Derivatives emerged as risk management tools allowing parties to hedge against price fluctuations in underlying assets like commodities and securities. Derivatives include forwards, futures, options, and swaps. While exchange-traded derivatives have standardized structures, OTC derivatives are customized bilateral contracts that pose greater risks due to lack of regulation and risk management standards. Derivatives serve important economic functions like risk transfer, price discovery, and stimulating new business, but instability can arise from large, concentrated derivative positions and shocks that alter credit exposures.

1. Introduction to derivatives
The emergence of the market for derivative products, most notably forwards,
futures and options, can be traced back to the willingness of risk-averse
economic agents to guard themselves against uncertainties arising out
of fluctuations in asset prices. By their very nature, the financial markets are
marked by a very high degree of volatility. Through the u s e o f d e r i v a t i v e
products, it is possible to partially or fully transfer price
risks by locking-in asset prices. As instruments of risk
m a n a g e m e n t , t h e s e g e n e r a l l y d o n o t influence the fluctuations in the
underlying asset prices. However, by locking-in asset prices, derivative products
minimize the impact of fluctuations in asset prices on the profitability and cash
flow situation of risk-averse
investors.D e r i v a t i v e p r o d u c t s i n i t i a l l y e m e r g e d , a s h e d g i n g d e v i
c e s a g a i n s t f l u c t u a t i o n s i n commodity prices and commodity-linked
derivatives remained the sole form of such products for almost three hundred
years. The financial derivatives came into spotlight in post-1970 period due to
growing instability in the financial markets. However, since their emergence,
these products have become very popular and by 1990s, they accounted
for about two-thirds of total transactions in derivative products. In recent years,
the marketfor financial derivatives has grown tremendously both in terms
of variety of instrumentsavailable, their complexity and also turnover. In the
class of equity derivatives, futuresa n d o p t i o n s o n s t o c k i n d i c e s h a v e
g a i n e d m o r e p o p u l a r i t y t h a n o n i n d i v i d u a l s t o c k s , especially
among institutional investors, who are major users of index-linked
derivatives.Even small investors find these useful due to high correlation of the
popular indices withvarious portfolios and ease of use. The lower costs

2. associated with index derivatives vis-vis derivative products based on individual
securities is another reason for their growing use.
The following factors have been driving the growth of financial
derivatives:1.Increased volatility in asset prices in financial
markets,2.Increased integration of national financial markets with the
international markets,3.Marked improvement in communication
facilities and sharp decline in their costs,4 . D e v e l o p m e n t o f m o r e
s o p h i s t i c a t e d r i s k m a n a g e m e n t t o o l s , p r o v i d i n g e c o n o m i c agents
a wider choice of risk management strategies, and5 . I n n o v a t i o n s i n t h e
derivatives markets, which optimally combine the risks
a n d returns over a large number of financial assets, leading to higher returns,
reducedrisk as well as trans-actions costs as compared to individual financial
assets.
1.1 Derivatives defined
Derivative is a product whose value is derived from the value
of one or more basicvariables, called bases (underlying asset,
index, or reference rate), in a c o n t r a c t u a l manner. The
underlying asset can be equity, forex, commodity or any other asset.
For example, wheat farmers may wish to sell their harvest at a future
date to eliminate therisk of a change in prices by that date. Such a
transaction is an example of a derivative. The price of this derivative is
driven by the spot price of wheat which is the “underlying”.In the Indian
context the Securities Contracts (Regulation) Act, 1956 (SC(R)
A) defines“equity derivative” to include
–1.A security derived from a debt instrument, shar
e , l o a n w h e t h e r s e c u r e d o r unsecured, risk instrumen

3. t o r c o n t r a c t f o r d i f f e r e n c e s o r a n y o t h e r f o r m o f security.
2.A contract, which derives its value from the pric
e s , o r i n d e x o f p r i c e s , o f underlying securities.The derivatives
are securities under the SC(R) A and hence the trading of derivatives
isgoverned by the regulatory framework under the SC(R) A.
1
1.2 Types of derivatives
The most commonly used derivatives contracts are forwards, futures
and options whichwe shall discuss in detail later. Here we take a brief look at
various derivatives contractsthat have come to be used.
Forwards
: A forward contract is a customized contract between two
e n t i t i e s , w h e r e settlement takes place on a specific date in the future at
today’s pre-agreed price.
Futures
: A futures contract is an agreement between two parties to buy or sell an asset
ata c e r t a i n t i m e i n t h e f u t u r e a t a c e r t a i n p r i c e . F u t u r e s
c o n t r a c t s a r e s p e c i a l t y p e s o f forward contracts in the sense that the
former are standardized exchange-traded contracts.
Options
: Options are of two types - calls and puts. Calls give the buyer the
right but nott h e o b l i g a t i o n t o b u y a g i v e n q u a n t i t y o f t h e
u n d e r l y i n g a s s e t , a t a g i v e n p r i c e o n o r before a given future
date. Puts give the buyer the right, but not the obligation to sell
agiven quantity of the underlying asset at a given price on or before a given
date.
Swaps

4. : Swaps are private agreements between two parties to exchange cash flows in
thefuture according to a prearranged formula. They can be regarded as
portfolios of forwardcontracts. The two commonly used swaps are:
•
Interest rate swaps
: These entail swapping only the interest related cash flows between
the parties in the same currency.
•
Currency swap
s
: These entail swapping both principal and interest between
the p a r t i e s , w i t h t h e c a s h f l o w s i n o n e d i r e c t i o n b e i n g i n a
d i f f e r e n t c u r r e n c y t h a n those in the opposite direction.
Warrants
: Options generally have lives of upto one year, the majority of options tradedon
options exchanges having a maximum maturity of nine months. Longer-dated
optionsare called warrants and are generally traded over-the-counter.
1.3 Participants and Functions
Three broad categories of participants - hedgers, speculators, and
arbitrageurs - trade inthe derivatives market.
Hedgers
face risk associated with the price of an asset. They usefutures or
options markets to reduce or eliminate this risk.
Speculators
w i s h t o b e t o n future movements in the price of an asset. Futures and options
contracts can give them anextra leverage; that is, they can increase both the
potential gains and potential losses in aspeculative venture.
Arbitrageurs

5. a r e i n b u s i n e s s t o t a k e a d v a n t a g e o f a d i s c r e p a n c y between
prices in two different markets. If, for example, they see the futures
price of anasset getting out of line with the cash price, they will take offsetting
positions in the twomarkets to lock in a profit.T h e d e r i v a t i v e m a r k e t
performs a number of economic functions. First, prices in
a n organized derivatives market reflect the perception of market participants
about the futureand lead the prices of underlying to the perceived future
level. The prices of derivativesconverge with the prices of the
underlying at the expiration of derivative contract. Thusderivatives
help in discovery of future as well as current prices. Second, the
derivativesmarket helps to transfer risks from those who have them
but may not like them to thosewho have appetite for them. Third,
derivatives, due to their inherent nature, are linked tothe underlying
cash markets. With the introduction of derivatives, the underlying
marketwitnesses higher trading volumes because of participation by
more players who wouldnot otherwise participate for lack of an
arrangement to transfer risk. Fourth, speculativetrades shift to a more
controlled environment of derivatives market. In the absence of
ano r g a n i z e d d e r i v a t i v e s m a r k e t , s p e c u l a t o r s t r a d e i n t h e
u n d e r l y i n g c a s h m a r k e t s . Margining, monitoring and
surveillance of the activities of various participants become.
extremely difficult in these kind of mixed markets. Fifth, an important
incidental benefitthat flows from derivatives trading is that it acts as a
catalyst for new entrepreneurialactivity. The derivatives have a history of
attracting many bright, creative, well-
educated p e o p l e w i t h a n e n t r e p r e n e u r i a l a t t i t u d e . T h e y
o f t e n e n e r g i z e o t h e r s t o c r e a t e n e w businesses, new products and
new employment opportunities, the benefit of which are immense. Sixth,
derivatives markets help increase savings and investment in the long

6. run.T r a n s f e r o f r i s k e n a b l e s m a r k e t p a r t i c i p a n t s t o e x p a n
d t h e i r v o l u m e o f a c t i v i t y . Derivatives thus promote economic
development to the extent the later depends on the rate of savings and
investment.
1.4 Development of exchange-traded derivatives
Derivatives have probably been around for as long as people have
been trading with oneanother. Forward contracting dates back at least
to the 12th century, and may well have been around before then.
Merchants entered into contracts with one another for future delivery of
specified amount of commodities at specified price. A primary motivation
for prearranging a buyer or seller for a stock of commodities in early
forward contracts wasto lessen the possibility that large swings would inhibit
marketing the commodity after
aharvest.A l t h o u g h e a r l y f o r w a r d c o n t r a c t s i n t h e U S a d d r e s s e d
m e r c h a n t s ’ c o n c e r n s a b o u t ensuring that there were buyers and
sellers for commodities, “credit risk” remained a serious problem. To
deal with this problem, a group of Chicago businessmen formed the
Chicago Board of Trade
(CBOT) in 1848. The primary intention of the CBOT was to p r o v i d e
a centralized location known in advance for buyers and sellers
t o n e g o t i a t e forward contracts. In 1865, the CBOT went one step further and
listed the first “exchangetraded” derivatives contract in the US; these contracts
were called “futures contracts”. In1 9 1 9 , C h i c a g o B u t t e r a n d E g g
B o a r d , a s p i n - o f f o f C B O T , w a s r e o r g a n i z e d t o a l l o w futures
trading. Its name was changed to
Chicago Mercantile Exchange
(CME). TheCBOT and the CME remain the two largest organized futures
exchanges, indeed the twolargest “financial” exchanges of any kind in the world
today.

7. 1.5 Exchange-traded vs. OTC derivatives markets
The OTC derivatives markets have witnessed rather sharp growth over the last
few years,which has accompanied the modernization of commercial
and investment banking
andglobalisation of financial activities. The recent
developments in information technologyhave contributed to a great
extent to these developments. While both exchange-traded a n d O T C
derivative contracts offer many benefits, the former have rigid
s t r u c t u r e s compared to the latter. It has been widely discussed that the highly
leveraged institutionsa n d t h e i r O T C d e r i v a t i v e p o s i t i o n s w e r e t h e
m a i n c a u s e o f t u r b u l e n c e i n f i n a n c i a l markets in 1998. These episodes
of turbulence revealed the risks posed to market stabilityoriginating in features
of OTC derivative instruments and markets.The OTC derivatives markets
have the following features compared to exchange-
tradedderivatives:1.The management of counter-party (credit) risk is
decentralized and located withinindividual
institutions,2 . T h e r e a r e n o f o r m a l c e n t r a l i z e d l i m i t s o n i n d i
v i d u a l p o s i t i o n s , l e v e r a g e , o r margining,3 . T h e r e are no
formal rules for risk and burden-sharing, 4 . T h e r e a r e n o
formal rules or mechanisms for ensuring market stabilit
y a n d integrity, and for safeguarding the collective interests of market
participants, and5 . T h e OTC contracts are generally not
regulated by a regulatory authority and t h e exchange’s self-
regulatory organization, although they are affected indirectly
bynational legal systems, banking supervision and market surveillance.S o m e
of the features of OTC derivatives markets embody risks to
financial
m a r k e t stability.T h e f o l l o w i n g f e a t u r e s o f O T C d e r i v a t i v e s
m a r k e t s c a n g i v e r i s e t o i n s t a b i l i t y i n institutions, markets,

8. and the international financial system: (i) the dynamic nature of gross
credit exposures; (ii) information asymmetries; (iii) the effects of
OTC derivativeactivities on available aggregate credit; (iv) the high
concentration of OTC derivativeactivities in major institutions; and (v) the
central role of OTC derivatives markets in theg l o b a l f i n a n c i a l s y s t e m .
Instability arises when shocks, such as counter-party
creditevents and sharp movements in asset prices that underlie
d e r i v a t i v e c o n t r a c t s , o c c u r which significantly alter the perceptions of
current and potential future credit exposures.When asset prices change
rapidly, the size and configuration of counter-party exposurescan
become unsustainably large and provoke a rapid unwinding of positions.There
has been some progress in addressing these risks and perceptions.
However,
the p r o g r e s s h a s b e e n l i m i t e d i n i m p l e m e n t i n g r e f o r m s i n r i s k
m a n a g e m e n t , i n c l u d i n g counter-party, liquidity and operational
risks, and OTC derivatives markets continue to p o s e a t h r e a t t o
international financial stability. The problem is more acute as
h e a v y reliance on OTC derivatives creates the possibility of systemic
financial events, whichfall outside the more formal clearing house
structures. Moreover, those who provide OTCderivative products, hedge
their risks through the use of exchange traded derivatives. In v i e w o f
the inherent risks associated with OTC derivatives, and their
d e p e n d e n c e o n exchange traded derivatives, Indian law considers them
illegal.
2.0 Indian Derivatives Market
Starting from a controlled economy, India has moved towards
a w o r l d w h e r e p r i c e s fluctuate every day. The introduction of risk
management instruments in India gained momentum in the last few years
due to liberalisation process and Reserve Bank of India’s(RBI) efforts in

9. creating currency forward market. Derivatives are an integral part
of liberalisation process to manage risk. NSE gauging the market requirements
initiated the p r o c e s s o f s e t t i n g u p d e r i v a t i v e m a r k e t s i n I n d i a . I n
J u l y 1 9 9 9 , d e r i v a t i v e s t r a d i n g commenced in India
Table 2.1
Chronology of instruments1991 Liberalisation process initiated1 4 D e c e m b e r
1 9 9 5 N S E a s k e d S E B I f o r p e r m i s s i o n t o t r a d e i n d e x f u t u r e s . 18
November 1996SEBI setup L.C.Gupta Committee to draft a
policy framework for index
futures.1 1 M a y 1 9 9 8 L . C . G u p t a C o m m i t t e e s u
b m i t t e d r e p o r t . 7 July 1999RBI gave
permission for OTC forward rate
agreements ( F R A s ) a n d interest rate
swaps.2 4 M a y 2 0 0 0 S I M E X c h o s e Nifty for
trading futures and options on an
I n d i a n index.2 5 M a y 2 0 0 0 S E B I g a v e p e r m i s s i o n t o
NSE and BSE to do index
futures trading.9 J u n e 2 0 0 0 T r a d i n g o f B S E
S e n s e x f u t u r e s c o m m e n c e d a t B S E . 1 2
J u n e 2 0 0 0 T r a d i n g o f N i f t y f u t u r e s
c o m m e n c e d a t N S E . 25 September 2000Nifty futures
trading commenced at
SGX.2 J u n e 2 0 0 1 I n d i v i d u a l S t o c k O p t i o
n s & D e r i v a t i v e s
2.1 Need for derivatives in India today
In less than three decades of their coming into vogue, derivatives
markets have becomethe most important markets in the world. Today,
derivatives have become part and parcelo f t h e d a y - t o -
day life for ordinary people in major part

10. o f t h e w o r l d . Until the advent of NSE, the Indian capital
market had no access to the latest tradingmethods and was using
traditional out-dated methods of trading. There was a huge
gap between the investors’ aspirations of the markets and the available means
of trading. Theopening of Indian economy has precipitated the process of
integration of India’s
financialm a r k e t s w i t h t h e i n t e r n a t i o n a l f i n a n c i a l m a r k e t s . I n t r o d
u c t i o n o f r i s k m a n a g e m e n t instruments in India has gained
momentum in last few years thanks to Reserve Bank of I n d i a ’ s
efforts in allowing forward contracts, cross currency options
e t c . w h i c h h a v e developed into a very large market. 2.2 Myths and realities
about derivatives
In less than three decades of their coming into vogue, derivatives
markets have becomethe most important markets in the world.
Financial derivatives came into the spotlight along with the rise in
uncertainty of post-1970, when US announced an end to the BrettonWoods
System of fixed exchange rates leading to introduction of currency
derivativesfollowed by other innovations including stock index
futures. Today, derivatives have become part and parcel of the day-
to-day life for ordinary people in major parts of the w o r l d . W h i l e
this is true for many countries, there are still apprehensions
a b o u t t h e introduction of derivatives. There are many myths about derivatives
but the realities thatare different especially for Exchange traded derivatives,
which are well regulated with allthe safety mechanisms in place.
What are these myths behind derivatives?
•
Derivatives increase speculation and do not serve any economic purpose

11. •
Indian Market is not ready for derivative trading
•
Disasters prove that derivatives are very risky and high
l y l e v e r a g e d instruments
•
Derivatives are complex and exotic instruments that Indian investors will
finddifficulty in understanding
•
Is the existing capital market safer than Derivatives?
2.2.1 Derivatives increase speculation and do not serve any economic purpose
While the fact is... N u m e r o u s s t u d i e s o f d e r i v a t i v e s a c t i v i t y h a v e
l e d t o a b r o a d c o n s e n s u s , b o t h i n t h e private and public sectors
that derivatives provide numerous and substantial benefits tothe
users. Derivatives are a low-cost, effective method for users to hedge
and
managet h e i r e x p o s u r e s t o i n t e r e s t r a t e s , c o m m o d
i t y p r i c e s , o r e x c h a n g e r a t e s . The need for
derivatives as hedging tool was felt first in the commodities
m a r k e t . Agricultural futures and options helped farmers and processors hedge
against commodity price risk. After the fallout of Bretton wood agreement, the
financial markets in the worldstarted undergoing radical changes. This
period is marked by remarkable innovations inthe financial markets
such as introduction of floating rates for the currencies,

12. increasedtrading in variety of derivatives instruments, on-line trading
in the capital markets, etc
3.0 SWAPS
A contract between two parties, referred to as counter parties, to exchange two
streams of payments for agreed period of time. The payments,
commonly called legs or sides, arecalculated based on the underlying
notional using applicable rates. Swaps contracts alsoinclude other
provisional specified by the counter parties. Swaps are not debt instrument
to raise capital, but a tool used for financial management. Swaps are
arranged in manydifferent currencies and different periods of time. US$
swaps are most common followed by Japanese yen, sterling and Deutsche
marks. The length of past swaps transacted has ranged from 2 to 25 years.
3.1 Why did swaps emerge?
In the late 1970's, the first currency swap was engineered to
circumvent the currencyc o n t r o l i m p o s e d i n t h e U K . A t a x w a s
l e v i e d o n o v e r s e a s i n v e s t m e n t s t o d i s c o u r a g e capital outflows.
Therefore, a British company could not transfer funds overseas in
order to expand its foreign operations without paying sizeable penalty.
Moreover, this Britishcompany had to take an additional currency
risks arising from servicing a sterling debtwith foreign currency cash
flows. To overcome such a predicament, back-to-back loans w e r e
used to exchange debts in different currencies. For example, a
B r i t i s h c o m p a n y wanting to raise capital in the France would raise
the capital in the UK and exchange itsobligations with a French company,
which was in a reciprocal position. Though this typeof arrangement was
providing relief from existing protections, one could imagine, the task
of locating companies with matching needs was quite difficult in as much as the
costof such transactions was high. In addition, back-to-back loans required
drafting multipleloan agreements to state respective loan obligations

13. with clarity. However this type of arrangement lead to development of
more sophisticated swap market of today.
Facilitators
The problem of locating potential counter parties was solved through dealers
and brokers.A s w a p d e a l e r t a k e s o n o n e s i d e o f t h e t r a n s a c t i o n a s
c o u n t e r p a r t y . D e a l e r s w o r k f o r investment, commercial or merchant
banks. "By positioning the swap", dealers earn bid-ask spread for the
service. In other words, the swap dealer earns the difference
betweent h e a m o u n t r e c e i v e d f r o m a p a r t y a n d t h e a m o u n t p a i d
to the other party. In an
ideals i t u a t i o n , t h e d e a l e r w o u l d o f f s e t h i s r i s k s b y m a t c
h i n g o n e s t e p w i t h a n o t h e r t o streamline his payments. If the
dealer is a counterparty paying fixed rate payments andreceiving
floating rate payments, he would prefer to be a counterparty receiving
fixed payments and paying floating rate payments in another swap. A perfectly
netted positionas just described is not necessary. Dealers have the flexibility to
cover their exposure by
matching multiple parties and by using other tools such as futures to
cover an exposed position until the book is complete.S w a p b r o k e r s ,
unlike a dealer do not take on a swap position themselves but
simplylocate counter parties with matching needs. Therefore,
b r o k e r s a r e f r e e o f a n y r i s k s involved with the transactions. After the
counter parties are located, the brokers negotiateon behalf of the counter
parties to keep the anonymity of the parties involved. By doingso, if
the swap transaction falls through, counter parties are free of any
risks associatedwith releasing their financial information. Brokers receive
commissions for their services.
3.2 Swaps Pricing:
There are four major components of a swap price.

14. •
Benchmark price
•
Liquidity (availability of counter parties to offset the swap).
•
Transaction cost
•
Credit risk
7
Swap rates are based on a series of benchmark instruments. They may
be quoted as as p r e a d o v e r t h e y i e l d o n t h e s e b e n c h m a r k
i n s t r u m e n t s o r o n a n a b s o l u t e i n t e r e s t r a t e basis. In the Indian
markets the common benchmarks are MIBOR, 14, 91, 182 & 364 dayT-bills,
CP rates and PLR rates.Liquidity, which is function of supply and
demand, plays an important role in swaps pricing. This is also
affected by the swap duration. It may be difficult to have
counter parties for long duration swaps, specially so in India Transaction costs
include the cost of hedging a swap. Say in case of a bank, which has
a floating obligation of 91 day T. Bill. Now in order to hedge the bank
would go long on a 91 day T. Bill. For doing so the bank must obtain funds. The
transaction cost would thus involve such a difference.Yield on 91 day T. Bill -
9.5%Cost of fund (e.g.- Repo rate) – 10%The transaction cost in this case would
involve 0.5%
Credit risk must also be built into the swap pricing. Based upon the
credit rating of thecounterparty a spread would have to be incorporated. Say
for e.g. it would be 0.5% for anAAA rating.
4.0 Forward contracts & Futures & Options

15. A forward contract is an agreement to buy or sell an asset on
a s p e c i f i e d d a t e f o r a specified price. One of the parties to the
contract assumes a long position and agrees to buy the underlying
asset on a certain specified future date for a certain specified
price.The other party assumes a short position and agrees to sell the
asset on the same date for the same price. Other contract details like
delivery date, price and quantity are negotiated b i l a t e r a l l y b y t h e p a r t i e s
to the contract. The forward contracts are normally
t r a d e d outside the exchanges.The salient features of forward contracts are:
•
They are bilateral contracts and hence exposed to counter–party risk.
•
Each contract is custom designed, and hence is unique in terms of
contract size,expiration date and the asset type and quality
•
The contract price is generally not available in public domain.
•
On the expiration date, the contract has to be settled by delivery of the asset.
•
If the party wishes to reverse the contract, it has to compulsorily go
to the samecounter-party, which often results in high prices being
charged.However forward contracts in certain markets have become
very standardized, as in thecase of foreign exchange, thereby
reducing transaction costs and increasing transactionsvolume. This
process of standardization reaches its limit in the organized futures
market.F o r w a r d contracts are very useful in hedging and
s p e c u l a t i o n . T h e c l a s s i c h e d g i n g application would be that of an
exporter who expects to receive payment in dollars threem o n t h s l a t e r . H e
is exposed to the risk of exchange rate fluctuations. By using

16. t h e currency forward market to sell dollars forward, he can lock on to a rate
today and reducehis uncertainty. Similarly an importer who is required
to make a payment in dollars twomonths hence can reduce his
exposure to exchange rate fluctuations by buying dollars forward.If a
speculator has information or analysis, which forecasts an upturn in a
price, then hecan go long on the forward market instead of the cash
market. The speculator would golong on the forward, wait for the
price to rise, and then take a reversing transaction to book profits.
Speculators may well be required to deposit a margin upfront. However, thisis
generally a relatively small proportion of the value of the assets underlying the
forwardcontract. The use of forward markets here supplies leverage to the
speculator.
4.1 Limitations of forward markets
•
Forward markets world-wide are afflicted by several problems:
•
Lack of centralization of trading
•
Illiquidity, and Counter party risk In the first two of these, the basic
problem is that of too much flexibility and generality.The forward
market is like a real estate market in that any two consenting adults can
formcontracts against each other. This often makes them design terms
of the deal, which arevery convenient in that specific situation, but makes
the contracts non-tradable.
4.2 Introduction to futures
Futures markets were designed to solve the problems that exist in
forward markets. Afutures contract is an agreement between two
parties to buy or sell an asset at a certain time in the future at a certain
price. But unlike forward contracts, the futures contracts arestandardized and

17. exchange traded. To facilitate liquidity in the futures contracts,
theexchange specifies certain standard features of the contract. It is a
standardized contractwith standard underlying instrument, a standard
quantity and quality of the underlying i n s t r u m e n t t h a t c a n b e
delivered, (or which can be used for reference purposes
i n settlement) and a standard timing of such settlement. A futures
contract may be offset prior to maturity by entering into an equal and
opposite transaction. More than 99% of futures transactions are offset this
way.The standardized items in a futures contract are:
-
•
Quantity of the underlying
•
Quality of the underlying
•
The date and the month of delivery
•
The units of price quotation and minimum price change
•
Location of settlement
4.3 Distinction between futures and forwards contracts
Forward contracts are often confused with futures contracts. The
confusion is primarily b e c a u s e b o t h s e r v e e s s e n t i a l l y t h e s a m e
e c o n o m i c f u n c t i o n s o f a l l o c a t i n g r i s k i n t h e presence of future
price uncertainty. However futures are a significant improvement over the
forward contracts as they eliminate counter party risk and offer more liquidity.
Table3.1 lists the distinction between the two.
Futures Terminology
•

18. Spot price:
The price at which an asset trades in the spot market.
•
Futures price:
The price at which the futures contract trades in the futures market.
•
Contract cycle:
The period over which a contract trades. The index futures contractso n t h e
NSE have one-month, two-months and three-months expiry
c y c l e s , w h i c h expire on the last Thursday of the month. Thus a
January expiration contract expireson the last Thursday of January
and a February expiration contract ceases trading on t h e last
Thursday of February. On the Friday following the last
T h u r s d a y , a n e w contract having a three-month expiry is introduced for
trading.
•
Expiry date:
It is the date specified in the futures contract. This is the last day
onwhich the contract will be traded, at the end of which it will cease to exist.
•
Contract size:
The amount of asset that has to be delivered under one contract.
For in-stance, the contract size on NSE’s futures market is 200 Nifties.
•
Basis:
In the context of financial futures, basis can be defined as the futures
priceminus the spot price. There will be a different basis for each delivery
month for eachcontract. In a normal market, basis will be positive. This
reflects that futures pricesnormally exceed spot prices.

19. •
Cost of carry:
The relationship between futures prices and spot prices can
b e summarized in terms of what is known as the cost of carry. This measures
the storagecost plus the interest that is paid to finance the asset less the
income earned on theasset.
•
Initial margin:
The amount that must be deposited in the margin account at the timea futures
contract is first entered into is known as initial margin.
•
Marking-to-market:
In the futures market, at the end of each trading day, the marginac-count is
adjusted to reflect the investor’s gain or loss depending upon the
futuresclosing price. This is called marking–to–market.
•
Maintenance margin:
This is somewhat lower than the initial margin. This is set toensure
that the balance in the margin account never becomes negative. If the balancein
the margin account falls below the maintenance margin, the investor
receives amargin call and is expected to top up the margin account to
the initial margin level before trading commences on the next day.
4.5 Introduction to options
In this section, we look at the next derivative product to be traded on
the NSE, namelyo p t i o n s . O p t i o n s a r e f u n d a m e n t a l l y d i f f e r e n t
f r o m f o r w a r d a n d f u t u r e s c o n t r a c t s . A n option gives the holder of the
option the right to do something. The holder does not haveto exercise this

20. right. In contrast, in a forward or futures contract, the two parties
havec o m m i t t e d t h e m s e l v e s t o d o i n g s o m e t h i n g . W h e r e a s i t
c o s t s n o t h i n g ( e x c e p t m a r g i n requirements) to enter into a futures
contract, the purchase of an option requires an up– front payment.
4.5.1 History of options
Although options have existed for a long time, they were traded OTC,
without muchknowledge of valuation. Today exchange-traded options
are actively traded on stocks, stock indexes, foreign currencies and futures
contracts. The first trading in options beganin Europe and the US as early
as the eighteenth century. It was only in the early 1900s t h a t a g r o u p
of firms set up what was known as the put and call Brokers
and DealersAssociation with the aim of providing a
m e c h a n i s m f o r b r i n g i n g b u y e r s a n d s e l l e r s together. If someone
wanted to buy an option, he or she would contact one of the member firms.The
firm would then attempt to find a seller or writer of the option either
from its ownc l i e n t s o r t h o s e o f o t h e r m e m b e r f i r m s . I f n o s e l l e r
c o u l d b e f o u n d , t h e f i r m w o u l d undertake to write the option itself
in return for a price. This market however suffered
from two deficiencies. First, there was no secondary market and
second, there was nomechanism to guarantee that the writer of the
option would honor the contract. It was in1 9 7 3 , t h a t B l a c k , M e r t o n
a n d S c h o l e s i n v e n t e d t h e f a m e d B l a c k S c h o l e s f o r m u l a . I n April
1973, CBOE was set up specifically for the purpose of trading options. The
marketfor options developed so rapidly that by early ’80s, the
number of shares underlying theoption contract sold each day
exceeded the daily volume of shares traded on the NYSE. Since then,
there has been no looking back.
4.6 Option Terminology
•

21. Index options:
These options have the index as the underlying. Some options
areE u r o p e a n w h i l e o t h e r s a r e A m e r i c a n . L i k e i n d e x f u t u r e s
c o n t r a c t s , i n d e x o p t i o n s contracts are also cash settled.
•
Stock options:
Stock options are options on individual stocks. Options currently trade
on over 500 stocks in the United States. A contract gives the holder the right
to buy or sell shares at the specified price.
•
Buyer of an option:
The buyer of an option is the one who by paying the
option p r e m i u m b u y s t h e r i g h t
b u t n o t t h e o b l i g a t i o n t o e x e r c i s e h i s o p t i o n o n t h e seller/
writer.
•
Writer of an option:
The writer of a call/put option is the one who receives
t h e option premium and is thereby obliged to sell/buy the asset if the
buyer exercises onhim. There are two basic types of options, call options and
put options.
Call optio
n: Acall option gives the holder the right but not the obligation to buy an asset
by a certaindate for a certain price.
Put optio
n: A put option gives the holder the right but not theobligation to sell an asset by
a certain date for a certain price.
•
Option price:

22. Option price is the price which the option buyer pays to the
optionseller.
•
Expiration date:
The date specified in the options contract is known as t
h e expiration date, the exercise date, the strike date or the maturity.
Strike price:
The price specified in the options contract is known as the strike
priceor the exercise price.
•
American options:
American options are options that can be exercised at any time upto the
expiration date. Most exchange-traded options are American.
•
European options:
European options are options that can be exercised only on
theexpiration date itself. European options are easier to analyze
than American options,a n d p r o p e r t i e s o f a n A m e r i c a n o p t i o n a r e
f r e q u e n t l y d e d u c e d f r o m t h o s e o f i t s European counterpart.
•
In-the-money option:
An in-the-money (ITM) option is an option that would lead toa positive
cashflow to the holder if it were exercised immediately. A call option
onthe index is said to be in-the-money when the current index stands
at a level higher than the strike price (i.e. spot price > strike price). If the
index is much higher than thestrike price, the call is said to be deep ITM.
In the case of a put, the put is ITM if theindex is below the strike price.
•

23. At-the-money option:
An at-the-money (ATM) option is an option that would leadto zero
cashflow if it were exercised immediately. An option on the index is
at-the-money when the current index equals the strike price (i.e. spot price =
strike price)._
•
Out-of-the-money option:
A n o u t - o f - t h e - m o n e y ( O T M ) o p t i o n i s a n o p t i o n t h a t would lead
to a negative cashflow it it were exercised immediately. A call option
onthe index is out-of- the-money when the current index stands at a
level which is lessthan the strike price (i.e. spot price < strike price). If the
index is much lower than thestrike price, the call is said to be deep OTM.
In the case of a put, the put is OTM if the index is above the strike price.
•
Intrinsic value of an option:
The option premium can be broken down into twocomponents
- intrinsic value and time value. The intrinsic value of a call
i s t h e amount the option is ITM, if it is ITM. If the call is OTM, its
intrinsic value is zero.Putting it another way, the intrinsic value of a
call isN½P which means the intrinsicvalue of a call is Max [0, (S
t
– K)] which means the intrinsic value of a call is the (S
t
– K). Similarly, the intrinsic value of a put is Max [0, (K -S
t
)] ,i.e. the greater of 0 or (K - S
t
). K is the strike price and S
t

24. is the spot price
Derivatives – Indian Scenario - 39 -
•
Time value of an option:
The time value of an option is the difference between its premium
and its intrinsic value. A call that is OTM or ATM has only time
value.Usually, the maximum time value exists when the option is
ATM. The longer thetime to expiration, the greater is a call’s time value, all
else equal. At expiration, a callshould have no time value.
4.7 Futures and options
An interesting question to ask at this stage is - when would one use
options instead of futures? Options are different from futures in several
interesting senses.At a practical level, the option buyer faces an interesting
situation. He pays for the optionin full at the time it is purchased. After this, he
only has an upside. There is no possibilityof the options position generating any
further losses to him (other than the funds already paid for the option). This
is different from futures, which is free to enter into, but
cang e n e r a t e v e r y l a r g e l o s s e s . T h i s c h a r a c t e r i s t i c m a k e s
o p t i o n s a t t r a c t i v e t o m a n y occasional market participants, who
cannot put in the time to closely monitor their futures positions.Buying put
options is buying insurance. To buy a put option on Nifty is to buy
insurance,which reimburses the full extent to which Nifty drops below
the strike price of the put
option. This is attractive to many people, and to mutual funds creating
“guaranteed return products”. The Nifty index fund industry will find it
very useful to make a bundle of a Nifty index fund and a Nifty put option
to create a new kind of a Nifty index fund, whichgives the investor protection
against extreme drops in Nifty.

25. 4.8 Index derivatives
Index derivatives are derivative contracts, which derive their value
from an underlyingindex. The two most popular index derivatives are index
futures and index options. Indexderivatives have become
very popular worldwide. In his report, Dr.L.C.Gupta attributesthe
popularity of index derivatives to the advantages they offer.
•
Institutional and large equity-holders need portfolio-
h e d g i n g f a c i l i t y . I n d e x – derivatives are more suited to them and
more cost–effective than derivatives based onindividual stocks. Pension
funds in the US are known to use stock index futures for risk hedging
purposes.
•
Index derivatives offer ease of use for hedging any portfolio
i r r e s p e c t i v e o f i t s composition.
•
Stock index is difficult to manipulate as compared to individual stock prices,
more soi n India, and the possibility of cornering is
r e d u c e d . T h i s i s p a r t l y b e c a u s e a n individual stock has a limited
supply, which can be cornered.
•
Stock index, being an average, is much less volatile than individual stock prices.
Thisimplies much lower capital adequacy and margin requirements.
•
Index derivatives are cash settled, and hence do not suffer from settlement
delays and problems related to bad delivery, forged/fake certificates.The
L.C.Gupta committee which was setup for developing a regulatory
framework for derivatives trading in India had suggested a phased

26. introduction of derivative products inthe following order:1. Index futures2.
Index options
3. Options on individual stocksWith all the above infrastructure in place,
trading of index futures and index options commenced at NSE in June
2000 and June 2001 respectively.
5 . 0 P a y o f f & P r i c i n g o f F u t u r e
s a n d Options
A payoff is the likely profit/loss that would accrue to a market participant with
change int h e price of the underlying asset. This is
generally depicted in the form of
payoff d i a g r a m s w h i c h s h o w t h e p r i c e o f t h e u n d e r l
y i n g a s s e t o n t h e X – a x i s a n d t h e profits/losses on the Y–axis.
In this section we shall take a look at the payoffs for buyersand sellers of futures
and options.
5.1 Payoff for futures
Futures contracts have linear payoffs. In simple words, it means that the losses
as well as profits for the buyer and the seller of a futures contract are
unlimited.T h e s e l i n e a r p a y o f f s a r e f a s c i n a t i n g a s t h e y c a n b e
c o m b i n e d w i t h o p t i o n s a n d t h e underlying to generate various complex
payoffs.
5.1.1 Payoff for buyer of futures: Long futures
The payoff for a person who buys a futures contract is similar to the
payoff for a personw h o h o l d s a n a s s e t . H e h a s a p o t e n t i a l l y
u n l i m i t e d u p s i d e a s w e l l a s a p o t e n t i a l l y unlimited downside.Take
the case of a speculator who buys a two-month Nifty index futures
contract whenthe Nifty stands at 1220. The underlying asset in this case is the

27. Nifty portfolio. When thei n d e x m o v e s u p , t h e l o n g f u t u r e s p o s i t i o n
s t a r t s m a k i n g p r o f i t s , a n d w h e n t h e i n d e x moves down it starts
making losses. Figure 5.1 shows the payoff diagram for the buyer of a futures
contract.
5.1.2 Payoff for seller of futures: Short futuresThe payoff for a person who sells
a futures contract is similar to the payoff for a person w h o s h o r t s a n
asset. He has a potentially unlimited upside as well as a
p o t e n t i a l l y unlimited downside. Take the case of a speculator who
sells a two-month Nifty indexfutures contract when the Nifty stands
at 1220. The underlying asset in this case is the Nifty portfolio. When
the index moves down, the short futures position starts
making p r o f i t s , a n d w h e n t h e i n d e x m o v e s u p , i t s t a r t s m a k i n g
l o s s e s . F i g u r e 5 . 2 s h o w s t h e payoff diagram for the seller of a futures
contract

28. 5.2 Options payoffs
The optionality characteristic of options results in a non-linear payoff
for options. Insimple words, it means that the losses for the buyer of an option
are limited, however the profits are potentially unlimited. For a writer,
the payoff is exactly the opposite. His profits are limited to the option
premium, however his losses are potentially unlimited.These non-linear
payoffs are fascinating as they lend themselves to be used to
generatevarious payoffs by using combinations of options and the underlying.
We look here at thesix basic payoffs.
5.2.1 Payoff profile of buyer of asset: Long asset
In this basic position, an investor buys the underlying asset, Nifty for instance,
for 1220,and sells it at a future date at an unknown price,S
4
it is purchased, the investor is said to be “long” the asset. Figure 5.3
shows the payoff for a long position on the Nifty.

29. 5.2.2 Payoff profile for seller of asset: Short asset
In this basic position, an investor shorts the underlying asset, Nifty for instance,
for 1220,and buys it back at a future date at an unknown price S
4
Once it is sold, the investor is said to be “short” the asset. Figure 5.4 shows
the payoff for a short position on the Nifty