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Technical Note on Derivative Instruments
GLOBAL SCENARIO
The era of globalization has brought many innovations to the field of financial engineering
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Derivatives can be defined as financial instruments whose returns are derived from underlying
assets
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The growth of these products in the
last 20 years has been one of the most extraordinary and important events in the financial markets
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Under fixed exchange rate system, the exchange rates of all currencies were fixed against the
US dollar
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In 1973, the Bretton Woods Agreement collapsed when the US
suspended the dollar‟s convertibility into gold
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Two months before the collapse of Bretton Woods System, the Chicago Mercantile Exchange
(CME) launched the world‟s first exchange-traded currency future
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As the
capital markets continued growing, the derivatives market also continued playing a significant role
in facilitating investor‟s needs
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In December 1999, the Securities Contract
Regulation Act (SCRA) was amended to include derivatives within the sphere of „securities‟ and a
regulatory framework was developed for governing derivatives trading
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Besides, the government also withdrew in March 2000, the
three-decade old notification, which prohibited forwards trading in securities
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Subsequently,
derivatives trading on the National Stock Exchange (NSE) started with S&P CNX Nifty Index
futures
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Similarly, trading in BSE Sensex options and options on individual securities commenced in
June 2001
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C
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Prof, Finance, IBS Hyderabad for usage of IBS class 2013
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Trading and settlement in derivative contracts is done in accordance with the rules, bylaws, and
regulations of the respective exchanges and their clearing house/ corporation duly approved by the
SEBI and notified in the official gazette
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It acts as legal counterparty to all deals on the F&O
segment and guarantees settlement
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Types of Risk
Risk in general is the possibility of some unpleasant happening or the chance of encountering loss
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This
uncertainty arises due to number of factors such as interest rate fluctuations, exchange rate changes,
market conditions and changes in prices of commodities etc
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Interest rates affect a firm in two ways – by affecting
the profits and by affecting the value of its assets or liabilities
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Similarly, a firm having fixed rate assets faces the risk of lower value of investments in an
increasing interest rate scenario
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For example, a firm that has
fixed rate borrowings and floating rate investments has a higher exposure than a firm having fixed
rate borrowings and fixed rate investments for the same term
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Exchange Rate Risk
The volatility in the exchange rates will have a direct bearing on the values of the assets and
liabilities that are denominated in foreign currencies
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While increase in the value of asset and decrease in the
value of liability has a positive impact on the corporates, increase in the value of liabilities and
decrease in the value of assets has a negative impact
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It is also referred to as price risk
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In addition to Interest rate risk and exchange
risk, adverse movements in equity prices and commodity prices also contribute to the market risk
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Similarly, commodity prices show a significant impact on the cash flow and profitability of a
business
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In a financial market, an investor always wishes to minimize or eliminate the risks in order to
maximize profits
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How the hedging is done using different derivative instruments
will be discussed in subsequent chapters
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a
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Commodities,

ii
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Equities, and

iv
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The nature of contract sets upon the right and obligations of both positions in the contract
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Nature of Contract: Based on the nature of the contract, derivatives can be classified into
three categories:
i
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Options, and

iii
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There can be a contract which is similar in all aspects except for the underlying asset
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Similarly, a futures contract can exist on a
commodity or a currency
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Market Mechanism
i
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Exchange-traded products
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Under efficient market
conditions, the market price of an asset should equal its economic value or fair value
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Different derivatives instruments such as forwards,
futures and options are used for the purchase and sale of spot market assets such as stocks, bonds
etc
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Now let us have a look at the fundamental linkage between spot and
derivatives markets using mechanisms such as arbitrage and storage
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The arbitrage opportunities cannot last for very long
periods of time in a stock, but the very existence of arbitrageurs implies that there are opportunities
in the markets for at least a short period
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Law of
one price states that equivalent combinations of financial instruments should have same price
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An individual engaged in arbitraging is called arbitrageur
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Sometimes, certain situations call for a second type of arbitrage
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An arbitrage
opportunity exists when the certain return of securities A and B together is higher than the risk-free
rate
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Thus, he can earn
arbitrage profits when the certain payoff occurs
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Storage and Carrying Costs
Storage is a significant linkage between spot and derivatives market
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Storage cost can be defined as the cost involved in storing an asset over a period of time
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In the case of risk neutral investors, current asset price is the expected
future price, less the storage and interest costs
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For goods such as electricity which are non-storable in nature, there
would not necessarily be a relation between current spot price and the expected future spot price
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The extent to which the futures price exceeds the cash price at one point of time is determined by the
concept called „cost-of-carry‟ that refers to the carrying charges
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The significance of carrying
costs cannot be ignored because they play a crucial role in determining pricing relationships between
the spot and futures prices
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PURPOSE OF DERIVATIVES
Derivative instruments serve various purposes in global social and economic systems
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As
such, derivative markets not only play a significant role in terms of actual trading, but also provide
guidance to the rest of the economy to optimal production and consumption decisions
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Future markets are often
considered as primary means of information for determining the spot price of the asset
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By using the information
available in the forward/futures price today, market observers try to estimate the price of a given
commodity/asset at a certain time in future
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The
price of copper twelve months from today cannot be said with certainty
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The price that is quoted on the market today for
a copper forward/futures contract expiring in twelve months is very essential in estimating the future
price
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Thus, a futures or forward price reflects a price which a market participant can lock-in today in lieu
of accepting the uncertainty of future spot price
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However, they provide information about volatility and
subsequently, the risk of the underlying spot asset
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It can be defined as a transaction in which an investor seeks
to protect a position or anticipated position in the spot market by using an opposite position in
derivatives
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These are people who are exposed to risks due
to the normal business operations and would like to eliminate or minimize or reduce the risk
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To protect a sale against price increase
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To protect an anticipated sale against a price decline
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Speculation
Speculation involves assimilation of available information about a security and assessing the rise or
fall of its price
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These people voluntarily
accept what hedgers wish to avoid
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For example, let us see how speculators take a
position to gain from the futures
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No doubt, this facilitates the traders to draw the details of the contract according to
their needs, but this also increases the probability that one of the traders might default on fulfilling
his obligation
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This is the second real problem
that one has to put-up with, if he wishes to deal in forwards
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Middlemen play a crucial role in forward markets, as they
purchase the produce from the producer by entering into a contract and then enter into a second
contract with the other purchaser regarding the supply of the same
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Therefore, they should not only be paid for their services, but also for credit risks they bear
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Prior to this, organized futures market in commodities had existed in the Chicago Board of
Trade since 1848
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Today, it is the oldest and the largest futures exchange in the world
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Another exchange to reckon with is the Chicago
Mercantile Exchange
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Futures contracts owe their origin to forward contracts
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A futures contract is an agreement between two parties to exchange a commodity or a financial asset
for certain consideration after a specified period
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The main differences between forwards and futures contract are:
i
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ii
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Differences between Futures and Forward Contracts
From what we have seen above, listing the differences should not be a problem
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These are traded in organized location known as exchange
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2
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Terms are structured to suit both the
contracting parties
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Contracts are cleared by a separate clearing house
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4
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No organization guarantees the
performance of the counterparty
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5
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trading position
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Traders have to pay daily settlement margin depending on the No such provisions are in vogue
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7
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Quite difficult to do so
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Futures markets are monitored and regulated by special

Regulation is not as tight as in futures

agencies
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Marking to market is done at the end of every trading day
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9
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When a group of traders come
together they will be able to trade only if all of them know for sure what a contract carries with it
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OPTIONS
An option is a contract in which the seller of the option grants the buyer the right to purchase from
or sell to, the seller a designated instrument or an asset at a specific price which is agreed upon at the
time of entering into the contract
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But, if the buyer decides to exercise his right the seller of the option has an
obligation to deliver or take delivery of the underlying asset at the price agreed upon
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TERMINOLOGY
Call Option
An option contract is called a „call option‟, if the writer gives the buyer of the option the right to
purchase from him the underlying asset, at a predetermined price at sometime in future
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Exercise Price
At the time of entering into the contract, the parties agree upon a price at which the underlying asset may
be bought or sold
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At this price, the buyer
of a call option can buy the asset from the seller and the buyer of a put option can sell the asset to the
writer of the option
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Expiration Period
At the time of introducing an option contract, the exchange specifies the period (not more than nine
months from the date of introduction of the contract in the exchange) during which the option can be
exercised or traded
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An option can be exercised
even on the last day of the expiration period
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Such options, which can be exercised on any day during the expiration period are called American
options
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European options can be
exercised only on the last day of the expiration period
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Depending on the expiration period, an option can be short-term or long-term in nature
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(In our country, Reliance Petroleum Ltd
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)
Option Premium or Option Price
This is the amount which the buyer of the option (whether it be a call or put option) has to pay to the
option writer to induce him to accept the risk associated with the contract
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In one definition, it refers to
the simultaneous purchase and sale of currency for different maturities or vice versa
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The base on which the cash flows are exchanged may be different and it gives
rise to different types of swaps
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Swaps have been defined variously as:
A transaction in which two parties agree to exchange a predetermined series of payments over
time;
An agreement between two parties to exchange interest payment for specific maturity on an
agreed upon notional amount;
An arrangement whereby one party exchanges one set of interest payments for another,
example fixed for floating rate;
An agreement between two parties to exchange a series of payments, the terms of which are
predetermined can be regarded as a financial swap
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While short-term
swaps have maturity periods of less than three years, medium-term swaps mature between
three and five years and long-term swaps have a life extending beyond five years

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