Financial instrument whose price is dependent
upon or derived from the value of underlying
The underlying not necessarily has to be an asset. It
could be any other random/uncertain event like
The most common
underlying assets includes:
derivative is a financial instrument
whose derivative A
the –– is derived from –– value depends
value of some other financial instrument,
called the underlying asset
examples of underlying assets
stocks, bonds, corn, pork, wheat,
Forward contract is a binding contract which fixes now the
buying/selling rate of the underlying asset to be bought/sold at
some time in future.
◦ Long Forward
Binding to buy the asset in future at the predetermined rate.
◦ Short Forward
Binding to sell the asset in future at the predetermined rate.
A commodity future is a futures contract in
commodities like agricultural product, metals and
material etc. in organised commodity future markets,
contracts are standardised with standard quantities. Of
course, this standard varies from commodity-tocommodity. They also have fixed delivery dates in each
month or a few months in a year. In India commodity
futures in agricultural products are popular.
COMMODITY EXCHANGE ARE AS
London Metal Exchange(LME) to deal in
Chicago Board of Trade(CBT) to deal in
soya bean oil.
New York Cotton Exchange(CTN) to deal in
4. What is the difference between Forward Contracts and Futures
Contract Terms Standardized
At the end of
any member of
Contract can be
with the same
with whom it
An option is a contract that gives the buyer the right, but not the
obligation, to buy or sell an underlying asset at a specific price
on or before a certain date
◦ Unlike a forward/future, this contract gives the right but not the
obligation. So its not a binding contract.
◦ The holder will exercise the option only if it is profitable.
On the basis of versatility
A normal option with no special or unusual features
A type of option that differs from common American
or European options in terms of the underlying asset or
the calculation of how or when the investor receives a
A call option, often simply labeled a "call", is a financial contract between two
parties, the buyer and the seller of this type of option.The buyer of the call option
has the right, but not the obligation to buy an agreed quantity of a particular
commodity or financial instrument (the underlying) from the seller of the option at a
certain time (the expiration date) for a certain price (the strike price). The seller (or
"writer") is obligated to sell the commodity or financial instrument to the buyer if the
buyer so decides. The buyer pays a fee (called a premium) for this right.
A put or put option is a contract between two parties to exchange an asset
(the underlying), at a specified price (the strike), by a predetermined date
(the expiry or maturity). One party, the buyer of the put, has the right, but not
an obligation, to re-sell the asset at the strike price by the future date, while
the other party, the seller of the put, has the obligation to repurchase the asset
at the strike price if the buyer exercises the option.
Pay Off = ST – K (for the long forward)
Pay Off = K – ST (for the short forward)
T = Time to expiry of the contract
ST = Spot Price of the underlying asset at time T
K = Strike Price or the price at which the asset will be
Counter parties:: A and B
Maturity:: 5 years
A pays to B : 6% fixed p.a.
B pays to A : 6-month KIBOR
Payment terms : semi-annual
Notional Principal amount: PKR 10 million.
Advantages and Disadvantages of Swaps
The advantages of swaps are as follows:
1) Swap is generally cheaper. There is no upfront premium and it reduces transactions costs.
2) Swap can be used to hedge risk, and long time period hedge is possible.
3) It provides flexible and maintains informational advantages.
4) It has longer term than futures or options. Swaps will run for years, whereas forwards and
futures are for the relatively short term.
5) Using swaps can give companies a better match between their liabilities and revenues.
The disadvantages of swaps are:
1) Early termination of swap before maturity may incur a breakage cost.
2) Lack of liquidity.
3) It is subject to default risk.
Credit Risk: When one of the two parties fails to perform its role as per the agreement, this
is called the credit risk. It can also be referred to as default or counterparty risk. It varies
with different sources.
Market Risk: This is a kind of financial loss that takes place due to the adverse price
movements of the underlying variable or instrument.
Liquidity Risk: When a firm is unable to devise a transaction at current market rates, it can
be referred to as liquidity risk. There are two kinds of liquidity risks involved in the scenario.
First is concerned with the liquidity of separate items and second is related to supporting
the activities of the organization with funds comprising derivatives.
Legal Risk: Legal issues related with the agreement need to be scrutinized well, as one can
deal in derivatives across the different judicial boundaries.
Derivatives Markets in India
Financial transactions are fraught with several risk factors.
Derivatives are instrumental in alienating those risk factors from
traditional instruments and shifting risks to
those entities that are ready to take them. Some of the basic risk
components in derivatives business are:Exchange Traded Derivatives
Over the Counter (OTC) Derivatives
Over the Counter (OTC) Equity Derivatives
Operators in the Derivatives Market
There are different kinds of traders in the derivatives market. These include:
Hedgers-traders who are interested in transferring a risk element of their portfolio.
Speculators-traders who deliberately go for risk components from hedgers in look out
Arbitrators-traders who work in various markets at the same time in order to gain profit
and do away with miss-pricing
The Swaps Market
Unlike most standardized options and futures contracts, swaps are not exchange-traded
instruments. Instead, swaps are customized contracts that are traded in the
over-the-counter (OTC) market between private parties. Firms and financial institutions
dominate the swaps market, with few (if any) individuals ever participating. Because
swaps occur on the OTC market, there is always the risk of a counterparty defaulting
on the swap.
SEE: Futures Fundamentals
Plain Vanilla Interest Rate Swap
The most common and simplest swap is a "plain vanilla" interest rate swap. In this
swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a
notional principal on specific dates for a specified period of time. Concurrently, Party B
agrees to make payments based on a floating interest rate to Party A on that same
notional principal on the same specified dates for the same specified time period. In a
plain vanilla swap, the two cash flows are paid in the same currency. The specified
payment dates are called settlement dates, and the time between are called settlement
periods. Because swaps are customized contracts, interest payments may be made
annually, quarterly, monthly, or at any other interval determined by the parties.
Credit default swap
A credit default swap (CDS) is a financial swap agreement that the seller of the
CDS will compensate the buyer in the event of a loan default or other credit event.
The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the
seller and, in exchange, receives a payoff if the loan defaults. It was invented by
Blythe Masters from JP Morgan in 1994.
In the event of default the buyer of the CDS receives compensation (usually the face
value of the loan), and the seller of the CDS takes possession of the defaulted
loan. However, anyone can purchase a CDS, even buyers who do not hold the loan
instrument and who have no direct insurable interest in the loan (these are called
"naked" CDSs). If there are more CDS contracts outstanding than bonds in existence,
a protocol exists to hold a credit event auction; the payment received is usually
substantially less than the face value of the loan.
Differences from insurance
CDS contracts have obvious similarities with insurance, because the buyer
pays a premium and, in return, receives a sum of money if an adverse
However there are also many differences, the most important being that
an insurance contract provides an indemnity against the losses actually
suffered by the policy holder on an asset in which it holds an
insurable interest. By contrast a CDS provides an equal payout to all
holders, calculated using an agreed, market-wide method. The holder
does not need to own the underlying security and does not even have to
suffer a loss from the default event. The CDS can therefore be used to
speculate on debt objects.
insurance requires the buyer to disclose all known risks, while CDSs do not (the
CDS seller can in many cases still determine potential risk, as the debt instrument
being "insured" is a market commodity available for inspection, but in the case of
certain instruments like CDOs made up of "slices" of debt packages, it can be
difficult to tell exactly what is being insured);
insurers manage risk primarily by setting loss reserves based on the
Law of large numbers and actuarial analysis. Dealers in CDSs manage risk
primarily by means of hedging with other CDS deals and in the underlying bond
CDS contracts are generally subject to mark-to-market accounting,
introducing income statement and balance sheet volatility while insurance contracts
Hedge accounting may not be available under US Generally Accepted Accounting
Principles (GAAP) unless the requirements ofFAS 133 are met. In practice this
to cancel the insurance contract the buyer can typically stop paying premiums,
while for CDS the contract needs to be unwound.
Recent developments in
FIMMDA Code of Conduct for usage of NDS-OM & OTC market
To enhance participation of PDs in corporate bond market
PDs allowed a sub-limit of 50 per cent of net owned funds for investment in
corporate bonds within overall permitted average fortnightly limit of 225 per
cent of NOF for call /notice money market borrowing,
PDs permitted to invest in Tier II bonds issued by other PDs, banks and
financial institutions to the extent of 10 per cent of the investing PD’s total
PDs allowed to borrow to the extent of 150 per cent of NOF through Inter
Repo in corporate debt
eligible category of collateral expanded to include short term instruments like
CP, CD and NCD.
Recent developments in
Eligible participant base increased all India Financial institution
like SIDBI,NABARD,NHB and
Exim bank added as users in CDS.
Insurance companies and mutual funds permitted to
participate as users
CDS permitted on unlisted but rated corporate bonds
securities with original maturity up to one year like CPs, CDs
and NCDs as reference/deliverable obligations
Users can unwind their CDS bought position with original
protection seller at mutually agreeable or
in absence of an agreement, unwinding at FIMMDA price.
Recent developments in
Enhancing foreign investment limits in G-sec and corporate
Limit for investment in G-sec enhanced from US$ 20 billion
to US$ 25 billion.
sub-limit of US$ 10 billion for investment by FIIs and the long
term investors in dated G-sec enhanced by
US$ 5 billion
condition of three year residual maturity of G-sec at the time
of first purchase for the above sub-limit not applicable.
investments not be allowed in short term papers like T-Bills
The limit for FII investment in corporate debt (other than
infrastructure sector) enhanced by US$ 5
billion to US$
25 billion. Investment is not allowed in CPs/CDs