dec 2017 Feb 2018
Month
Futures 75 70 78.5 69.5
Price
Margin rates are fixed by futures exchanges. Also, the brokers add some
extra premium to the margin rate set by exchange – in order to lower the
risk exposure.