FINANCIAL DERIVATIVES, MBA

1. Kothakota Venkata Ramana,
Assistant Professor,
MBA Dept.,
Giacr Engg. College,
Rayagada
FINANCIAL DERIVATIVES

2. INTRODUCTION TO FINANCIAL
DERIVATIVES
A derivative is a financial security with a value that is reliant
upon or derived from, an underlying asset or group of
assets—a benchmark. The derivative itself is a contract
between two or more parties, and the derivative derives its
price from fluctuations in the underlying asset.
The most common underlying assets for derivatives are
stocks, bonds, commodities, currencies, interest rates, and
market indexes. These assets are commonly purchased
through brokerages.

3.  Derivatives can trade over-the-counter (OTC) or on an
exchange. OTC derivatives constitute a greater
proportion of the derivatives market. OTC-traded
derivatives, generally have a greater possibility
of counterparty risk. Counterparty risk is the danger that
one of the parties involved in the transaction might
default. These parties trade between two private parties
and are unregulated.
 Conversely, derivatives that are exchange-traded are
standardized and more heavily regulated.

4. • Derivatives are securities that derive their value from an
underlying asset or benchmark. Common derivatives
include futures contracts, forwards, options, and swaps.
• Most derivatives are not traded on exchanges and are
used by institutions to hedge risk or speculate on price
changes in the underlying asset.
• Exchange-traded derivatives like futures or stock options
are standardized and eliminate or reduce many of the
risks of over-the-counter derivatives
• Derivatives are usually leveraged instruments, which
increases their potential risks and rewards.

5. Origin of the Derivatives Market in India
Derivatives market in India has a history dating back in 1875. The
Bombay Cotton Trading Association started future trading in this year.
History suggests that by 1900 India became one of the world’s largest
futures trading industry.
However after independence, in 1952, the government of India officially
put a ban on cash settlement and options trading. This ban on
commodities future trading was uplift in the year 2000. The creation of
National Electronics Commodity Exchange made it possible.
In 1993, the National stocks Exchange, an electronics based trading
exchange came into existence. The Bombay stock exchange was
already fully functional for over 100 years then.
Over the BSE, forward trading was there in the form of Badla trading, but
formally derivatives trading kicked started in its present form after 2001
only. The NSE started trading in CNX Nifty index futures on June 12,
2000, based on CNX Nifty 50 index.

6. Advantages of Derivatives
Derivatives can be a useful tool for businesses and
investors alike. They provide a way to lock in prices,
hedge against unfavorable movements in rates,
and mitigate risks—often for a limited cost.
In addition, derivatives can often be purchased on
margin—that is, with borrowed funds—which makes
them even less expensive.

7. Disadvantages of Derivatives
On the downside, derivatives are difficult to
value because they are based on the price of
another asset. The risks for OTC derivatives
include counter-party risks that are difficult to
predict or value as well.
Most derivatives are also sensitive to changes
in the amount of time to expiration, the cost of
holding the underlying asset, and interest
rates. These variables make it difficult to
perfectly match the value of a derivative with
the underlying asset.

8. Pros
Lock in prices
Hedge against risk
Can be leveraged
Diversify portfolio
Cons
Hard to value
Subject to
counterparty default (if OTC)
Complex to understand
Sensitive to supply and
demand factors

10. A forward contract or simply a forward is a contract between
two parties to buy or sell an asset at a certain future date for
a certain price that is pre-decided on the date of the
contract.
The future date is referred to as expiry date and the pre-
decided price is referred to as Forward Price.
It is the customized contract, in the sense that the term of
the contract are agreed upon by the individual parties.
Hence it is traded on Over The Counter (OTC).
Default risk, Credit risk & Counter-party risk involved in
this type of contract.

12. Like a forward contract, a futures contract is an agreement
between two parties in which the buyer agrees to buy an
underlying asset from the seller, at a future date at a price
that is agreed upon today.
Unlike a forward contract, a futures contract is not a private
transaction but gets traded on a recognized stock exchange.
In addition, a futures contract is standardized by the
exchange.
Both buyer and seller of the futures contracts are protected
against the counter party risk by an entity called the Clearing
Corporation.

14. Like forwards and futures, options are derivative
instruments that provide the opportunity to buy or
sell an underlying asset on a future date.
Options can be divided into two different
categories depending upon the primary exercise
styles associated with options. These categories
are American option & European option.
There are two types of options—call options and
put options—which are explained below.

16. Call option gives the buyer the right but not the obligation to
buy a given quantity of the underlying assets, at a given price
on or before a given future date.
If assets price is higher than the strike price – Option is in the
money.
If assets price is exactly at the strike price – Option is at the
money.
If assets price is below the strike price – Option is out of the
money.

19. Put gives the buyer the right but not obligation to sell agiven
quantity of the underlying asset at a given price on or before
a given date.
If asset price is lower than the strike price – Option is in the
money.
If asset price is exactly at the strike price – Option is at the
money.
If asset price is higher than the strike price – Option is out of
the money.

22. Swaps are private agreement between two parties to
exchange cash flows in the future according to pre arranged
formula. They can be regarded as portfolio’s of forward
contract.
The two commonly used swaps are:
Interest rate swaps: This entail swapping only the interest
related cash flows between the parties in the same currency.
Currency swaps: This entail swapping both principal and
interest between the parties with the cash flows in one
direction being in a different currency than those in the
opposite direction.

23. DERIVATIVE MARKETS
Exchange Traded Derivatives: Derivatives which are traded on
an exchange are called exchange traded derivatives. Trades
on an exchange generally take place with anonymity i.e.
buyer and seller do not know each other. Generally go
through the clearing corporation. E.g. S&PCNX nifty futures,
OPTINDX nifty.
OTC Derivatives: A derivative contract which is privately
negotiated is called the OTC derivative. OTC trades have no
anonymity and they generally do not go through a clearing
corporation. E.g. foreign exchange transaction between banks
and its cliants.

24. MARKET
PARTICIPANTS

25. HEDGERS
Hedge is the position taken in derivative exchange/markets
for the purpose of reducing risk. A person who takes such
position is called hedger.
A hedger uses the derivatives market to reduce risk caused by
movement in prices of shares/securities, commodities,
exchange rates, interest rate, indices, etc.
The position taken by hedger is opposite to the risk he is
exposed.
Taking an opposite position to the risk exposure is called
hedging strategy.

26. SPECULATORS
A speculator may be defined as a investor who is willing to
take a risk by taking derivatives position with the expectation
to earn profits.
The speculator forecasts the future economic conditions and
decides which position (long or short) to be taken will yield a
profit if his forecast is correct.

27. MARGIN TRADERS
A margin refers to the minimum amount that you need to deposit with the
broker to participate in the derivative market. It is used to reflect your losses
and gains on a daily basis as per market movements. It enables to get a
leverage in derivative trades and maintain a large outstanding position.
Imagine that with a sum of Rs. 2 lakh you buy 200 shares of ABC Ltd. of Rs
1000 each in the stock market. However, in the derivative market you can own
a three times bigger position i.e. Rs 6 lakh with the same amount. A slight price
change will lead to bigger gains/losses in the derivative market as compared to
stock market.

28. ARBITRAGEURS
An arbitrageur is an intelligent trader who attempts to make
profits in a derivatives market by simultaneously entering into
two transaction at a time in two different markets and takes
advantage of the difference in pricing.
The arbitrage opportunities available in two markets usually
do not last long because of heavy transaction by arbitrageur
when such opportunity arises.