Origin of Derivatives
Over 2000 years ago, contracts for delivery in the
future was commonly used with Greek olive farmers
In the 1600s, Tulip derivatives were used by the Dutch
and it was more or less only as Louis Bachelier in 1900
formally introduced futures pricing when people
began to take derivatives at more than just face value.
More systematic derivative products initially
emerged as hedging devices against fluctuations in
commodity prices. Commodity linked derivatives
remained the sole form of such product for almost 3
Emergence of Financial Derivatives in the post-1970
period. These products are extremely popular and
account for 2/3 of the total derivatives transactions.
What are derivatives?
Derivatives really on a fundamental level are:
– Merely pieces of paper or
– In modern days, electronic contracts
To give you a right or an obligation, or a
combination of the two to receive or give
something in the future
Characteristics of OTC
OTC Derivatives Derivatives market:
– The management of counter-party (credit)
risk is located within individual institutions.
No formal limit on individual positions,
leverage, or margining.
– No formal rules of risk and burden sharing
– No formal rules for ensuring market stability
– Lack of regulator, although they are affected
indirectly by national legal systems, banking
supervision and market surveillance.
Derivative is a product whose value is derived from
the value of the underlying asset.
Underlying asset can be equity, forex, commodity, or
any other asset say an agreement with your neighbour
for 2 bags of sugar next week.
Security Contract (Regulation) Act,1956
[SC(R)A] defines derivative to include
A security derived from a debt instrument,
share, loan (secured/unsecured), risk
instrument or contract for differences or any
other form of security
A contract which derives its value from
prices, or index of prices, of underlying
Derivatives thus are securities under the
SC(R)A and hence the trading of derivatives is
governed by the regulatory framework under
Types of Derivatives
Forwards A forward contract is a customized contract
between two entities, where settlement takes place on a
specific date in the future at today’s pre-agreed price
Futures A future contract is an agreement between
two parties to buy or sell an asset at a certain time in the
future at a certain price. Futures are special types of
forward contracts in the sense that futures are
standardized exchange-traded contracts.
An agreement to buy/ sell an asset on a specified
date for a specified price
A bilateral contract with counter-party risk
Each contract is custom designed
Contract price is generally not available publicly
Reversing the contract needs mutual agreement
Meaning of Futures
Farmer growing any commodity
Uncertainty about price- Supply and demand
Merchant requires commodity
Oversupply- he/she is having negotiation power
Years/time of scarcity- exposed to price risk
Trade on MCX/ NCDEX/ NMCE
Definition of Futures
It is an agreement between the parties to buy/
sell an asset at a certain price in future
A futures contract is a forwards contract which is
traded on an exchange
Unlike forwards, they are standardized as in
terms of: quantity, quality, and liquidity
Generally contracts are offset by an equal and
Difference Between Forwards and Futures
OTC/ Not Fixed
Central Exchange with wide
Bank or client
Over the Phone with
Regulated by Exchange
Through Clearing house
Offsetting the positions
Commission, charges, etc.
No unique method
Direct costs are low
Size of Contract
Buyers/ sellers are required to deposit a margin on the
Typically 5-10% of the contract value, determined by the
exchange & the clearing house based on expected
Gains/ losses are netted against the initial margin:
In case the margin becomes too low, investors is required
to replenish with maintenance margin (75% of initial
If balance falls below the maintenance margin, investor
receives a margin call and is required to deposit
additional funds called variation margin
S&P CNXType : FUTIDX
Underlying : NIFTY
Trading cycle: 3-month trading cycle - the near month
(one), the next month (two)& far month (three).
A new contract is introduced on the trading day
following the expiry of the near month contract. The
new contract will be introduced for a three month
Expiry day: on the last Thursday of the expiry month
Contract size: may not be less than Rs. 2 lakhs at the
time of introduction. The permitted lot size for futures
contracts & options contracts shall be the same for a
given underlying or such lot size as may be stipulated by
the Exchange from time to time.
Permitted Lot Sizes of Contracts
S&P CNX Nifty
Derivatives on Individual Securities
Associated Cement Co. Ltd.
Alok Industries Ltd.
Each contract between buyer-seller is substituted by
2 contracts such that the clearing house become
buyer to every seller and seller to every buyer
BUYER – Clearing House – SELLER
This removes counterparty risk
Importance of Clearing House
Entirely different but, works closely with exchange
for its smooth functioning and as ‘de facto’
guarantor for all transactions
Increases confidence of the traders, volume and
Maintenance of delivery schedules, delivery of
underlying assets, delivery points, etc.
Important Functions of Clearing House
Ensuring adherence to system and procedures
for smooth trading
Minimizing credit risk by being a counterparty
to all traders.
Accounting for all the gains/losses on daily
Monitoring the speculation margins.
Ensuring delivery of payment for the assets on
the maturity date for all outstanding contracts.
NSE Clearing House
National Securities Clearing Corporation Ltd.
Clearing & settlement process has three main
It is simultaneous purchase and sale of similar assets
in different markets to take advantage of price
Transaction cost reduces the profit of the
arbitrageur to the minimum.
Arbitragers work at making profits by taking
advantage of discrepancy between prices of the same
product across different markets.
Practitioners working within risk finance or
quantitative finance often develop models to price
various assets being traded across the markets
Upon finding price discrepancies, one can make use
of a specific combination of derivatives in order to
make a risk less profit.
Types of Futures
An Interest-earning asset
A physical commodity
Futures on individual stock
Hedging with Currency Futures
An US exporter is exporting to Germany
On 01 May exported. Got confirmation that he
would get DM 625,000 on 01 July
Risk: If DM depreciates there will be a loss
Hedge with selling DM futures
01 July: spot rate $/DM is 0.4407
1 July spot cash flow is $275,437.5
Sell 1 July DM 6,25,000 @ $/DM 0.4407
01, July: Dollar depreciates and spot exchange
rate is 0.4508
$ value of DM is (625,000*0.4508) = 281,750
Gain on the spot mkt is $281,750 – $275,437.5 =
Options are of two types:
– Calls & Puts
Calls give the buyer the right but not the
obligation to buy a given quantity of the
underlying asset, at a given price on or before
a given future date.
Puts give the buyer the right but not the
obligation to sell a given quantity of the
underlying asset, at a given price on or before
a given future date.
Hedging a long position in Stock
Buy stock in the spot mkt
Risk: price decline
Hedge the above risk by buying put
An investor buys a share for Rs. 100. Buys a put for Rs.
16 with an exercise price of Rs. 110.
Types of Derivatives
– Interest Rate Swaps – Currency Swaps
Swaptions are options to buy or sell a swap
that will become operative at the expiry of the
options. Swaption is nothing but an option on
a forward swap.
Receiver Swaption is an option to receive fixed and
Payer Swaption is an option to pay fixed and receive
Types of Derivatives
Warrants. Longer -dated options are called warrants
and are generally traded over-the-counter (OTC)
LEAPS Long-Term Equity Anticipation Securities.
These are options having a maturity of up to three
Basket options are options on
portfolios of underlying assets. The underlying
asset is usually a moving average of a basket of
assets. Equity index options are a form of basket
Swaps are private agreements between two parties to
exchange cash flows in the future
– Agreement on formula to be used for exchange of
cash-flows is determined in advance
Exchange Traded Derivatives Market
Individuals trade standardized contracts that
have been defined by the exchange. (First
Futures contract were traded in 1865 in CBOT)
NSE’s derivatives market
Commencement of derivative trading with
S & P CNX Nifty Index futures on 12/06/2000.
Trading in index options commenced on 04/06/2001.
Single Stock trading in options started on 02/07/2001
Single Stock trading in futures started on 09/11/2001
Three Contracts are available for trading with
1,2,3 month expiry. A new contract is
introduced on the next trading day following
the expiry of the near month contract.
Participants and Functions
Self Clearing Member (SCM)
Trading Member Clearing Member (TM-CM)
Professional clearing Member (PCM)
Economic Functions of Derivative Market
Derivatives help in discovery of future as well
as current prices.
The derivatives market helps to transfer risks
from those who have them but may not like
them in comparison to those who have an
appetite for them.
Speculative trades shift to a more controlled
environment of derivatives market.
Act as a catalyst for new entrepreneurial
Uses of Derivatives
Done by parties who seek to offset their existing risks
by entering into a derivatives transaction.
Existing risks could be an investment portfolio, price
changes in oil for a petroleum mining company or
perhaps investments in a foreign country.
Speculation is more commonly used by hedge funds
or traders who aim to generate profits with only a
Growth Driving Factors
Increased volatility in asset prices in Financial Markets
Increased integration between International Markets
Exponential improvement in communication at
exceptionally reduced costs
Development of more sophisticated Risk Management
tools, providing economic agents a wider choice of Risk
Innovations in the derivatives markets, which optimally
combine the risks and returns over a large number of
financial assets leading to higher returns, reduced risk as
well as transactions cost as compared to individual
Growth in Derivative Trading: NSE
Average Daily Turnover (Rs. cr.)
Are Derivatives Dangerous?
"We view them as time bombs both for the parties that deal
in them and the economic system .. In our view ...
derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially
- Warren Buffett, the Chairman of Berkshire Hathaway and
his critique of the derivatives market.
-Are derivatives dangerous?
-That's almost like asking if water is dangerous.
-Derivatives can be dangerous if used incorrectly - as several
large companies and individuals have found out in recent
Derivatives contribute to the 'completeness' of
the global markets, and without them, loopholes
within the financial industry would exist.
Even through numerous financial disasters ala
Barings, LTCM, Enron and others related to the
mismanagement of derivatives
It is key to consider that it has not been the use of
derivatives as a tool which has led to the downfall
of these companies - but rather, the misuse and
compromise of such instruments.
Structured investments arose from the needs of
companies which want to issue debt more
Combinations of derivatives and financial
instruments create structures targeted
investments tied to their specific risk profiles,
returns requirements and market expectations.
In India, equity related structured products seem
to be in violation of the Securities Contract
Regulation Act (SCRA). SCRA prohibits the issue
and trade of equity derivative except those which
trade on nationally recognized stock and
Benefits of Structured Products
Tax-efficient access to fully taxable investments
Enhanced returns within an investment
Reduced volatility (or risk) within an investment
State Highways of MP :
From the Government’s perspective
Projects with government subsidy
• Conditions of roads in MP has substantially
deteriorated over last few years.
• The bad conditions of roads led to lower
Projects not viable
on BOT basis
• To make an impact, 14 roads of 2000 kms of
length were taken up for reconstruction /
• These were the highest traffic density state
highways of MP
• The DPRs of these roads were prepared and
the total capital expenditure for the projects
was around Rs. 1000 crores
• The GoMP decided to raise Rs. 500 crores
through Government guaranteed bonds for
road reconstruction projects. The repayment
of the bonds would happen through the
deduction from budgetary allocation to
MPPWD in five years.
• The initial idea was to reconstruct all these
roads by the MPPWD only. However this
approach had following limitations:
- Only 1000 kms of seven roads could be
- It was not possible to raise more than Rs.
500 crores as MPPWD budgetary
allocation did not have more debt
- As the road condition had deteriorated
substantially, the capital expenditure could
not be reduced without compromising on
the quality of reconstructed roads
- After reconstruction the regular
maintenance of the roads would again be
with MPPWD and had the risk of poor
maintenance in years to come
• In the above scenario the following options
- To reconstruct only seven roads of 1000
kms that can be completed in Rs. 500 crores
- To reconstruct some roads completely and
on the remaining roads only very bad
patches to be repaired
- To maintain these roads from the toll to be
collected by MPPWD on completed roads
• As all the above options were not found very
suitable the following option was developed
- To take up all roads on BOT basis with
maintenance on BOT developer for the
concession period with a provision of capital
subsidy from MPPWD to make the projects
- Rs.500 crores were to be utilized by
MPPWD to provide capital subsidy to BOT
• After a lot of deliberation the option of BOT
with MPPWD subsidy was chosen. It was
estimated that though subsidy would differ
from road to road, in aggregate for all roads
50-60% of project costs will come from
MPPWD as subsidy and the remaining would
come from BOT developers. The BOT
developers would then maintain the roads for
the concession period as per the decided
• Project cost on an average of Rs. 50 lacs per km.
• Total road length 1700 kms
• Concession Period : 15 years
• Roughness index during concession Period : 3500mm/km
• Subsidy : ______ bid criterion
• IRR : 20 %
• Bad patches to be repaired in four months of signing
concession agreement to create positive atmosphere
among road users
• GoMP adopted uniform toll rates for the
state.The rates are:
Car / Jeep
LCV/ Mini Bus
Toll rates to increase @ 7 % per year
• Toll booths at locations to cover homogeneous
• For part/full travel on homogeneous sections,
the toll for that section would be charged.
• Local traffic/traffic during important social
religious event exempt
• Toll can start on a completed homogeneous
• Seven roads of 983 kms of length already awarded
on BOT basis
• Total Project Cost Rs. 522 crores
• Total subsidy asked Rs. 245 crores
• Concession Agreements signed
• Work on sites commenced
• Financial closure expected in coming two months.
• Roads likely to be completed in 15-18 months by
the last quarter of year 2002
• This is for the first time in India that a state
has awarded around 1000 kms of important
state highways on BOT basis. This was
possible by structuring the commercially
unviable projects on viable format with the
help of government subsidy
• Looking to this success many Governments
are likely to follow the public-private
partnership for reconstruction and
maintenance of important state highways
Nayan Parikh & Consultants,
303-B, Shapath- III, Nr. GNFC Info. Tower
Ph- +91-79-2684 0022
Fax- +91-79-2685 1183
Email – firstname.lastname@example.org