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Derivatives
Objectives
To understand the meaning of financial
derivatives;
To know the various types of financial derivatives
are available;
To know about background and uses of financial
derivatives;
To know classification of derivatives markets;
Difference between Forward & Futures Contract;
To know important players in the derivatives
market ;
Introduction
A derivative is a financial product which has
been derived from another financial product
or commodity.
Concept of Derivatives:
“ A derivative is instrument whose value is
derived from the value of one or more
underlying assets”. These underlying
assets can be securities, commodities,
bullion, currency, livestocks and so forth.
Legal definition of Derivatives –
Indian Context
In India, the Securities Contracts
(Regulations) Act of 1956, SC(R) A, defines
the word ‘derivatives’ to include;
1. 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.
2. A contract which derives its value from the
prices, or index of prices, of underlying
securities.
Legal definition of Derivatives…..
Futures Options
- Obligation - both the - Only the seller (writer)
parties of the contract is obliged
- No premium is paid - The buyer pays
- Holder of the contract - The buyer’s loss is
is exposed to the entire restricted to downside
spectrum of downside risk risk to the premium paid.
- Contract must perform at - The buyer can exercise
settlement date. Not option at any time prior
obliged to perform before to the expiry date.
the date.
Swaps: Swaps re agreements between two
parties to swap the cash flows arising from
particular financial instruments.
Interest rate swaps: which entail swapping
only the interest-related cash flows between the
parties, in the same currency.
Currency swaps: which entail swapping both
principal and interest between the parties, with
the cash flows in one direction being in a
different currency to those in the opposite
direction.
Growth of derivatives market:
(in India)
Equity Derivatives:
BSE Derivatives:
Trading in BSE-30(sensex) index Futures - June 9
2000. It was introduced with three month trading cycle
– the near month (one), the next month (two) and the
far month (three).
BSE Sensex Options – June 4, 2001
Individual options – July 2001.
Derivatives market in India……..
NSE Derivatives:
NSE launched the S&P CNX Nifty Index
futures – on June 12, 2000.
Futures contract on Individual Stocks – Nov,
2001
Index Options – June 4, 2001
Options on individual securities – July 2, 2001
Derivatives market in India……..
Commodity Exchange:
1970 Commodity exchange through OTC
Cotton was the first trade commodity on
organized exchange in India.
The Forward Contract Regulation Act (FCRA)
governs commodity exchange in India.
National Multi Commodity Exchange-NMCE
(Ahmedabad) – First commodity exchange-2002
Derivatives market in India……..
Commodity Exchange…………
National Commodities and Derivatives Exchange
(NCDEX) & Multi Commodity Exchange (MCE)
started functioning by last quarter of 2003.
Bullion and Energy products contribute 75-80
percent of MCX business.
Agri-products which contribute around 80 percent
of NCDEX business.
Banks, FIs, MFs, PFs, Insurance & FIIs are
allowed in the commodity market.
Derivatives market in India……..
Currency Derivatives:
India trading forward contracts in currency for the
last 7 years.
RBI recently allowed options in the over-the-counter
currency.
Interest Rate Derivatives:
NSE introduced trading in cash settled interest rate
Futures in 2003
Uses of Derivatives:
Derivatives are used to control, avoid, shift and
manage efficiently different risk by using various
strategies like hedging, arbitraging, spreading etc.
No immediate full amount, enhance liquidity and
reduce transaction cost.
Attract the investors due to competitive trading in
the market.
It develops ‘complete markets’, where no particular
investors be better of than others, or there is no
further scope of additional security.
Critics of Derivatives:
Speculative and gambling motives: more
speculative trading due to more trading volume
increased in multiples & only one or two percent of
derivatives settled by the actual delivery.
Increase in risk: OTC markets, as customized,
privately managed more credit risk.
Price instability: due to fluctuations in asset prices.
Increased regulatory burden
Displacement effect: increased volume in
secondary market by the investors, reduce the
volume of the business in the primary market.
Players in derivatives market
(a) Hedgers – who wish to eliminate the risk
(price change) to which they are already
exposed. Ex; Forex risk (Forward contract)
Hedgers Example….
Similarly,