1. Financial Derivatives
Derivatives are financial contracts whose value/price is dependent on the behaviour of the price of one
or more basic underlying assets (often simply known as the underlying). These contracts are legally
binding agreements, made on the trading screen of stock exchanges, to buy or sell an asset in future.
The asset can be a share, index, interest rate, bond, rupee dollar exchange rate, sugar, crude oil,
soyabean, cotton, coffee and what you have.
Thus, a ‗derivative‘ is a financial instrument, or contract, between two parties that derived its value from
some other underlying asset or underlying reference price, interest rate, or index. A derivative by itself
does not constitute ownership, instead it is a promise to convey ownership.
TYPES OF DERIVATIVES
1. Forwards : - A Forward contract is a customized contract between two entities, where settlement takes
place on a specific date in the future at today‘s pre-agreed price. The rupee-dollar exchange rate is a big
forward contract market in India with banks, financial institutions, corporate and exporters being the
market participants. Forward contracts are generally traded on OTC.
2. Futures :- 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 exchange-traded contracts. Unlike forward contracts, the counterparty
to a futures contract is the clearing corporation on the appropriate exchange. Future often are settled in
cash or cash equivalents, rather than requiring physical delivery of the underlying asset. Parties to a
futures contract may buy or write options on futures.
3. Options :- An option represents the right (but not the obligation) to buy or sell a security or other asset
during a given time for a specified price (the strike price). Options are of two types- calls and puts. Calls
give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given
price on or before a given future date. Puts give the buyer the right, but not the obligation to sell a given
quantity of the underlying asset at a given price on or before a given date.
4. Complex (Swap) :- Swap are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of forward contracts.
Swaps generally are traded OTC through swap dealers, which generally consist of large financial
institution, or other large brokerage houses, there is a recent trend for swap dealers to mark to market
the swap to reduce the risk of counterparty default.
Other types of financial derivatives:
Warrants: Options generally have lives of up to one year, the majority of options traded on options exchanges
having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded
over-the-counter.
LEAPS: The acronym LEAPS means long-term equity anticipation securities. These are options having a
maturity of upto three years.
Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving
average of a basket of assets. Equity index options are a form of basket options.

2. TRADERS IN DERIVATES MARKETS
Those who trade or participate in derivative/underlying security transaction may be broadly classified into three
categories: -
1. Hedgers (Those who desire to off-load their risk exposure on a position) ;- Hedgers are those traders
who wish to eliminate price risk associated with the underlying security being traded. The objective of
these kind of traders is to safeguard their existing positions by reducing the risk. They are not in the
derivatives market to make profits.
2. Speculators (Those willing to absorb risk of hedgers for a cost) : - While hedgers might be adept at
managing the risks of exporting and producing petroleum products around the world, there are parties
who are adept at managing and even making money out of such exogenous risks. Using their own
capital and that of clients, some individuals and organizations will accept such risks in the expectation of
a return. But unlike investing in business along with its risks, speculators have no clear interest in the
underlying activity itself.
3. Arbitragers (Those who wish to have riskless gain in the transaction of hedgers and speculators) :- The
third players are known as arbitrageurs. From the French for arbitrage or judge, these market
participants look for mis-pricing and market mistakes, and by taking advantage of them, they disappear
and never become too large. If you have even purchased a produce of a green grocer only to discover
the same produce somewhat cheaper at the next grocer, you have an arbitrage situation.
DEVELOPMENT OF DERIVATIVE MARKETS IN INDIA
Derivatives markets have been in existence in India in some form or other for a long time. In the area of
commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s India
had one of the world‘s largest futures industry. In 1952 the government banned cash settlement and options
trading and derivatives trading shifted to informal forwards markets. In recent years, government policy has
changed, allowing for an increased role for market-based pricing and less suspicion of derivatives trading. The
ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic
commodity exchanges were created. In the equity markets, a system of trading called ―badla‖ involving some
elements of forwards trading had been in existence for decades. However, the system led to a number of
undesirable practices and it was prohibited off and on till the Securities and Exchange Board of India (SEBI)
banned it for good in 2001. A series of reforms of the stock market between 1993 and 1996 paved the way for the
development of exchange traded equity derivatives markets in India. In 1993, the government created the NSE in
collaboration with state-owned financial institutions. NSE improved the efficiency and transparency of the stock
markets by offering a fully automated screen-based trading system and real-time price dissemination. In 1995, a
prohibition on trading options was lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded
derivatives.
The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by exchanges with SEBI providing
a supervisory and advisory role). Another report, by the J. R. Varma Committee in 1998, worked out various
operational details such as the margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared ―securities.‖ This allowed the regulatory framework
for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if
they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999.

3. Types of Financial Futures
Eurodollar Futures
Eurodollar futures are U.S. dollars that are deposited outside the country in commercial banks mainly in Europe
which are known to settle international transactions. They are not guaranteed by any government but only by the
obligation of the bank that is holding them.
U.S. Treasury Futures
Because U.S. Dollars is the reserved currency for most countries, the stability of the dollars allows for treasury
futures market and instruments such as treasury bonds and treasury bills.
Foreign Government Debt Futures
Most government issue debt that are corresponded to the futures markets that are listed around the world.
Swap Futures
This is generally agreements that are between two parties to exchange periodic interest payments.
Forex Futures
This type of futures is to manage the risks and take advantage of related forex exchange rate fluctuations.
Single Stock Futures
Most popular futures contracts are related to the equity markets, they are also known as security futures. There
are about 10 companies in Malaysia that offer single stock futures. They are Bursa Malaysia Bhd, Air Asia Bhd,
AMMB Holdings Bhd, Berjaya Sports Toto Bhd, Genting Bhd, IOI Corporation Bhd, Maxis Communications Bhd,
RHB Capital Bhd, Scomi Group Bhd and Telekom Malaysia Bhd.
Index Futures
Futures that are based on the stock index. In the case of the Kuala Lumpur Composite Index, the index futures
will be the FTSE Bursa Malaysia KLCI Futures (FKLI).

4. Improve this chart Forward Contract Futures Contract
Definition: A forward contract is an agreement A futures contract is a standardized
between two parties to buy or sell an contract, traded on a futuresexchange, to
asset (which can be of any kind) at a pre- buy or sell a certain underlying
agreed future point in time. instrument at a certain date in the
future, at a specified price.
Structure & Purpose: Customized to customer needs. Usually Standardized. Initial margin payment
no initial payment required. Usually used required. Usually used for speculation.
for hedging.
Transaction method: Negotiated directly by the buyer and Quoted and traded on the Exchange
seller
Market regulation: Not regulated Government regulated market (the
Commodity Futures Trading
Commission or CFTC is the governing
body)
Institutional The contracting parties Clearing House
guarantee:
Risk: High counterparty risk Low counterparty risk
Guarantees: No guranantee of settlement until the Both parties must deposit an initial
date of maturity only the forward price, guarantee (margin). The value of the
based on the spot price of the underlying operation is marked to market rates with
asset is paid daily settlement of profits and losses.
Contract Maturity: Forward contracts generally mature by Future contracts may not necessarily
delivering the commodity. mature by delivery of commodity.
Expiry date: Depending on the transaction Standardized
Method of pre- Opposite contract with same or different Opposite contract on the exchange.
termination: counterparty. Counterparty risk remains
while terminating with different
counterparty.
Contract size: Depending on the transaction and the Standardized
requirements of the contracting parties.

5. Swaps
A swap is any agreement to a future exchange of one asset for another, one liability for another, or more
specifically, one stream of cash flows for another. A swap is a private agreement between two parties in which
both parties are ‗obligated‘ to exchange some specified cash flows at periodic intervals for a fixed period of time.
Unlike a forward or a futures contract, a swap agreement generally involves multiple future points of exchange.
Evolution of Swaps
Currency loans evolved from the ‗parallel loan‘ concept which was devised by three global private sectors for
purposes of circumventing cross-border capital controls. Consider the working of a parallel loan. Let us suppose
that a British company wanted to establish a subsidiary in the U.S. in 1975. At that time, it was illegal by British
law for the company to raise debt in the form of British Pounds for purposes of overseas investment. The British
government‘s rationale for the control was the belief that stopping overseas investment was a way to ensure that
British capital be used for domestic investment, and thus to create jobs for British citizens.
However, there was no law to prevent a British company from raising British pounds in England and lending them
to a British subsidiary of an American firm. In return, on the other side of the Atlantic Ocean, the parent of the
American subsidiary could raise the equivalent amount in dollars by issuing debt in the United States and then
lend the dollars to the U.S. subsidiary of the British parent.
For the British parent, its U.S. subsidiary could receive the financing it needed. Britain‘s capital export controls
would be circumvented. While the British subsidiary of the U.S. firm made future pound-denominated interest and
principal payments to the British parent, the British parent‘s subsidiary would make dollar interest and principal
payments to the U.S. parent. Thus, in addition to the British circumvention of their capital controls, the U.S.
parent would be effectively repatriating the earnings of its overseas subsidiary to the U.S. without any repatriation
taxes levied by the host government.
Features of Swaps
The following are the important features of a swap:
a. Basically a forward: - A swap is nothing but a combination of forwards. So, it has all the properties of
forward contract.
b. Double coincidence of wants: - Swap requires that two parties with equal and opposite needs must
come into contact with each other. i.e. rate of interest differs from market to market and within the
market itself.
c. Comparative Credit Advantage: - Borrowers enjoying comparative credit advantage in floating rate
debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying
comparative advantage in fixed interest rate debt, like bond.
d. Flexibility: - In short term market, the lenders have the flexibility to adjust the floating interest rate (short
term rate) according to the conditions prevailing in the market as well as the current financial position of
the borrower.
e. Necessity of an intermediary: - Swap requires the existence of two counterparties with opposite but
matching needs. This has created a necessity for an intermediary to cancel both the parties.
f. Settlement: - Through a specified principal amount is mentioned in the swap agreement; there is no
exchange of principal. On the other hand, a stream of fixed rate interest is exchanged for a floating rate
of interest, and thus, there are streams of cash flows rather than single payment.
g. Long term agreement: - Generally, forwards are arranged for short period only. Long dated forward
rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate
fluctuations etc. but, swaps are in the nature of long term agreement and they are just like long dated
forward rate contracts.
Categories of Swap
The two basic categories of swap contracts are – Commodity Swaps, and Financial Swaps.
Types of commodity Swaps :-
There are two types of commodity swaps: Fixed-floating or Commodity-for-interest
1. Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the
exception that both indices are commodity based indices. General market indices in the commodities
market with which many people would be familiar include the Goldman Sachs Commodities Index

6. (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights
on the various commodities so that they will be used according to the swap agent‘s requirements.
2. Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity
in question is exchanged for some money market rate (plus or minus a spread).
Types of financial swaps
The two major types are
1. Interest rate swaps :- A standard fixed-to-floating interest rate swap, known in the market jargon as a
plain vanilla coupon swap (exchange borrowings) is an agreement between two parties in which each
contracts to make payments to the other on particular dates in the future till a specified termination date.
One party, known as the fixed rate payer, makes fixed payments all of which are determined at the
outset. The other party known as the floating rate payer will make payments the size of which depends
upon the future evolution of a specified interest rate index (6 month LIBOR).
2. Currency Swap: - Currency swaps are derivative products that help to manage exchange rate and
interest rate exposure on long-term liabilities. A currency swap involves exchange of interest payments
denominated in two different currencies for a specified term, along with exchange of principals. The rate
of interest in each leg could either be a fixed rate, or a floating rate indexed to some reference rate, like
the LIBOR.

7. Binomial option pricing model
In finance, the binomial options pricing model (BOPM) provides a generalizable numerical method for the
valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein (1979). Essentially, the
model uses a ―discrete-time‖ (lattice based) model of the varying price over time of the underlying financial
instrument. In general, binomial options pricing models do not have closed-form solutions.
Use of the model
The Binomial options pricing model approach is widely used as it is able to handle a variety of conditions for
which other models cannot easily be applied. This is largely because the BOPM is based on the description of
an underlying instrument over a period of time rather than a single point. As a consequence, it is used to
value American options that are exercisable at any time in a given interval as well as Bermudan options that are
exercisable at specific instances of time. Being relatively simple, the model is readily implementable in
computer software (including a spreadsheet).
Although computationally slower than the Black–Scholes formula, it is more accurate, particularly for longer-dated
options on securities with dividend payments. For these reasons, various versions of the binomial model are
widely used by practitioners in the options markets.
For options with several sources of uncertainty (e.g., real options) and for options with complicated features
(e.g., Asian options), binomial methods are less practical due to several difficulties, and Monte Carlo option
models are commonly used instead. When simulating a small number of time steps Monte Carlo simulation will
be more computationally time-consuming than BOPM (cf. Monte Carlo methods in finance). However, the worst-
n
case runtime of BOPM will be O(2 ), where n is the number of time steps in the simulation. Monte Carlo
simulations will generally have a polynomial time complexity, and will be faster for large numbers of simulation
steps. Monte Carlo simulations are also less susceptible to sampling errors, since binomial techniques use
discrete time units. This becomes more true the smaller the discrete units become.
Method
The binomial pricing model traces the evolution of the option's key underlying variables in discrete-time. This is
done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates.
Each node in the lattice represents a possible price of the underlying at a given point in time.
Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of
expiration), and then working backwards through the tree towards the first node (valuation date). The value
computed at each stage is the value of the option at that point in time.
Option valuation using this method is, as described, a three-step process:
1. price tree generation,
2. calculation of option value at each final node,
3. sequential calculation of the option value at each preceding node.
STEP 1: Create the binomial price tree
The tree of prices is produced by working forward from valuation date to expiration.
At each step, it is assumed that the underlying instrument will move up or down by a specific factor ( or ) per
step of the tree (where, by definition, and ). So, if is the current price, then in the
next period the price will either be or .
The up and down factors are calculated using the underlying volatility, , and the time duration of a step, ,
measured in years (using the day count convention of the underlying instrument). From the condition that
the variance of the log of the price is , we have:

8. Above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for generating the
lattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model, allowing for an up, down or
stable path.The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and then
down (u,d), the price will be the same as if it had moved down and then up (d,u) — here the two paths merge or
recombine. This property reduces the number of tree nodes, and thus accelerates the computation of the option
price.
This property also allows that the value of the underlying asset at each node can be calculated directly via
formula, and does not require that the tree be built first. The node-value will be:
Where is the number of up ticks and is the number of down ticks.
STEP 2: Find Option value at each final node
At each final node of the tree — i.e. at expiration of the option — the option value is simply its intrinsic, or
exercise, value.
Max [ ( ), 0 ], for a call option
Max [ ( – ), 0 ], for a put option:
Where is the strike price and is the spot price of the underlying asset at the period.
STEP 3: Find Option value at earlier nodes
Once the above step is complete, the option value is then found for each node, starting at the penultimate time
step, and working back to the first node of the tree (the valuation date) where the calculated result is the value of
the option.
In overview: the ―binomial value‖ is found at each node, using the risk neutrality assumption; see Risk neutral
valuation. If exercise is permitted at the node, then the model takes the greater of binomial and exercise value at
the node.
The steps are as follows:
(1) Under the risk neutrality assumption, today's fair price of a derivative is equal to the expected value of its
future payoff discounted by the risk free rate. Therefore, expected value is calculated using the option values
from the later two nodes (Option up and Option down) weighted by their respective probabilities—
―probability‖ p of an up move in the underlying, and ―probability‖ (1-p) of a down move. The expected value is
then discounted at r, the risk free rate corresponding to the life of the option.
The following formula to compute the expectation value is applied at each node:
Binomial Value = [ p × Option up + (1-p) × Option down] × exp (- r × Δt), or
where
is the option's value for the node at time ,
is chosen such that the related binomial distribution simulates the geometric
Brownian motion of the underlying stock with parameters r and σ,
is the dividend yield of the underlying corresponding to the life of the option. It follows that in a risk-
neutral world futures price should have an expected growth rate of zero and therefore we can
consider for futures.

9. Note that for to be in the interval the following condition on has to be
satisfied .
(Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see ―delta-
hedging‖.)
(2) This result is the ―Binomial Value‖. It represents the fair price of the derivative at a particular point in time (i.e.
at each node), given the evolution in the price of the underlying to that point. It is the value of the option if it were
to be held—as opposed to exercised at that point.
(3) Depending on the style of the option, evaluate the possibility of early exercise at each node: if (1) the option
can be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the value at the node is the
exercise value.
What is the difference between futures and options?
Derivatives;
derviatives is the product its price is derived from underlining asset (underlining asset my be
stocks,bonds,commodities,etc)
derivatives are as follows
futures and options it normally call as F&O...
futures:it is a contract between two parties to purchase and sell of products for future period at pre-determind
price....
options:it is the right but not the obligation to buy or sell underlining assets....
call option:is the right but not the obligation to buy the underlining asset....buyer may refuse the contract before
the maturity of contract.
put option:it is opposit of call option......
The primary difference lies in the obligation placed on the contract buyers and sellers.In a futures contract, both
participants in the contract are obliged to buy (or sell) the underlying asset at the specified price on settlement
day. As a result, both buyers and sellers of futures contracts face the same amount of risk.On the other hand, the
option contract buyer has the right but not the obligation to buy (or sell) the underlying asset. Hence the term
"option" and this option comes at a price in the form of a premium (more specifically, the time value of the
premium). With this "option", the option buyer's risk is limited to the premium paid but his potential profit is
unlimited.
Sellers of options take on an additional volatility risk in exchange for the premium. However, their potential profit
is then capped while their potential losses has no limit. Hence, this premium can be high if the underlying asset is
perceived to be very volatile.