MBA 406 (F): Financial Derivatives

UNIT-I: Introduction to Derivatives

Introduction

Derivative

It is a financial instrument, which derives its value from the underlying assiette’s. a forward
contract on gold, is the derivative instrument, while gold is the actual, underlying asset

The price of the derivative contract will be closely linked to the price & changes in price, of the
underlying asset, in this case, gold.

However, the underlying could also be a random event, or a state of nature (like weather)

In fact, exotic, complex, hybrid & customized derivatives, while being instrumental in growth &
protection, have often had terrible consequences, when unchecked for sense & sensibility.

The Net Supply of the Derivative Instrument is ZERO.

The supply of the Underlying, or Fundamental Asset, is a reality.

e.g., If there is a future contract on the exchange, on Reliance Industries

There can only be a derivative contract in existence, if there is a buyer and a seller, and both consent
to the price, executing the trade. Every single contract that exists has both, a buyer, and a seller. If
both close their positions, then the net derivative position becomes ZERO.

Contrast this with the actual underlying asset, in this case, shares of Reliance Industries.

The company has issued equity shares and the total outstanding equity is Rs. 3,238 crores (media
release, Reliance Industries Ltd, 16th October 2015)

This translates into a total of 323. 8 crore equity shares of Rs. 10/ each, fully paid-up

These shares exist, even if no fresh buyers or sellers transact. In other words, the market cannot
change the outstanding equity base of Reliance Industries, no matter how many trades there are.

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The market can increase or decrease the quantity of derivatives contracts outstanding, depending
on the number of trades.

What are the underlying assets?

The underlying assets most commonly include.

Stocks Bonds Commodities Currencies

Interest Rates

Which are the Common Financial Derivatives?

Forwards Futures Options Swaps

We shall briefly cover all this in this paper, but the discerning reader will no doubt have a big
question in mind.

FORWARD CONTRACT

A forward contract is

* a contract between two parties

* either on a one-on-one basis,
* binding on both parties
* completed with one buyer and one seller.
* specific in terms of, the price of the underlying to be exchanged, the
quality/type of the underlying, the date of delivery, the quantity, and
where applicable, the place and mode of delivery.
* a customized contract wherein both parties to the contract must be
consensus ad idem

e.g. if “A” agrees to purchase 100 kg of wheat from “B” at Rs. 40/ per kg, after
6 months, it is a forward contract.

Note that the quality, specifications, delivery terms are all clearly specified in the
contract)

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“A” is assured of a buyer of 100 kg, @ 40/ per kg, 6 months from now
“B” is assured of supply of 100 kg, @ 40/ per kg, 6 months from now.

Win-Win situation, right? THERE IS COUNTER- PARTY RISK IN

FORWARD CONTRACTS

Counter-party risk is the risk of default by one of the parties to the contract. This
may not be mala fide, but it happens. One person’s gain is another person’s loss.
When the price of wheat becomes 55/ then “A” has every incentive to default on a
contract to deliver at 40/. The reverse would hold true, if the price of wheat crashed
to 25/…in which case, “B” would be better off, not honoring the forward contract,
but rather, purchasing the required quantity in the spot market. With the best of
intentions also, it is possible that one party is not able to fulfill her/his commitment
as per the forward contract.

FUTURES CONTRACT

A futures contract is:

* a contract between two parties

* executed thru a stock exchange.
* binding on both parties (even though neither has inkling about
the identity of the other)
* tantamount to the stock exchange being a counter-party to both, buyer
& seller.
* theoretically, free from counter-party risk (by a process known as
NOVATION, the stock exchange becomes the buyer for the seller,
and the seller for the buyer
* standardized, as per the exchange regulations.
* specific, as to price, quantity, specifications, delivery date, terms etc.

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Distinction Between Forwards & Futures

Forward Future

* Customized Standardized

* Private trading or OTC Public Trading on Exchange

* Default Risk exists No Default Risk

* Entire transaction is settled between Stock Exchange is the Counter-party

same two parties hence, both parties deal only with the
Exchange

* Can be closed out, but only by Can be closed out by any party, any time
mutual consent on the floor of the Exchange
* No liquidity Highly liquid

OPTIONS:

An Option

Gives the Buyer the Right but Not the Obligation,

To Buy or Sell a contracted quantity of the Underlying,

at a pre-determined Price,

on or before a specified Date

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This is a blatantly, one-sided contract: only one party seems to benefit, hence the
Buyer of the Option pays to the Seller or Writer, an amount upfront, called the
Option Premium

The Seller (or Writer) of the Option HAS THE OBLIGATION, (BUT NO RIGHT
) to COMPLY WITH THE RIGHT OF THE BUYER OR OPTION HOLDER

Call Option:

Gives the buyer the right (without

obligation) To Purchase the Underlying

Put Option

Gives the buyer the right (without

obligation) To Sell the Underlying

There is a buyer & a seller for both, call & put options

The Profit of the Buyer is Unlimited, Loss is limited to the Option Premium
paid The Profit of the Seller is limited to the Option premium paid, the Loss is
Unlimited

European Options: Can be exercised only on maturity

American Options: Can be exercised at any time, on or before maturity

Please Note, this pertains only to exercise. The Options can be bought or sold at
any time (an open position can be closed out at any time)

Expiration date – the date the option matures.

Exercise price - the contracted price at which the option can be

exercised Covered option – an option written against stock held in an
investor’s portfolio. Naked (uncovered) option – an option written
without the stock to back it up.

In-the-money call – a call option whose exercise price is less than the current price
of the underlying stock. K < S

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Out-of-the-money call – a call option whose exercise price exceeds the current stock
price.

K>S
At-the-money call – a call option whose exercise price is equal to the current stock price.

K=S
In-the-money put – a put option whose exercise price is more than the current price
of the underlying stock. K > S

Out-of-the-money put – a put option whose exercise price is less than the current
stock price. K < S

At-the-money put – a put option whose exercise price is equal to the current stock price.

K=S
In India, all financial derivatives are cash settled on the
NSE. On the BSE, derivatives on stocks can be
delivered settled. Worldwide, all index derivatives are
cash settled

Commodity derivatives can be settled by delivery, or they may be cash settled.

SWAPS

A Swap is an agreement between two counterparties to exchange cash flows on

specific dates, based on the terms of the contract entered into in an interest rate swap,

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the Principal amount does not change hands. Interest payments are exchanged, based on the
“NOTIONAL PRINCIPAL”

INTEREST RATE SWAPS DO NOT GENERATE NEW FUNDING: THEY

MERELY CONVERT THE PAYMENT OF INTEREST, FROM FIXED TO
FLOATING RATE & VICE

VERSA (Plain Vanilla Swap)

Types of Swaps

Currency
Interest
Rate Equity
Commodity
Others

Example “Plain Vanilla” Interest Rate Swap (IRS)

“A” has borrowed US$ 100 million @ 6 month LIBOR for

3 years But “A” has inflows which are of a fixed rate

Hence, there is the risk of a cash flow mismatch & an Interest Rate Risk (if LIBOR
increases)

For “A” to enter into an IRS, there must be a counter-party “B”, with a different view
on the market, or an opposing requirement

“A” agrees to receive 6 month LIBOR from “B” & to pay “B” a fixed rate of 5%
p.a. (payable HLY) for 3 years (i.e. 6 * HLY interest transactions)

Notional Principal is US$ 100 million

Growth of Derivative Markets in India

Derivative market in India is comparatively of recent origin. They cater to the investment risk.
management needs of the financial and product market. Several committees have been set up to

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review the functioning of financial and derivative markets to ensure that investors risk
management needs are fulfilled by products offered by these changes.

At present Indian market trades in both exchanges traded and over the counter derivative on
various

asset classes including securities, commodities, currencies, stock indices and more. today, the
derivative

markets in India are growing. The growth and development of financial derivative in India may be

studied for each asset class as follows:

Growth of equity derivative market in India

The growth and development of financial derivative in India may be studied for each asset class
as follows:
1. Growth of equity derivative market
India joined the league of exchange traded equity derivative in June 2000, when futures contracts
were introduced at two major exchanges, namely, BSE and NSE. The BSE sensitive index,
popularly known as the SENSEX, and S&P CNX Nifty index commenced trade in futures on June
9, 2000, and June 12, 2000 respectively.
The growth of equity derivatives business on Indian exchanges has been phenomenal. A modest
start of an average daily volume of rupees 10 crores has developed into a business opportunity of
rupees 30,000.crores per day.
2. Growth of commodity derivative markets
The forward contract Regulation Act governs commodity derivative in India. The FCRA
specifically prohibits OTC commodity derivatives. Further, FCRA does not even allow options on
commodities.
It should be noted that the trading in commodity derivatives has been concentrated regionally. This
is due to the regional exchanges offering only a single product. For example, pepper exchange in
Kochi trades only. Soya exchange in Indore trades only soya.
3. Growth of currency derivative market
India has been trading forward contracts in currency for the last years. Recently, the RBI has
allowed options in the OTC market. The OTC currency market in the country is well developed.

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However, the business is concentrated with a limited number of market participants, mainly,
banks-both international and local. The business in currency derivatives is expected to grow soon.
Growth and development of derivative market in India Derivative market in India are
comparatively of recent origin. They cater to the investment risk management needs of the
financial and product market. Several committees have been set up to review the functioning of
financial and derivative markets to ensure that investors’ risk management needs are fulfilled by
products offered by these changes.
At present Indian market trades in both exchanges traded and over the counter derivative on
various asset classes including securities, commodities, currencies, stock indices and more. today,
the derivative markets in India are growing. The growth and development of financial derivative
in India may be studied for each asset class as follows.
4. Growth of interest rate derivative markets
There has been significant progress in interest rate derivatives in the India OTC market. The NSE
introduced trading in cash settled interest rate futures in the year 2003. However, due to some
structural
Uses of Derivatives and Misuses of Derivatives
Advantages of Derivatives
Following, we’ve discussed some crucial advantages of Derivatives. Let’s discuss:
1. Risk Management:
The best tool for risk hedging, or the process of reducing risk in one investment by making another,
is a derivative. Derivatives are commonly utilized as a kind of risk insurance and as a way to lower
market risk. By fixing the price of maize, the corn farmer and buyer used derivatives to protect
themselves against price risk, as is clear from the case.

Derivatives help investors manage their risk levels by allowing them to hedge against potential
losses. By using derivatives, investors can reduce their exposure to certain risks, such as currency
or interest rate fluctuations.
2. Liquidity:
Due to their great liquidity, derivatives are simple to buy and sell on the open market. This enables
investors to profit from price fluctuations rapidly and without having to spend a lot of money.
3. Leverage:

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Derivatives can be used to increase leverage and amplify returns. By using derivatives, investors
can borrow money, allowing them to place larger trades than they would otherwise be able to.
4. Access:
Derivatives provide access to a variety of markets, allowing investors to trade in a range of asset
classes. Investors that desire to diversify their portfolios may benefit from this.
5. Low Transaction Costs:
Trading in the derivatives markets has reduced transaction costs as compared to traditional assets
as shares or bonds. Lower transaction costs are made possible by derivatives because they
effectively act as a risk management tool.
Disadvantages of Derivatives
Following, we’ve discussed some drawbacks of derivatives. Let’s discuss:
1. Risk of Loss:
One of the main disadvantages of derivatives is that they can be very risky investments. They are
highly leveraged, which means that a small move in the price of the underlying asset can lead to a
large gain or loss. This makes them very volatile and unpredictable. Furthermore, they are subject
to counterparty risk, meaning that the other party to the contract could default on their obligations,
leading to a loss for the investor.
2. Cost:
Using derivatives usually involves the payment of fees and commissions, which can be quite high.
This can significantly erode the profits that an investor might make from using derivatives.
3. Complexity:
Derivatives are sophisticated financial tools that call for a deep knowledge of both the market and
the financial instrument. Without this knowledge, it can be difficult to make informed decisions,
leading to losses.
4. Lack of Regulation:
Derivatives are not as heavily regulated as other investments, which can leave investors exposed
to greater levels of risk. Additionally, due to the lack of regulation, it is challenging for investors
to obtain reliable information about the expenses and risks related to derivatives.
5. Margin Calls:
Margin calls are a common feature of derivatives trading. If a trader’s losses exceed their account
size, they may be required to deposit additional funds to maintain their position. This can be a

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costly and risky proposition, as it leaves the trader vulnerable to further losses if the market moves
against them.
Fundamental Linkages between Spot and Derivative Market

There is a formal connection between spot and derivative markets. Derivative instruments are
available for the purchase and sale of spot market assets such as bonds and stocks. Prices of the
derivatives are related to those of the underlying spot market instruments through two main
mechanisms which are discussed below.

1. The storage mechanism

Storage is an important linkage between spot and derivative markets. Many types of assets can
be purchased and stored. Holding a stock or a bond is a form of storage. Even making a loan
is a form of storage. One can also buy a commodity such as wheat or corn and store it in a
grain elevator. Storage is a form of investment in which one defers selling the item today in
anticipating selling it at a later stage. Storage spreads consumption across time. Storage entails
risk because prices constantly fluctuate. Derivatives can be used to reduce that risk by
providing a means of establishing today the item’s future sale price. This suggests that the risk
entailed in storing the item can be removed.

2. Delivery and settlement

Another important linkage between spot and derivative markets is delivery and settlement. At
expiration, forward and/or futures contracts call for either immediate delivery of the item or a
cash payment of the same value. Thus, an expiring forward or futures contract is equivalent to
a spot transaction. The price of the expiring contract, therefore, must equal the spot price. Few
derivative traders hold their positions until the contracts expire. They use the derivative
markets’ liquidity to enter into offsetting transactions. The fact that delivery or an equivalent
cash payment will occur on positions open at expiration is an important consideration in pricing
the spot and derivative instruments.

3. Price fixation Mechanism

The spot market is the foundation stone to determine prices for future and forward market.
Based on spot market prices a percentage of price increase or decrease is to be added based
on the present value and trend.

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The Role of Derivatives Market / Functions of Derivative Market

Derivatives usually perform the following functions.

1.Price discovery of the underlying asset

Price discovery is a method of determining the price for a specific commodity or security through
basic supply and demand factors related to the market. Price discovery is the general process used
in determining the spot price. These prices are dependent upon market conditions affecting supply
and demand. For example, if the demand for a particular commodity is higher than its supply, the
price will typically increase and vice versa.

Futures market prices depend on a continuous flow of information from around the world and
require a high degree of transparency. A broad range of factors (climatic conditions, political
situations, debt default, refugee displacement, land reclamation and environmental health, for
example) impact supply and demand of assets (commodities in particular) - and thus the current
and future prices of the underlying asset on which the derivative contract is based. This kind of
information and the way people absorb it constantly changes the price of a commodity. This
process is known as price discovery.

2.Techniques of risk management

Financial derivatives are useful for dealing with various types of risks, mainly market, credit and
operational risks. The importance of derivatives has been increasing since the instrument has been
used to hedge against price movements. The financial tool assists with the transfer of risks
associated with a specific portfolio without requiring selling the portfolio itself. Essentially,
derivatives allow investors to manage their risks and so reach the desired risk profile and
allocation more efficiently.

The relationship between derivatives and risk management is relatively simple. Derivatives are
seen as the tool that enables banks and other financial institutions to break down risks into smaller
elements. From this, the elements can be bought or sold to align with the risk management
objectives. So, the original purpose of derivatives was to hedge and spread risks. The main motive
of the financial tool has aided with the great development and expansion of derivatives.

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3.Operational advantages

Derivative markets entail lower transaction costs. They have greater liquidity compared to spot
markets. Derivative markets allow short selling of underlying securities more easily.

4.Market efficiency

Spot markets for securities probably would be efficient even if there were no derivative markets.
A few profitable arbitrage opportunities exist, however, even in markets that are usually efficient.
The presence of these opportunities means that the price of some assets is temporarily out of line.
Investors can earn returns that exceed what the market deems fair for the given risk level. There
are important linkages between spot and derivative prices. The ease and low cost of transacting
in these markets facilitates arbitrage trading and rapid price adjustments that quickly eradicate
these profit opportunities. Society benefits because the prices of underlying goods more
accurately reflect the good’s true economic value.

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