Chapter XXVIII

Introduction to
Derivatives Market
After reading this chapter, you will be conversant with:

• History of Perspective
• The Rise of Derivatives Market
• Major Exchanges for Derivatives
• The Classification of Derivatives
• The Important Features of Derivatives
• Participants in Derivatives Market
 Introduction to Derivatives Market

HISTORICAL PERSPECTIVE
In this era of globalization, we are witnessing innovations in financial engineering,
resulting in the evolution of a new set of products in the banking and financial
sector named derivatives. The growth of these products in the last 20 years has
been one of the most extraordinary and important features of the financial market
place. Although, commodity forwards and futures have been traded actively since
the turn of the century and historians find antecedents for the options contracts in
ancient Greek writings, it was not until 1972 that the market for modern
derivatives was born.
Towards the end of the Second World War, representatives of 44 nations gathered
in 1944 in Bretton Woods, New Hampshire, USA and agreed on a fixed exchange
rate system which lasted till the early 1970s. Under that system, the exchange rates
of all currencies were fixed against the US dollar. As the US dollar was then
convertible to gold at $35 per ounce, all currencies were indirectly fixed in terms
of gold. In 1973, the Bretton Woods agreement, the pact that instituted a fixed
exchange rate regime for the world’s major nations, effectively collapsed when the
US suspended the dollar’s convertibility into gold. This resulted in increase of
exchange rate and interest rate volatility.
Two months before the collapse of Bretton Woods system, the Chicago Mercantile
Exchange (CME) launched the world’s first exchange-traded currency futures. In
1975, interest rate futures contracts started on GNMA CDRs (Government Nation
Mortgage Association Certificates of Deposit Rollover) on the Chicago Board of
Trade (CBOT) and in the T-Bills on the CME.

THE RISE OF DERIVATIVES MARKET

In the 1980s, the process of liberalization and deregulation of the financial markets
gained momentum when the British and American leadership led what could
perhaps be considered as the worldwide deregulatory movement. While the
liberalization drive under the Reagan administration in the USA brought about
major changes, London’s pre-eminent position in the world’s financial arena was
further elevated by the “Big-Bang” of 1986, which allowed increased presence of
foreign firms. This resulted in what is known as integration and the securitization
of the world financial markets. The arrival of Information Technology (IT)
facilitated the process of integration on an unprecedented scale. Cross-border
activities in finance flourished and the access to different markets in the world
increased manifold while transfer of resources from one market to another became
rapid and almost cost free.
Figure 1: Percent Change in Yen/USD Exchange Rate

Source: Robert J. Schwartz and Clifford W. Smith. Jr; The Handbook of

Currency and Interest Rate Risk Management.

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Figure 2: First Difference in US Treasury Yield Five Year Constant Maturity

Source: Robert J. Schwartz and Clifford W. Smith. Jr; The Handbook of Currency
and Interest Rate Risk Management.
It was also at this juncture that trends in disintermediation manifested manifold
compelling banks to create new products and services. The prescription of Capital
Adequacy norms by the Bank for International Settlement (BIS) resulted in
increased costs of loans to banks and as an off-shoot of this development, banks
found securitization, an off-balance sheet activity, an attractive route to expand
assets. With the integration of the financial markets and free mobility of capital,
risks also multiplied and risk diversification came to occupy the center stage. This
logically led to the evolution of risk hedging mechanisms, first in the forex
markets and later in the other segments of financial service industry; and these
have come to be known generally as Derivatives.
After emerging in the USA, the derivatives business expanded rapidly and
flourished in the European markets. According to a recent estimate, the total value
of derivatives issued world wide in the third quarter of 2002 was over $192
trillion1.
The important developments in the derivatives markets also occurred in the early
1980s. In May 1972, the International Monetary Market on the Chicago Mercantile
Exchange began trading futures contracts on the British pound, Canadian dollar,
Deutschemark, Japanese yen and Swiss franc. Currency swaps were next to
appear. Option contracts on foreign exchange followed closely on the heels of
swaps. In December 1982, the Philadelphia Stock Exchange introduced an option
contracts on the British pound. Although exchange-traded options on individual
equities were available in the US, it was currency options and futures generally
that spurred the development of a whole new generation of risk management
techniques and strategies.

1 Source: BIS (Bank for International Settlement)

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 Introduction to Derivatives Market

Table 1: Amounts Outstanding of Over-The-Counter (OTC) Derivatives

Under Risk Category and Instrument
(in billions of US dollars)
Notional amounts Gross market values
Risk 1999 2000 2000 2001 2001 2002 1999 2000 2000 2001 2001 2002
Category/Instrument December June December June December June December June December June December June
TOTAL CONTRACTS 88,202 94,008 95,199 99,755 111,115 127,564 2,813 2,572 3,183 3,934 3,788 4,450
Foreign exchange 14,344 15,494 15,666 16,910 16,748 18,075 662 578 849 773 779 1,052
contracts
Outright forwards and 9,593 10,504 10,134 10,582 10,336 10,427 352 283 469 395 374 615
forex swaps
Currency swaps 2,444 2,605 3,194 3,832 3,942 4,220 250 239 313 314 335 340
Options 2,307 2,385 2,338 2,496 2,470 3,427 60 55 67 63 70 97
Interest rate 60,091 64,125 64,668 67,465 77,513 89,995 1,304 1,230 1,426 1,573 2,210 2,468
contracts
Forward rate 6,776 6,771 6,423 6,537 7,737 9,146 12 13 12 15 19 19
agreements
Interest rate swaps 43,936 47,993 48,768 51,407 58,897 68,274 1,150 1,072 1,260 1,404 1,969 2,214
Options 9,380 9,361 9,476 9,521 10,879 12,575 141 145 154 154 222 235
Equity-linked 1,809 1,645 1,891 1,884 1,881 2,214 359 293 289 199 205 243
contracts
Forwards and swaps 283 340 335 329 320 396 71 62 61 49 58 62
Options 1,527 1,306 1,555 1,556 1,561 1,828 288 231 229 150 147 181
Commodity 548 584 662 590 598 777 59 80 133 83 75 78
contracts
Gold 243 261 218 203 231 279 23 19 17 21 20 28
Other commodities 305 323 445 387 367 498 37 61 116 62 55 51
Forwards and swaps 163 168 248 229 217 290 – – – – – –
Options 143 155 196 158 150 208 – – – – – –
Other 11,408 12,159 12,313 12,906 14,375 16,503 428 392 485 417 519 609
Memorandum item:
GROSS CREDIT – – – – – 24,085 1,023 937 1,080 1,019 1,171 1,316
EXPOSURE

Table 2: The Market Size for Financial Derivatives

Instruments National amounts outstanding at the end of
1994 1995 1996 1997 1998 Q2 1999
In billions of U.S. dollars
Exchange-traded instruments 8,862.9 9,188.6 9,879.6 12,202.2 13,549.2 15,097.8
Interest rate futures 5,777.6 5,863.4 5,931.2 7,489.2 7,702.2 8,607.5
Interest rate options 2,623.6 2,741.8 3,277.8 3,639.9 4,602.8 4,858.0
Currency futures 40.1 38.3 50.3 51.9 38.1 59.9
Currency options 55.6 43.5 46.5 33.2 18.7 19.1
Stock market index futures 127.7 172.4 195.9 211.5 321.0 349.2
Stock market index options 238.4 329.3 378.0 776.5 866.5 1,204.1
OTC Instruments1 11,303.2 17,712.6 25,453.1 29,035.0 50,997.0 –
Interest rate swaps 8,815.6 12,810.7 19,170.9 22,291.3
Currency swaps2 914.8 1,197.4 1,559.6 1,823.6 – –
Interest rate options3 1,572.8 3,704.5 4,722.6 4,920.1 – –
1. Data collected by ISDA only.
2. Adjusted for reporting of both currencies; including cross-currency interest rate swaps.
3. Caps, collars, floors and swaptions.
Source: BIS Annual Report June, ’99 and Quarterly Review August, 1999.
We have already mentioned that interest rate volatility increased after the collapse
of the Bretton Woods system. Figure 1 shows the volatility in the US interest rates.
Exchange rate volatility was also seen during the same period which was at
unprecedented levels by the then standards. Figure 2 shows the exchange rate
volatility. Due to this, the presence of derivatives products in interest rates and
exchange rates also increased.

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Table 3: Annual Volume of Chicago Board of Trade2

(World's largest derivatives exchange)
(in US $ millions)
1994 1995 1996 1997 1998 1999 2000
Futures and Options
Combined Totals
Agricultural 42,348,484 50,260,845 65,369,379 62,023,609 58,749,036 59,407,848 60,303,460
Financial 177,017,577 160,300,159 156,994,150 179,703,338 218,570,232 190,996,164 169,432,716
Stock Index – – – 911,608 3,812,910 4,125,646 3,772,840
Metals 128,589 107,652 60,222 44,658 49,233 30,974 19,536
Energy – – – – 272 22 –
Insurance 9,424 3,324 66 – – –
PCS Insurance – 1,064 14,688 15,706 7,753 561 6

Grand Total 219,504,074 210,673,044 222,438,505 242,698,919 281,189,436 254,561,215 233,528,558

Table 24.4 gives an idea to the student about the range of derivative products
available for trading to the investors. The product list given below indicates the
range of products available with the Chicago Mercantile Exchange.
CME’s products are futures contracts – also called “derivatives,” because they
derive their value from whatever the contract is based on, rather than the contract
itself and options on futures. CME offers more than 60 different derivative
products, based on a variety of financial instruments as well as physical
commodities. Each of these products is unique to CME, and traded through a
public, auction-like Process.
Table 4
Industrial
Foreign Exchange Interest Rate Agricultural
Index Products Commodity
Products Products Commodity
Products
S&P500
E-mini S&P 500 Australian Dollar Agency Notes NYMEX e-miny
Nasdaq-100 Brazilian Real Eurodollars Beef Weather
E-mini Nasdaq-100 British Pound Euro yen Dairy Products
S&P Midcap 400 Canadian Dollar Japanese Govt. Forest Chemical
Russell 2000 Cross Rates Bond LIBOR E-Live Stock Products
E-mini Russell 2000 Euro FX QBI Hogs
S&P Barra Growth Japanese Yen Swap Futures
S&P Barra Value Mexican Peso T-bills
Nikkei 225 New zeland Dollar Turn Futures
Fortune-50 Norwegian Krone
GSCI
S&P/TOPIX 150
TRAKRS
By mid-1980s, futures, options, swaps and Forward Rate Agreements (FRAs) had
revolutionized financial and commodity risk management. The trading in the
derivatives increased manifold on all the derivatives products. CBOT ran into ten
million contracts a year and derivatives exchanges came into existence in many
regions: The New York Futures Exchange in 1980, London International Financial
Futures Exchange (LIFFE) in 1982, The Singapore International Monetary
Exchange (SIMEX) in 1984, The Tokyo Financial Exchange (TFE) in 1985, and
French Matif in 1985. Now financial futures account for more than 60 percent of
futures traded around the world3.

2 Source: WWW.CBOT.Com.
3 Doreen Soh: “How to invest in commodities, Gold & Currencies” Times Books International.

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MAJOR EXCHANGES FOR DERIVATIVES

The following is the list of major derivatives exchanges in the world:

Table 5: Major Exchanges throughout the

World Trading Futures and Options, with their Official Abbreviations
American Stock Exchange AMEX
Australian Options Market AQM
Bombay Stock Exchange BSE
Belgian Futures & Options Exchange BELFOX
Bolsa de Mercadorias e Futuros, Brazil BM&F
Chicago Board of Trade CBOT
Chicago Board Options Exchange CBOE
Chicago Mercantile Exchange CME
Coffee, Sugar & Cocoa Exchange, New York CSCE
Commodity Exchange, New York COMEX
Copenhagen Stock Exchange FUTOP
Deutsche Termin Borse, Germany (formerly DTB) EUREX
European Options Exchange EOE
Financiele Termijnmarkt Amsterdam FTA
Finnish Options Market FOM
Hong Kong Futures Exchange HKFE
International Petroleum Exchange, London IPE
Irish Futures & Options Exchange IFOX
Kansas City Board of Trade KCBT
Kobe Rubber Exchange KRE
Kuala Lumpur Commodity Exchange KLCE
London Commodity Exchange LCE
London International Financial Futures & Options Exchange LIFFE
London Metal Exchange LME
London Securities and Derivatives Exchange OMLX
Manila International Futures Exchange MIFE
Marche a Terme International de France MATIF
Marche de Options Negociables de Paris MONEP
MEFF Renta Fija y Variable, Spain MEFF
Mercado de Futuros y Opciones S.A., Argentina MERFOX
Mid America Commodity Exchange MidAm
Minneapolis Grain Exchange MGE
Montreal Exchange ME
Multi Commodity Exchange MCX
National Commodity and Derivative Exchange Ltd. NCEDX
National Stock Exchange NSE
New York Cotton Exchange NYCE
New York Futures Exchange NYFE

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New York Mercantile Exchange NYMEX

New York Stock Exchange NYSE
New Zealand Futures & Options Exchange NZFOE
Osaka Grain Exchange OGE
Osaka Securities Exchange OSA
OTOB Aktiengesellschaft OTOB
Pacific Stock Exchange PSE
Philadelphia Stock Exchange PHLX
Singapore International Financial Futures Exchange SIMEX
Stockholm Options Market OM
Swiss Options and Financial Futures Exchange SOFFEX
Sydney Futures Exchange SFE
Tokyo Grain Exchange TGL
Tokyo International Financial Futures Exchange TIFFE
Toronto Stock Exchange TSE
Vancouver Stock Exchange VSE
Winnipeg Commodity Exchange WCE
Source: Icfai Research Center.

Ongoing Developments
The world of derivatives is synonymous with ‘innovation’. Every year new
derivatives exchanges are coming into play and the old one are either
consolidating or giving way to the new players. For example, the setting up of
“Eurex” which is now rivaling volumes with that of CME and CBOT is pointer at
the pace things change in the derivatives world. New contracts come into existence
on an ongoing basis in the market every month and new innovations in the type of
instruments available to the investors is also on an increase.
Over 50 exchanges throughout the world now trade in some form of derivatives or
the other. At the same time, the OTC market has developed a vast array of
products that can be customized to suit any risk/reward profile of investors. All the
derivatives products like Swaps, FRAs, Options can now be purchased from a
large number of professional market makers and brokers on different underlying
assets.
Derivatives have enabled institutional investors, bank treasurers and corporate
CFOs to manage risks more efficiently and to speculate on them if they wish.
Portfolio managers can now execute investment decisions without going to the
asset market, which may be illiquid or expensive for an individual market
participant. With derivative instruments, corporates can alter or synthesize assets
and liabilities, quickly and efficiently without much cost.
The most significant feature (most dangerous too) of the derivatives is that the cash
outlay required for taking position is insignificant when compared to the cash outlay
required for taking a similar position on the underlying assets. In the last decade,
several major cases of corporate losses were reported in international media due to
trading in the derivative markets. Major losers like Bearings Bank, Procter &
Gamble and Orange County have highlighted the risks involved in these instruments.
Incidents like these have strongly developed a perception that derivatives only add
to the risk rather then mitigate them. But however it has to be noted that the
disasters mentioned above have only highlighted the importance of strong risk
management framework, the need for scrupulous adherence to the guidelines,
adequate infrastructure and proper controls and reporting system to be in place.

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THE CLASSIFICATION OF DERIVATIVES

It is easier to understand a derivative than to describe it and it is easier to describe
a derivative than to define it. However, attempts were made to define a derivative.
The following are a few definitions.
“A contract or an agreement for exchange of payments, whose value derives from
the value of an underlying asset or underlying reference rates or indices”.
A derivative is a security whose price ultimately depends on that of another asset
(called underlying).
– Nasim Taleb.
Literally speaking a derivative instrument is an asset which derives, i.e. takes its
origin from another asset. As a matter of fact, the price of a derivative instrument
is contingently on the value of its underlying asset. Accordingly, derivatives are
also sometimes called contingent claims. The simplest form of a derivative is a
forward contract, “It is an agreement to buy or sell an asset at a certain future time
for a certain price4”. The value of an existing forward contract depends on the
ruling spot rate and forward margin for the currency; in other words, the value is
the cash flow that needs to be exchanged, if the contract is to be canceled now.
Other forms of derivatives include futures, options and swaps, etc. For example, an
interest rate futures contract is a derivative that commits the parties to exchange a
debt security, say a Treasury Bond, at a future date for a predetermined price. The
value of the futures contract depends on the underlying treasury bond. If the
treasury bond price rises, the value of the futures contract also rises because the
buyer of the futures contract is now entitled to receive a more valuable asset. The
enormous and rapid growth in the variety of derivatives can be wildering even to
experienced financial market participants. Notwithstanding the growth, all
derivatives can be classified based on the following features:
a. Nature of contract.
b. Underlying asset.
c. Market mechanism.
a. Nature of Contract: Based on the nature of the contract, derivatives can be
classified into three categories:
i. Forward Rate Contracts and Futures
ii. Options
iii. Swaps.
The nature of contract sets upon the rights and obligations of both the
position to the contract.
b. Underlying Asset: Most derivatives are based on one of the following four
types of assets:
i. Foreign exchange
ii. Interest bearing financial assets
iii. Commodities
iv. Equities.
There can be a contract which is similar in all aspects except for the
underlying asset. Thus an option contract can exist in currency or a stock.
Similarly a futures contract can exist on commodity or on a currency.
c. Market Mechanism:
i. Over the Counter (OTC) Products
ii. Exchange traded products.

4 John C. Hull; Options, and other Derivatives. Third edition.

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Mechanics of Derivative Markets

Some derivatives are traded on organized exchanges while others are traded only
in the OTC markets. Exchange-traded derivatives have standardized features and
are not tailored to the needs of individual buyers and sellers. For example, in S&P
500 stock index futures which are traded on the Chicago Mercantile Exchange, the
value of the futures contracts is tied to the Standard & Poor’s Composite Stock
Price Index. The futures have standard maturity and the Exchange prescribes rules
for settlement of any outstanding contracts in cash on the expiration dates. In
contrast, OTC derivatives are customized to meet the specific needs of the
counterparty. Financial Swap is a good example of OTC derivative. OTC market,
remains predominantly a telephone market. Notwithstanding the advantages and
disadvantages of such market, it remains a significant market, contributing to the
volumes and innovation as well.
An important difference between exchange-traded and OTC derivatives is the
credit risk. In the OTC markets, one party is exposed to the risk that his
counterparty may default on the contract. In case of default, there will be a need to
replace the counterparty which is also known as replacement risk. This risk
becomes insignificant in case of exchange traded derivatives since every contract
between the two parties, say A and B, is substituted with two contract – one
between A and the exchange and the other between the exchange and B. Thus, in
the market for exchange traded derivatives, credit risk is taken by the exchange
which acts as clearing house for all the trades. When a future contract is traded on
the exchange, the exchange will become seller to the buyer and buyer to the seller.
Hence, a party who is entering into the contract need not worry about the
creditworthiness of the counterparty. The exchange protects itself by asking parties
to deposit certain amount as margin on a day-to-day basis with the exchange which
is usually enough to cover the price movement of the underlying assets on any
given day. On any particular day, if the exchange feels that the volatility is likely
to be high on the underlying asset, the exchange may request the parties to deposit
additional margins during the trading day. Due to the above mechanics, losses to
the exchange and to the counterparties who enter into the contract are minimized.
Role of Clearing Houses: A clearing house is a key institution in the derivatives
market. It performs two critical functions; offsetting customers dealings and
assuring the financial integrity of the transactions that take place in the exchange.
The clearing house could be part of the exchange or a separate body coordinating
with the exchange.
The following is a list of the main exchanges and their clearing houses:
Table 6: Major Exchanges and Clearing Houses
Futures Exchanges Clearing Houses
Chicago Board of Trade (CBOT) Board of Trade Clearing Corp. (BOTCC)
Chicago Mercantile CME Clearinghouse
Exchange (CME) Division*
New York Mercantile Exchange NYMEX Clearinghouse Division*
(NYMEX)
Commodity Exchange, Inc. (COMEX) COMEX Clearing Association
Coffee, Sugar & CSC Clearing
Cocoa Exchange (CSCE) Corporation Commodity clearing Corp.
New York Cotton Intermarket Clearing Corp. (ICC)
Exchange (NYCE)
New York Futures BOTCC
Exchange (NYFE)

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Kansas City Board of Trade (KCBOT) KCBOT Clearing corp.

Minneapolis Grain MGE Clearinghouse
Exchange (MGE) Division*
Chicago Rice & BOTCC
Cotton Exchange (CRCE)
AMEX Commodities Corp. ICC
(AMEXCC)
Philadelphia Board of Trade (PHBOT) ICC
Pacific Futures ICC
Exchange (PFE)
Options exchanges Clearing houses
Chicago Board Options Exchange Options Clearing Corp. (OCC)
(CBOE)
American Stock OCC Philadelphia Stock
Exchange (AMEX) Exchange (PHLX)
New York Stock OCC
Exchange (NYSE)
Pacific Stock OCC
Exchange (PSE)
National Association of OCC
Securities Dealers (NASD)

Clearing Houses for Both Futures and Options

National Stock Exchange (NSE) National Securities Clearing Corporation
Ltd. (NSCCL) for both options and
futures
Bombay Stock Exchange Clearing House – for both options and
futures
*Clearinghouse is a department within the exchange. All other clearinghouses are
separately incorporated as independent from the exchange.
Source: Options and Futures, by Edward & Ma, McGraw Hill, Publications.

THE IMPORTANT FEATURES OF DERIVATIVES

Derivatives became very popular because of their unique nature. There are four
important features that distinguish derivatives from underlying assets and make
them useful for a variety of purposes:
a. Relation between the values of derivatives and their underlying assets:
When the values of underlying assets change, so do the values of derivatives
based on them. For some derivative instruments such as swaps and futures,
the relation between the underlying assets and the instrument is straight
forward, i.e. if the product price changes the instrument price also changes. In
a currency future contract, the price to be paid when the currency is delivered
will be fixed by the future contract, the value of the currency delivered will
fluctuate depending on the movements of the underlying currency. Thus, the
value of the future contract depends on the value of the underlying currency.
b. It is easier to take short position in derivatives than in other assets: As all
transactions in derivatives take place in future specific dates5 it is easy for the
investor to sell the underlying assets, i.e. in an asset he is obligated to deliver
it in future. The short position means taking stand for selling the underlying
asset, with or without possessing the asset.

5 There are some derivatives their delivery date cannot be found out before like American Option and
Hybrid Derivatives.

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c. Exchange traded derivatives are liquid and have low transaction cost:
Exchange traded derivatives are more liquid and have lower transaction costs
than other assets. They are more liquid because they have standardized terms
and low credit risk. The transaction costs are also low due to high volume in
trade and competition. In addition, margin requirement in the exchange
traded derivatives is relatively low.
d. It is possible to construct portfolio that is exactly needed, without having
the underlying assets: Derivatives can be constructed or combined to
closely match specific portfolio requirements. For example, suppose a firm
with a floating-rate loan needs to limit its exposure to sharp increases in the
interest rate. The firm can purchase a derivative called an interest rate cap.
This derivative pays the firm the difference between the floating rate of
interest and a predetermined maximum called the cap rate whenever the
floating rate exceeds the cap. Similarly, the lender can protect the decrease in
the interest rate by buying the floor. The derivative product seller pays the
lender the difference between a predetermined rate maximum called the cap
rate whenever the floating rate falls below the floor rate.

PARTICIPANTS IN DERIVATIVES MARKET

In order to understand the significance of these markets it will be necessary to
know the participants of the market. While participants can be banks, FIs,
Corporates, Brokers, Individuals, etc., all of these can be classified into three
categories:
• Hedgers
• Speculators
• Arbitrageurs.
HEDGERS
A transaction in which an investor seeks to protect a position or anticipated
position in the spot market by using an opposite position in derivatives is known as
a hedge. A person who hedges is called a hedger. These are the people who are
exposed to risk due to their normal business operations and would like to eliminate
or minimize or reduce the risk. For example, an exporter whose receivable is
denominated in US dollars is exposed to the risk of adverse movements of US
dollars. Similarly, a corporate who borrowed a floating rate loan runs the risk of an
increase in interest rates. If these risks are to be covered, they can take a
corresponding position in the derivatives to hedge the risk. The exporter in the
above example can sell futures in US dollars to hedge currency risk.
SPECULATORS
A person who buys and sells a contract in the hope of profiting from subsequent
price movements is known as a speculator. These people voluntarily accept what
hedgers want to avoid. A speculator does not have any risk to hedge. He/she has a
view on the market and based on the forecast the speculator would like to make
gains by taking long and short positions on the derivatives. They perform a
valuable economic function by feeding information and analysis into the derivative
markets. In general, speculators can be the counterparties for hedgers.
ARBITRAGEURS
These are the third important participants in the derivative market. Arbitrage
means obtaining risk-free profits by simultaneously buying and selling identical
or similar instruments in different markets. For example, one could buy in the
cash market and simultaneously sell in the futures market. The person who does
this activity is called an arbitrageur. They consistently keep track of the different
markets. Whenever there is any chance of getting profit without any risk they
will take position and make riskless profit. They perform a very valuable
economic function by keeping the derivatives prices and current underlying
assets price closely consistent. Arbitrageurs are in the same class as that of

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speculators to the extent that they have no risk to hedge. However, they buy to
make gains by identifying mispriced derivatives, or inefficiencies between the
markets for derivatives and the corresponding underlying assets. While
speculators help in enhancing liquidity, arbitrageurs help in price discovery
heading to market efficiency.

Trading Techniques
The efficiency of a market depends upon the pace with which information is
assimilated into market prices. In the absence of a derivative market, the
information flow gets reflected in the market for assets. The existence of a
derivative market changes the information flow with derivatives market being
affected first before the corresponding assets markets is affected. Kawaller, Koch
and Koch6 in their study determined that futures contract times lead the cash index
for as long as 20 to 45 minutes, even though equivalent prices often occur
simultaneously. Stoll and Whaley7 in their study determined that futures provide a
price discovery function with lead time of five minutes on average and up to 10
minutes. This is because of the flexibility with which a position can be altered
when compared to the asset market and the less margins required to take position
in derivatives market.
Figure 3: Information Flows without Derivatives Markets

External Cash Market

Environment

Speculators
Figure 4: Information Flows with Derivatives Markets
Cash Market
External
Arbitrageurs
Environment
Derivatives
Speculators Markets

In a pure cash market, speculators feed information directly into the spot price. In
the presence of the derivatives market, the information received by the speculator
will be used in taking position in the derivatives market as it will give a better
opportunity to make profit. From the derivative market the information will be
processed by the arbitrageurs looking for better profits either in the derivatives
market or in the cash market and take an appropriate position. They act as a critical
link between the derivatives market and the cash market so that both the markets
synchronize to the extent that there cannot be much scope for disequilibrium in the
markets.
In short, derivative trading could be seen as a means of transfer of unwanted risk
by those investors (hedgers) who seek less risks to those wanting to profit by
having more risk possibilities (speculators). Options and futures can be used for
hedging as well as speculation.

6 Ira Kawaller, Paul Koch and Timothy Koch, "The Temporal Relationship Between S&P Futures and the
S&P 500 Index," The Journal of Finance, Vol. 42, No. 5, December 1987, pp. 1309 - 1329.
7 Hans Stoll and Robert Whaley, "The dynamics of Stock Index and Futures Returns," Journal of Financial
and Quantitative Analysis, Vol. 25, No. 4, December 1990, pp. 441 - 468.

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SUMMARY
• Derivatives play an important role in the financial markets around the world.
Over the years, the derivatives market has grown by leaps and bounds and
today it is bigger in size than the equity and money markets in some
countries. The innovative nature of the derivatives markets has further
contributed to their growth and development. Derivatives are classified
mainly based on the ‘nature of the contract’, ‘underlying asset’ and the
‘market mechanism’.
• Derivatives became popular because of their four unique features that
distinguish them from the underlying assets and make them useful for a
variety of purposes. Different participants like banks, FIs, corporates,
brokers, individuals, etc., play an important role in the derivatives market.
These participants can be classified into three categories namely hedgers,
speculators and arbitrageurs. There is no doubt derivatives are here to stay
and play an important role in the development of financial markets. The
various types of derivatives like futures, options and swaps play an increasing
role in the field of finance, particularly risk management and help corporates
hedge their risks. Thus, the growth of the derivatives market has enabled
setting up of new exchanges like ‘Eurex’, etc., and brought in new
arrangements in various existing derivatives exchanges around world.

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 Introduction to Derivatives Market

Appendix I
Derivative Financial Instruments Traded on Organized Exchanges by Instrument
and Location
(Notional principal in billions of US dollars)

INSTRUMENTS/LOCATION AMOUNTS OUTSTANDING TURNOVER TURNOVER

1999 2000 2001 2002 2002 2000 2001 2001 2001 2001 2002 2002 2002
Dec Dec Dec March Sep. Year Year Q2 Q3 Q4 Q1 Q2 Q3

FUTURES 8,294.2 8,338.5 9,633.5 10,447.5 10,687.7 317,993.8 445,838.0 107,626.7 108,708.2 117,539.2 118,953.2 123,990.6 138,910.3
All markets

Interest rate 7,913.9 7,892.1 9,234.0 10,021.2 10,326.8 292,018.7 420,589.3 101,388.3 102,676.0 111,066.5 112,354.1 116,679.3 130,855.3

Currency 36.7 74.4 65.6 66.6 37.6 2,416.8 2,499.3 582.1 607.2 675.1 577.3 689.1 633.4

Equityt index 343.5 372.0 334.0 359.6 323.3 23.558.4 22,749.5 5,656.2 5,424.9 5,797.6 6.021.7 6,622.2 7,408.7

North America 3,553.2 4,283.0 5,906.4 6,289.1 6,249.6 150,912.4 243,989.6 59,842.8 59,097.6 65,119.1 69,656.3 71,750.9 74,375.5

Interest rate 3,358.4 4,052.8 5,696.5 6,072.7 6,057.2 136,368.7 230,160.3 56,299.9 55,888.9 61,616.3 65,993.6 67,622.3 70,001.1

Currency 32.1 35.6 35.9 34.6 34.1 1,794.6 1,924.3 459.3 500.5 493.1 478.5 573.6 548.1

Equity index 162.8 194.5 174.0 181.9 158.3 12,749.2 11,904.9 3,083.6 2,708.2 3,009.7 3,184.1 3,555.1 3,825.3

Europe 2,379.2 2,318.6 2,444.5 2,751.6 3,118.5 111,551.6 154,435.2 36,951.7 37,951.4 40,502.5 38,961.9 40,584.6 51,939.9

Interest rate 2,274.2 2,201.9 2,324.8 2,622.5 3,004.9 104,606.2 146,967.4 35,221.8 36,000.7 38,615.0 37,035.2 38,495.6 49,406.0

Currency 0.6 0.2 0.1 0.1 0.2 3.1 2.5 0.9 0.5 0.5 0.2 0.3 0.3

Equity index 104.4 116.4 119.6 129.0 113.4 6,942.2 7,465.4 1,729.0 1,950.2 1,887.0 1,926.5 2,088.8 2,533.6

Asia and Pacific 2,149.8 1,482.1 1,202.0 1,312.9 1,225.6 52,247.7 42,861.4 9,916.3 10,810.1 10,104.0 9,400.7 10,545.7 11,927.1

Interest rate 2.075.0 1,393.1 1,140.0 1,240.1 1,174.4 48,469.6 39,663.6 9,109.3 10,075.6 9,267.9 8,525.3 9,587.0 10,888.1

Currency 1.1 34.6 24.1 26.6 1.2 68.1 86.4 24.1 20.6 15.4 17.7 18.3 19.1

Equity index 73.6 54.4 37.9 46.2 50.0 3,709.9 3,111.4 782.8 713.9 820.7 857.8 940.3 1,019.9

Other Markets 211.9 250.9 80.4 93.5 94.1 3,253.7 4,504.3 903.9 837.7 1,800.8 923.2 1,109.4 667.8

Interest rate 206.3 244.3 72.7 85.9 90.4 2,574.1 3,798.0 757.3 710.9 1,567.3 800.1 974.4 573.1

Currency 3.0 3.9 5.4 5.3 2.1 550.9 485.9 97.8 85.6 165.9 80.8 97.0 65.9

Equity index 2.7 2.7 2.4 2.3 1.6 128.8 220.4 48.8 41.3 67.5 42.4 38.0 25.8

OPTIONS

All markets 5,258.7 5,876.3 14,083.7 14,314.7 17,929.9 66,178.7 148,269.3 33,465.2 41,875.3 46,089.1 42,774.6 45,047.3 53,574.9

Interest rate 3,755.5 4,734.2 12,492.6 12,474.3 16,142.0 47,378.9 122,762.8 27,027.9 35,579.1 38,721.9 34,912.5 36,134.3 43,520.9

Currency 22.4 21.4 27.4 26.4 30.9 211.8 355.9 74.0 96.5 97.5 99.9 124.8 104.0

Equity index 1,480.8 1,120.7 1,563.7 1,814.0 1,757.1 18,587.9 25,150.6 6,363.3 6,199.7 7,269.7 7,762.1 8,788.2 9,949.9

North America 3,377.1 3,884.7 10,292.2 10,350.7 11,605.9 43,996.8 107,675.6 24,688.0 30,375.1 33,240.3 30,415.7 33,408.8 35,136.5

Interest rate 2,259.4 3,116.9 9,220.0 9,069.7 10,404.0 31,959.5 92,071.9 20,272.8 26,660.4 29,373.5 26,549.0 29,331.0 30,298.8

Currency 13.1 14.4 18.1 19.1 23.0 149.4 199.3 42.9 58.3 47.6 47.2 69.4 66.9

Equity index 1,104.7 753.4 1,054.1 1,261.9 1,178.8 11,887.9 15,404.4 4,372.3 3,656.5 3,7817.2 3,819.5 4,008.4 4,770.9

Europe 1,603.2 1,855.7 3,698.0 3,853.7 6,216.6 17,430.2 33,404.6 7,364.9 9,660.2 10,122.9 9,136.2 7,631.2 14,112.2

Interest rate 1,300.0 1,560.6 3,238.4 3,359.0 5,707.5 13,806.1 29,512.5 6,468.9 8,607.0 9,109.9 8,099.4 6,497.4 12,913.8

Currency 0.5 0.2 0.1 0.1 0.3 0.9 0.6 0.1 0.1 0.1 0.1 0.3 0.2

Equity index 302.7 294.9 459.4 494.6 508.8 3,623.2 3,891.4 895.9 1,053.1 1,012.9 1,036.7 1,133.5 1,198.2

Asia and Pacific 240.7 100.6 62.8 82.5 79.2 4,162.6 6,510.6 1,254.4 1,693.2 2,533.5 3,035.3 3,845.4 4,192.9

Interest rate 191.3 52.3 31.3 39.3 24.7 1,577.2 1,119.3 279.5 306.8 220.7 247.8 275.0 255.4

Currency 0.1 0.5 – 0.2 – 0.2 – – – – 0.0 – –

Equity index 39.3 47.9 31.5 43.1 54.5 2,585.2 5,391.4 975.0 1,386.4 2,312.8 2,787.6 3,570.4 3,906.5

Other Markets 37.7 35.3 30.8 27.8 28.3 589.1 678.5 157.9 146.8 192.3 187.3 162.0 133.3

Interest rate 4.8 4.4 2.9 6.4 5.7 36.1 59.2 6.8 5.0 15.8 16.4 31.0 22.0

Currency 8.7 6.4 9.2 7.0 7.6 61.3 155.9 30.9 38.0 49.7 52.5 55.1 36.9

Equity index 24.2 24.5 18.6 14.5 14.9 491.7 463.4 120.2 103.7 126.8 118.4 75.9 74.3

Source: BIS Website.

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