Financial Derivatives introduction

1. FINANCIAL DERIVATIVES

2. FINANCIAL DERIVATIVES
Module I: Introduction to financial derivatives
Introduction to derivative trading, Characteristics of derivatives, Underlying assets (Equity
Bonds/loans, Foreign Currency, and Commodity), Importance of derivatives as an investment
option, introduction to types of derivatives, Participants in derivatives market (Hedgers,
Speculators, Arbitrageurs), Evolution of Derivative markets in India

3. Introduction to Derivative Trading
• One of the key features of financial markets are extreme volatility.
• Prices of foreign currencies, petroleum and other commodities,
equity shares and instruments fluctuate all the time, and poses a
significant risk to those whose businesses are linked to such
fluctuating prices .
• To reduce this risk, modern finance provides a method called
hedging. Derivatives are widely used for hedging.

4. Introduction to Derivative
• Literal meaning of derivative is that something which is derived.
• Now question arises as to what is derived?
• From what it is derived?
• Simple one line answer is that value/price is derived from any
underlying asset.
• The term ‘derivative’ indicates that it has no independent value, i.e.,
its value is entirely derived from the value of the underlying asset.
• The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else. The Securities Contracts
(Regulation) Act 1956 defines ‘derivative’ as under:

5. Introduction to Derivative
• The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else.
• There are two types of derivatives.
1. Commodity derivatives: In commodity derivatives, the underlying asset is a
commodity. It can be agricultural commodity like wheat, soybeans, cotton
etc. or precious metals like gold, silver etc.
2. Financial derivatives:

6. Introduction to Derivative
• The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else.
• There are two types of derivatives.
1. Commodity derivatives:
2. Financial Derivatives: The term financial derivative denotes a variety of
financial instruments including stocks, bonds, treasury bills, interest rate,
foreign currencies and other hybrid securities. Financial derivatives include
futures, forwards, options, swaps, etc. Futures contracts are the most
important form of derivatives, which are in existence long before the term
‘derivative’ was coined.

7. Characteristics of Derivatives
• Derivatives have the characteristic of Leverage or Gearing. With a
small initial outlay of funds (a small percentage of the entire contract
value) one can deal big volumes.
• Pricing and trading in derivatives are complex and a thorough
understanding of the price behavior and product structure of the
underlying is an essential pre-requisite before one can venture into
dealing in these products.
• Derivatives, by themselves, have no independent value. Their value is
derived out of the underlying instruments.

8. Underlying Assets
(Equity Bonds/loans, Foreign Currency, and
Commodity)
• Underlying asset is an investment term that refers to the real financial asset or
security that a financial derivative is based on.
• Thus, the value of the underlying asset drives the value of the financial
derivative. (A derivative is simply a financial security or instrument that is derived
from another security or financial asset).
• There are different types, or classes, of underlying assets, and they come with
unique characteristics that, in turn, affect the nature and structure of the
derivatives associated with each type of underlying asset.
• For example, different underlying asset classes are subject to different types of financial risk.
Stocks and commodities are subject to market risk and general economic risk. Bonds and
other debt instruments are subject to default risk, interest rate risk, and counterparty risk.
Currencies are subject to interest rate risk and political risk.

9. Importance of derivatives as an investment option
• Hedging risk exposure: Since the value of the derivatives is linked to
the value of the underlying asset, the contracts are primarily used for
hedging risks. For example, an investor may purchase a derivative
contract whose value moves in the opposite direction to the value of an
asset the investor owns. In this way, profits in the derivative contract
may offset losses in the underlying asset.
• Underlying asset price determination:
• Market efficiency:
• Access to unavailable assets or markets:

10. Importance of derivatives as an investment option
• Hedging risk exposure:
• Underlying asset price determination: Derivatives are frequently
used to determine the price of the underlying asset. For example, the
spot prices of the futures can serve as an approximation of a
commodity price.
• Market efficiency:
• Access to unavailable assets or markets:

11. Importance of derivatives as an investment option
• Hedging risk exposure:
• Underlying asset price determination:
• Market efficiency: It is considered that derivatives increase the
efficiency of financial markets. By using derivative contracts, one can
replicate the payoff of the assets. Therefore, the prices of the
underlying asset and the associated derivative tend to be in equilibrium
to avoid arbitrage opportunities.
• Access to unavailable assets or markets:

12. Importance of derivatives as an investment option
• Hedging risk exposure:
• Underlying asset price determination:
• Market efficiency:
• Access to unavailable assets or markets: Derivatives can help
organizations get access to otherwise unavailable assets or markets. By
employing interest rate swaps, a company may obtain a more
favorable interest rate relative to interest rates available from direct
borrowing.

13. Types of Derivatives Instruments
• Derivative contracts are of several types. The most common types are
forwards, futures, options and swap.
• Forward Contracts
• A forward contract is an agreement between two parties – a buyer and a
seller to purchase or sell something at a later date at a price agreed upon
today.
• Forward contracts, sometimes called forward commitments, are very
common in everyone life.
• Any type of contractual agreement that calls for the future purchase of a
good or service at a price agreed upon today and without the right of
cancellation is a forward contract.

14. Types of Derivatives Instruments
• Future Contracts
• A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a
predetermined price at a specified time in the future. Futures contracts are standardized for
quality and quantity to facilitate trading on a futures exchange.
• A futures contract is an agreement between two parties – a buyer and a seller – to buy or sell
something at a future date.
• The contact trades on a futures exchange and is subject to a daily settlement procedure. Future
contracts evolved out of forward contracts and possess many of the same characteristics.
• Unlike forward contracts, Futures contracts trade on organized exchanges, called future
markets. Future contacts also differ from forward contacts in that they are subject to a daily
settlement procedure.

15. Types of Derivatives Instruments
Options Contracts
• Options are of two types – calls and puts.
• Calls (buy) 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 (sell) 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 date.

16. Types of Derivatives Instruments
Swaps
• Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula.
• Interest rate swaps: These entail swapping only the interest related cash
flows between the parties in the same currency
• Currency Swaps: These entail swapping both principal and interest on
different currency than those in the opposite direction.

17. Participants in Derivatives Market
• The participants in the derivative markets can be broadly classified in
three depending upon their motives. These are:
1.Hedgers
2.Speculators
3.Arbitrageurs

18. Participants in Derivatives Market
1.Hedgers:
• Hedgers are those who enter into a derivative contract with the objective of covering risk.
• Farmer growing wheat faces uncertainty about the price of his produce at the time of the harvest.
• Similarly, a flour mill needing wheat also faces uncertainty of price of input.
• The farmer apprehends price fall while the flour mill fears price rise.
• Both the parties face price risk.
• Both the farmer and the flour mill can enter into a forward contract, where the farmer agrees to sell his produce
when harvested at predetermined price to the flour mill.
• A forward contract would eliminate price risk for both the parties.
• A forward contract is entered into with the objective of hedging against the price risk being faced by the farmer as
well as the flour mill.
• Such participants in the derivatives markets are called hedgers.
• The hedgers would like to conclude the contract with the delivery of the underlying asset.
• In the example the contract would be settled by the farmer delivering the wheat to the flour mill on the agreed date at
an agreed price.

19. Participants in Derivatives Market
2. Speculators
• Speculators are those who enter into a derivative contract to make profit by
assuming risk. They have an independent view of future price behavior of
the underlying asset and take appropriate position in derivatives with the
intention of making profit later.
• For example, the forward price in US dollar for a contract maturing in three
months is 48.00. If one believes that three months later the price of US dollar
would be 50, one would buy forward today and sell later. On the contrary, if
one believes US dollar would depreciate to ` 46.00 in 1 month one would sell
now and buy later. Note that the intention is not to take delivery of underlying,
but instead gain from the differential in price.

20. Participants in Derivatives Market
Arbitrageurs
• Arbitrageurs, performs the function of making the prices in different markets
converge and be in tandem with each other.
• While hedgers and speculators want to eliminate and assume risk respectively,
the arbitrageurs take riskless position and yet earn profit.
• They are constantly monitoring the prices of different assets in different
markets and identify opportunities to make profit that emanate from mispricing of
products.
• The most common example of arbitrage is the price difference that may be
prevailing in different stock markets.
• For example, if the share price of Hindustan Unilever is ` 175 in National Stock Exchange
(NSE) and ` 177 in Bombay Stock Exchange (BSE), the arbitrageur will buy at NSE and sell
at BSE simultaneously and pocket the difference of ` 2 per share.

21. Evolution of Derivative markets in India
• Starting from a controlled economy, India has moved towards a world where price
fluctuates every day.
• The introduction of risk management instruments in India gained momentum in the last
few years due to liberalization process and efforts of the Reserve Bank of India (RBI) in
creating currency forward market.
• The National Stock Exchange (NSE) gauged the market requirements and initiated the
process of setting up derivative markets in India.
• In 1996, the NSE submitted a proposal to the Securities Exchange Board of India (SEBI)
for the introduction of derivatives.
• The SEBI constituted the L.C. Gupta Committee for policy formulation in the area of
Stock Index Futures.
• In 1998, the committee submitted its report approved by the SEBI. Following which in
1999 derivatives operations began in Interest Rate Swaps and Forward Rate Agreements.

22. Thank You