Financial Derivative

Done by: Syed Roshan Javed

CONTENT
1.
2. 3.

Introduction to Financial Derivatives

Types Of Derivatives Trading Participants In Financial Derivatives

4.
5. 6. 7. 8.

Risk Factors In Financial Derivatives

Factors Affecting Financial Derivatives Derivatives In India Conclusion Bibliography
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INTRODUCTION
A derivative is a financial instrument that derives or gets it value from some real good or stock. It is in its most basic form simply a contract between two parties to exchange value based on the action of a real good or service. Typically, the seller receives money in exchange for an agreement to purchase or sell some good or service at some specified future date

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DEFINITION OF DERIVATIVES
The term Derivative has been defined under the section 2(ac) of the Securities Contract Regulation Act 1956 as derivative includes(a) A security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; (b) A contract which derives its value from the prices, or index of prices, of underlying securities.
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FACTORS DRIVING GROWTH OF DERIVATIVES

1.The derivatives market is like any other market. 2.It is a highly leveraged market in the sense that loss/profit can be magnified compared to the initial margin. 3.Market view is as important in the derivatives market as in the cash market. The profit/loss positions are dependent on the market view. 4. Derivatives contracts have a definite lifespan or a fixed expiration date. 5. The derivatives market is the only market where an investor can go long and short on the same asset at the same time.
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TYPES OF DERIVATIVES

Forwards Futures Swap Swaptions

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FORWARDS
A forward contract is a contract between two parties obligating each to exchange a particular good or instruments at a set price on a future date. It is an over the counter agreement. A forward contract is an agreement to replace a risk with a certainty. The buyer in the contract is said to hold a long position, and the seller is said to hold a short position. The specified price in the contract is called the delivery price and the specified time is called maturity.
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FUTURES
Future same as a forward contract, an agreement to buy or sell at a specified future time a certain amount of an underlying asset at a specified price. Futures have evolved from standardization of forward contracts. Future contracts are organized/standardized contracts in terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges.
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DISTINCTION BETWEEN FUTURES AND FORWARD

Future Contract
1 Traded on an organized stock exchange

Forward Contract
1 Over the Counter (OTC) in nature

2 Standardized contract 2 Customized contract terms, hence, more liquid. terms, hence, less liquid
3 Requires margin payments 4 Follows daily settlement 4 Settlement happens at Sep-13 the end of the period 3 No margin payment

OPTIONS

Options- An agreement that the holder can buy from, or sell to, the seller of the option at a specified future time a certain amount of an underlying asset at a specified price. But the holder is under no obligation to exercise the contract. The holder of an option has the right, but not the obligation, to carry out the agreement according to the terms specified in the agreement

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FEATURES OF OPTIONS

The buyer has the right to buy or sell the asset. To acquire the right of an option, the buyer of the option must pay a price to the seller. This is called the option price or the premium. It is the fixed price at which the holder of the call or put can buy or sell the underlying asset. The expiration date is the final date that the option holder has to exercise to buy or sell the underlying Sep-13 asset.

SWAP
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

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FEATURES
Most involve multiple payments, although one-payment contracts are possible When initiated, neither party exchanges any cash; a swap has zero value at the beginning. One party tends to pay a fixed rate while the other pays on the movement of the underlying asset. However, a swap can be structured so that both parties pay each other on the movement of an underlying asset. Parties make payments to each other on a settlement date. Parties may decide to agree to just exchange the difference that is due to each other. This is called netting. Final payment is made on the termination date. Sep-13

MOST COMMONLY USED TYPES SWAP

An INTEREST RATE SWAP (IRS) is a popular and highly liquid financial derivative instrument in which two parties agree to exchange interest rate cash flows, based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another. Interest rate swaps are commonly used for both hedging and speculating ______________________________________________________ A CURRENCY SWAP is a foreign-exchange agreement between two institutions to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap.
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SWAPTIONS
Swaptions are options on swaps. It is an option that entitles the holder the right to enter into having calls and puts, Swaptions have receiver Swaptions (an option to receive fixed and pay floating) and a payer Swaptions (an option to pay fixed and receive floating).
Types: Payer swaption: A n option to enter into a swap as a fixed-rate payer. Receiver swaption: An option to enter into a swap as a fixed-rate receiver.
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FEATURES
Expiration date: Swaptions can be European style (exercisable only at expiration) or American style (exercisable at any time prior to expiration). Underlying: A swaption is based on a specific underlying swap. Swap payments will be annual. The underlying can be viewed as a five-year swap at the time the swaption is initiated, and will be a three-year swap when the swaption expires. Price: A swaption has a price or premium, which is an amount paid by the buyer to the seller up front. Settlement: There are a number of ways to settle a swaption at expiration.
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USES OF SWAPTIONS.
Anticipation of the need for a swap in the future. Parties often expect to need a swap later and would like to hedge against unfavorable interest rate moves while preserving the flexibility to gain from favorable moves.

Anticipation of the need to terminate an already existing swap. A party may wish to terminate an existing swap before expiration. Suppose a party in a swap is paying fixed and receiving floating. If it owned a receiver Swaptions, it could exercise the Swaptions, thereby entering into a swap to receive fixed rate a pay a floating rate. It would then have offset the floating parts of the swap, effectively removing any randomness from the position.
Speculating on interest rates. As with any interest rate sensitive instrument, Swaptions can be used to speculate. Their prices move with interest rates and they contain significant leverage like all options.

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TRADING PARTICIPANTS
Hedgers: The process of managing the risk or risk management is called
as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximizing of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk Speculators: Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity.
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 Arbitrageurs: Arbitrage is the simultaneous purchase and sale of the

same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary. Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly wellinformed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed. Intermediary participants in the derivatives market
Brokers Jobbers
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RISK FACTOR OF DERIVATIVES

Credit risk: Credit risk is the risk of loss due to counterpartys failure to perform on an obligation to the institution. Market risk: Market risk is the risk of loss due to adverse changes in the market value (the price) of an instrument or portfolio of instruments. Such exposure occurs with respect to derivative instruments when changes occur in market factors such as underlying interest rates, exchange rates, equity prices, and commodity prices or in the volatility of these factors. Liquidity risk: Liquidity risk is the risk of loss due to failure of an institution to meet its funding requirements or to execute a transaction at a reasonable price. Institutions involved in derivatives activity face two types of liquidity risk: market liquidity risk and funding liquidity risk.

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Operational risk: Operational risk is the risk of loss occurring as a result of inadequate systems and control, deficiencies in information systems, human error, or management failure. Derivatives activities can pose challenging operational risk issues because of the complexity of certain products and their continual evolution. Legal risk: Legal risk is the risk of loss arising from contracts which are not legally enforceable (e.g. the counterparty does not have the power or authority to enter into a particular type of derivatives transaction) or documented correctly. Regulatory risk: Regulatory risk is the risk of loss arising from failure to comply with regulatory or legal requirements. Reputation risk: Reputation risk is the risk of loss arising from adverse public opinion and damage to reputation.

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FACTORS AFFECTING DERIVATIVES

(i.) Misconception of Derivatives: There is a wrong feeling that derivatives would bring in financial collapse. the improper handling of these instruments is the main cause for this and one can not simply blame derivatives for all these miss happenings. (ii.) Leveraging: One the important characteristic features of derivatives is that they lend themselves to leveraging. That is, they are high risk high reward vehicles. (iii.) Off Balance Sheet Items: Invariably, derivatives are off balance sheet items. For instance, swap agreements for substituting fixed rate interest bearing asset by floating rate bonds or for substituting fixed rate interest bearing asset by floating rate interest paying liability. Hence, accountants, regulators and others look down upon derivatives.
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(iv.) Absence of Proper Accounting System: To achieve the desired results, derivatives must be strongly supported by proper accounting systems, efficient internal control and strict supervision. Unfortunately, they are all at infancy level as far as derivatives are concerned.

(v.) Inbuilt Speculative Mechanism: In fact all derivatives contracts are structured basically on the basis of the future price movements over which the speculators have an upper hand. Indirectly, derivatives make one accept the fact that speculation is beneficial. (vi.) Absence of Proper Infrastructure: An imported requirement for using derivative instrument like options, futures, etc. is the existence of proper infrastructure. Hence, the institutional infrastructure has to be developed. There has to be effective surveillance, price dissemination and regulation of derivative transactions.
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SCOPE OF DERIVATIVE IN INDIA

In the forex market, there are brighter chances of introducing derivatives on a large scale. In fact, the necessary groundwork for the introduction of derivatives in forex market was prepared by a highlevel expert committee appointed by the RBI. It was headed by Mr. O.P. Sodhani. Committees report was already submitted to the Government in 1995. As it is, a few derivative products such as interest rate swaps, coupon swaps, currency swaps and fixed rate agreements are available on a limited scale. It is easier to introduce derivatives in forex market because most of these products are OTC products (Over-the-counter) and they are highly flexible.

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These are always between two parties and one among them is always a financial intermediary. However, there should be proper legislations for the effective implementation of derivative contracts. The utility of derivatives through Hedging can be derived, only when, there is transparency with honest dealings. The players in the derivative market should have a sound financial base for dealing in derivative transactions. What is more important for the success of derivatives is the prescription of proper capital adequacy norms, training of financial intermediaries and the provision of well-established indices. Brokers must also be trained in the intricacies of the derivativetransactions. Now, derivatives have been introduced in the Indian Market in the form of index options and index futures. Index options and index futures are basically derivate tools based on stock index. They are really the risk management tools.

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Since derivate are permitted legally, one can use them to insulate his equity portfolio against the vagaries of the market. Every investor in the financial area is affected by index fluctuations. Hence, risk management using index derivatives is of far more importance than risk management using individual security options. Moreover, Portfolio risk is dominated by the market risk, regardless of the composition of the portfolio. Hence, investors would be more interested in using index-based derivative products rather than security based derivative products. There are no derivatives based on interest rates in India today. However, Indian users of hedging services are allowed to buy derivatives involving other currencies on foreign markets. India has a strong dollar- rupee forward market with contracts being traded for one to six month expiration. Daily trading volume on this forward market is around $500 million a day. Hence, derivatives available in India in foreign exchange area are also highly beneficial to the users
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USERS OF FINANCIAL DERIVATIVES

In India, Financial Institutions have not been heavy users of exchangetraded derivatives So far, with their contribution to total value of NSE trades being less than 8% in October 2005. However, market insiders feel that this may be changing, as indicated by the Growing share of index derivatives (which are used more by Institutions than by retail Investors). In contrast to the exchange-traded markets, domestic financial institutions and Mutual funds have shown great interest in OTC fixed income instruments. Transactions Between banks dominate the market for interest rate derivatives, while state-owned banks Remain a small presence (2003). Corporations are active in the currency forwards Corporations are active in the currency forwards and swaps markets, buying these instruments from banks. Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE.
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The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors (including small brokerages trading for themselves) are the major participants in equity derivatives, accounting for about 60% of turnover in October 2005, according to NSE. The success of single stock futures in India is unique, as this instrument has generally failed in most other countries. One reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the markets for commodity derivatives, due in part to their longstanding expertise in trading in the havala or forwards markets.
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CONCLUSION
Regulatory reform will help the markets grow faster. For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. Due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest growing segment of the market globally, are absent in India and require regulatory action if they are to develop. As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmed to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading.
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BIBLIOGRAPHY Web Links :

http://www.newyorkfed.org/research/economi sts/sarkar/derivatives_in_india.pdf Investopedia - Educating the world about finance www.investopedia.com/ Wikipedia, the free encyclopedia en.wikipedia.org/

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