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Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Hedging Hedging using derivatives is commonly used by parties who seek to offset their existing risks by entering into a derivatives transaction. Speculating Speculation is more commonly used by hedge funds or traders who aim to generate profits with only a marginal investment. Arbitrage Practitioners working within risk finance or quantitative finance often develop models to price various assets being traded across the markets, and upon finding price discrepancies, one can make use of a specific combination of derivatives in order make a riskless profit.

Derivative securities include stock options, warrants, rights, convertible debt, and convertible preferred stock. These securities confer a right to buy or sell an underlying asset, typically a financial security like a stock or bond, at a fixed price within a designated period of time. Derivative securities are typically valued using a version of the Black-Scholes Option Pricing Model. The two key inputs in valuing derivative securities are the price of the underlying asset and the volatility of the asset s return.

The commodity derivative market has been functioning in India since the nineteenth century with organized trading in cotton through the establishment of Cotton Trade Association in 1875. Over the years, there have been various bans, suspensions and regulatory dogmas on various contracts. There are 25 commodity derivative exchanges in India as of now and derivative contracts on nearly 100 commodities are available for trade. The overall turnover touched Rs 5 lakh crore (Rs 5 trillion) by the end of 20082009. National Commodity and Derivatives Exchange (NCDEX) is the largest commodity derivatives exchange with a turnover of around Rs 3,000 crore (Rs 30 billion) every fortnight.

S C E N A R I O

The OTC segment operates with almost complete disregard of national borders. Derivatives exchanges themselves provide equal access to customers worldwide. As long as local market regulation does not impose access barriers, participants can connect and trade remotely and seamlessly from around the world (e.g. from their London trading desk to the Eurex exchange in Frankfurt). The fully integrated, single derivatives market is clearly a reality within the European Union. Taken as a whole, the derivatives market is truly global. For example, today almost 80 percent of the turnover at Eurex, one of Europe s major derivatives exchanges, is generated outside its home markets of Germany and Switzerland, up from only 18 percent ten years ago

After Independence, the Constitution of India adopted by Parliament on 26 January, 1950 placed the subject of Stock Exchanges and Futures Market in the Union list and therefore the responsibility for regulation of forward contracts devolved on government of India. The Parliament passed the Forward Contracts (Regulation) Act, 1952, (FCRA) which presently regulates forward contracts in commodities all over India. The Securities Contracts (Regulation) Act (SCRA) was enacted in 1957 on the lines of FCRA, 1952, but another department of the government regulated security markets.

L E G A L F R A M E W O R K

Derivatives make future risks tradable, which gives rise to two main uses for them. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporates and nancial institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates, interest rates etc., as shown in the box below. They serve as insurance against unwanted price movements and reduce the volatility of companies cash flows, which in turn results in more reliable forecasting, lower capital requirements, and higher capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the world s 500 largest companies manage their price risks using derivatives.

 The Act applies to goods, which are defined as any movable property other than security, currency and actionable claims. In the preamble of the Act itself, the intention of the legislature to prohibit options in goods is made explicit. By a specific provision, section 19, such agreements are prohibited. (The proposal to regulate options in goods is under consideration of the government.) The Act classifies contracts/agreements into two broad categories, viz., ready delivery contracts and forward contracts. Ready delivery contract are those where delivery of goods and full payment of price therefore is made within a period of eleven days. (The proposal to extend the period to thirty days is under consideration of Government). It is further clarified that notwithstanding the period of performance contract, if the contract is performed by payment of 164 Regulation and Policy issues for . . . money difference (cash settlement), it would not be a ready delivery contract. The Act defines forward contract as the contract for delivery of goods which is not a ready delivery contract.

Forward contracts are implicitly classified into two broad categories, viz., specific delivery contracts and non-specific delivery contracts or standardized contracts. Though, de-facto, the focus of the regulation are standardized contracts (futures contracts), these are not defined in the present Act (it is proposed to introduce definition of futures contract in the Act). Specific delivery contracts (where the terms of the contracts are specific to each contract customized contracts) where the buyer does not transfer the contract by merely transferring document of title to the goods and exchanging money difference between the sale and purchase price (also termed as Non-transferable Specific Delivery Contracts) are normally outside the purview of the Act. However, there is an enabling provision empowering the government to regulate or prohibit such contracts. The Act provides for either regulation of the other forward contract in specified commodities or prohibition of specified commodities. Such contracts in the commodities, which do not figure in, regulated or prohibited categories, are outside the purview of the Act, except when they are organized by some exchange.

 In response to heightened concern, governments worldwide are acting to rationalize markets, and to rein in risks. In the U.S., proposed legislation will address the credit risks posed by the nature of the bilateral agreement, as well as the risks posed to the financial system from fraud and market manipulation. The Over-the-Counter Derivatives Markets Act of 2009 drafted by the U.S. administration in August contains rules that are likely to find their way into law in the near future.

y A major thrust of this draft legislation is to force OTC derivatives away from bilateral agreements and into central clearing houses. OTC derivatives, including credit default swaps, will be classified as standardized or non-standardized.
Contracts that are accepted by a clearing house would be put

into the standardized category. y Standardized contracts would be required to be centrally cleared.
Standardized contracts would be required to be traded on a

CFTC- or SEC-regulated exchange or on alternative swap execution facilities approved by regulators. The CFTC and SEC would be given authority to prevent market participants from using spurious customization to avoid central clearing and exchange trading. Higher capital requirements and margin requirements will be required for non-standardized derivatives.

A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. Futures contracts are special types of forward contracts in the sense that the former are standardized exchangetraded contracts. When a forward contract is traded on a recognized exchange, it is referred to as a futures contract". Examples of futures include commodities, interest rates, currencies, and stock market indices.

Advantages of Futures Trading in India High Leverage. Profit in both bull & bear markets. Lower transaction cost Lower transaction cost.

Disadvantages of Futures Trading in India partial hedge. highly risky fixed amounts and terms commission costs subject to basis risk

F U T U R E S

Both total U.S. and total foreign futures and option trading volume have increased significantly over the period 1994-1998; the U.S. share of total worldwide futures and option trading activity appears to be stabilizing as the larger foreign markets have matured; as in 1994, the most actively traded foreign products tend to fill local or regional risk management needs and few products offered by foreign exchanges directly duplicate products offered by U.S. markets; the increased competition among mature segments of the global futures industry, particularly in Europe, may reflect industry restructuring and the introduction of new technologies, particularly electronic trading; and to date, the distinctions in regulatory regimes between various countries do not appear to have been a significant factor in the competitive position of the world's leading exchanges.

OPTIONS: The right, but not the obligation, to buy (for a call option) or sell (for a put option) a specific amount of a given stock, commodity, currency, index, or debt, at a specified price (the strike price) during a specified period of time. For stock options, the amount is usually 100 shares. Each option has a buyer, called the holder, and a seller, known as the writer
1.

CALL OPTION: An option contract that gives the holder the right to buy a certain quantity (usually 100 shares) of an underlying security from the writer of the option, at a specified price (the strike price) up to a specified date (the expiration date). PUT OPTION: An option contract that gives the holder the right to sell a certain quantity of an underlying security to the writer of the option, at a specified price (strike price) up to a specified date (expiration date); here also called put

2.

An ETF is an Exchange Traded Fund, meaning it is traded on the major stock exchanges. The NYSE, and NASDAQ have ETF s, but the American Stock Exchange (AMEX) is the primary trading venue for Gold ETF funds. When you buy an ETF, you are typically investing in a conglomerate of companies, rather than a single corporation. It works like this, the Gold ETF fund will purchase a large amount of gold, maintaining the physical metal in storage. They will then issue shares in baskets, the idea here being that the value of the shares will increase with the price of gold bullion. If the price of gold goes up by 10%, then individual shares would increase in value by the same 10%. What makes this attractive to most buyers is the fact that trading in gold can be done very easily at any time during stock market hours using your online brokerage account. Another thing people like is you don t have to buy a large amount of gold to invest. Most gold ETF funds have a minimum investment but you can buy in portions of an ounce. This is really ideal since the price of an ounce of gold these days is not something everyone can afford to purchase. Some of the more popular venues for buying gold or gold mining companies include the SPDR Gold Trust (GLD), Market Vectors Gold Miners ETF (GDX), and ProShares Ultra Gold (UGL).

2012

Rs. 29,000

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement.

Risks of forward contracts: Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaults between the initial agreement date and delivery date, you may have a loss. However, two conditions must apply before a party faces a loss: The spot price moves in favor of the party, entitling it to compensation by the counterparty, and the counterparty defaults and is unable to pay the cash difference or deliver the asset. The disadvantages of forward contracts are: The advantages of forward contracts are: 1) They can be matched against the time period of exposure as well as for the cash size of the exposure. 2) Forwards are tailor made and can be written for any amount and term. 3) It offers a complete hedge. 4) Forwards are over-the-counter products. 5) The use of forwards provide price protection. 6) They are easy to understand. 1) It requires tying up capital. There are no intermediate cash flows before settlement. 2) It is subject to default risk. 3) Contracts may be difficult to cancel. 4) There may be difficult to find a counterparty.

Bonus certificates are participation products that feature full upside participation and a conditional capital protection as long as the underlying asset doesn t cross a predefined threshold (barrier). In most products, a fixed bonus will be paid to the holder of the certificate if the underlying asset didn t cross the preset barrier and if the performance of the underlying asset is lower than the predefined bonus. Hence, bonus certificates tend to perform well in both sideways and rising markets. There are however two major disadvantages of the product: first, bonus certificates do not pay out any dividends, which stock shareholders get on a yearly or quarterly basis. Second, the payoff shown below is only valid at maturity; the mark-to-market price of the bonus certificate during its lifetime differs strongly from its final payoff. It may be stated that in general, the contingent protection and bonus will only grip after most of the product s maturity has elapsed.

The government would enlarge the coverage of futures market to minimize the wide fluctuations in commodity prices, as also for hedging their risk. It was mentioned that an endeavor would be to cover all-important agricultural products under futures trading in the course of time. An expert committee on agricultural marketing headed by Mr. Shankerlal Guru recommended linkage of spot and forward markets, introduction of electronic warehouse receipt system, inclusion of more and more commodities under futures trading and promotion of national system of warehouse receipt.

A sub-group on forward and futures markets was formed under the chairmanship of Dr. Kalyan Raipuria to examine the feasibility of implementing the recommendations made by the expert committee, which recommended that the commodity specific approach to the grant of recognition should be given up. The Finance Minister announced expansion of futures and forward trading to cover all agricultural commodities. The economic survey for the year 2000-2001 indicated the intention of the government to allow futures trading in Bullion. A number of initiatives were also taken to decontrol the spot markets in commodities. The number of commodities listed as essential commodities has been pruned down to 17.

oThe derivatives market has grown rapidly in recent years as the bene ts of using derivatives, such as effective risk mitigation and risk transfer, have become increasingly important. oEurope is by far the most important region for derivatives that have become a major part of the European nancial services sector and a major direct and indirect contributor to economic growth.

 On the whole, derivatives are a great investment vehicle if regulated

and traded properly.

 Hedgers can control their risk with the use of a small amount of

money down.
 Investors or speculators have the ability to participate in a wide

variety of investments through the use of derivatives that wouldnt otherwise be feasible.
 Those who use derivatives properly often benefit and those who

dont will often create problems for themselves and others.