As per the Davangere University syllabus, the chapter 1 been prepared

1. Financial Derivatives
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

2. Module No. 1: Introduction to
Financial Derivatives
Introduction - Meaning, Definition,
Features, Functions, Uses, Types – Forwards,
Futures, Options and Swaps, Exchange Trade
v/s OTC Derivatives, Participants in Derivatives
market, History and Evolution of Global
Derivatives market and Evolution of
Derivatives market in India, Spot market,
Index, Derivatives in Financial markets.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

3. Introduction
The objective of an investment decision is to get required
rate of return with minimum risk. To achieve this objective,
various instruments, practices and strategies have been
devised and developed in the recent past. With the opening
of boundaries for international trade and business, the world
trade gained momentum in the last decade, the world has
entered into a new phase of global integration and
liberalization. The integration of capital markets world-wide
has given rise to increased financial risk with the frequent
changes in the interest rates, currency exchange rate and
stock prices. To overcome the risk arising out of these
fluctuating variables and increased dependence of capital
markets of one set of countries to the others, risk
management practices have also been reshaped by inventing
such instruments as can mitigate the risk element. These new
popular instruments are known as financial derivatives which,
not only reduce financial risk but also open us new
opportunity for high risk takers.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

4. Meaning of Derivatives
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.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

5. Definition of Derivatives
The underlying asset can be securities,
commodities, bullion, currency, livestock or
anything else. The Securities Contracts
(Regulation) Act 1956 defines ‘derivative’ as
under:
‘Derivative’ includes– Security derived from a
debt instrument, share, loan whether secured or
unsecured, risk instrument or contract for
differences or any other form of security.
A contract which derives its value from the
prices, or index of prices of underlying securities.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

7. Functions of Derivatives
1. Discovery of price: Prices in an organised derivatives market reflect the perception of market participants
about the future and lead the prices of underlying assets to the perceived future level. The prices of
derivatives converge with the prices of the underlying at the expiration of the derivative contract. Thus
derivatives help in discovery of future as well as current prices.
2. Risk transfer: The derivatives market helps to transfer risks from those who have them but may not like
them to those who have an appetite for them.
3. Linked to cash markets: Derivatives, due to their inherent nature, are linked to the underlying cash
markets. With the introduction of derivatives, the underlying market witnesses higher trading volumes
because of participation by more players who would not otherwise participate for lack of an arrangement
to transfer risk.
4. Check on speculation: Speculation traders shift to a more controlled environment of the derivatives
market. In the absence of an organised derivatives market, speculators trade in the underlying cash
markets. Managing, monitoring and surveillance of the activities of various participants become extremely
difficult in these kind of mixed markets.
5. Encourages entrepreneurship: An important incidental benefit that flows from derivatives trading is that it
acts as a catalyst for new entrepreneurial activity. Derivatives have a history of attracting many bright,
creative, well-educated people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are immense.
6. Increases savings and investments: Derivatives markets help increase savings and investment in the long
run. The transfer of risk enables market participants to expand their volume of activity.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

8. Uses of Derivatives
Unsurprisingly, derivatives exert a significant impact on modern
finance because they provide numerous advantages to the financial
markets:
1. 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.
2. 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.
3. 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.
4. 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. 8
Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

9. Types of Financial Derivatives
There are four types of financial
derivatives are as follows:
• Forward contracts
• Future contracts
• Option and
• Swaps
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

10. Forwards:
• Forwards contracts are similar to futures contracts in
the sense that the holder of the contract possesses not
only the right but is also under the obligation to carry
out the contract as agreed.
• However, forwards contracts are an over-the-counter
product, which means they are not regulated and are
not bound by specific trading rules and regulations.
Since such contracts are unstandardised, they are
traded over the counter and not on the exchange
market. As the contracts are not bound by a regulatory
body’s rules and regulations, they are customizable to
suit the requirements of both parties involved.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

11. Futures:
Futures contracts are standardized
contracts that allow the holder of the contract
to buy or sell the respective underlying asset
at an agreed price on a specific date. The
parties involved in a futures contract not only
possess the right but also are under the
obligation, to carry out the contract as agreed.
The contracts are standardized, meaning they
are traded on the exchange market.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

12. Options:
Options are financial derivative
contracts that give the buyer the right, but not
the obligation, to buy or sell an underlying
asset at a specific price (referred to as the
strike price) during a specific period of time.
American options can be exercised at any time
before the expiry of its option period. On the
other hand, European options can only be
exercised on its expiration date.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

13. Swaps
• Swaps are derivative contracts that involve two
holders, or parties to the contract, to exchange
financial obligations. Interest rate swaps are the
most common swaps contracts entered into by
investors.
• Swaps are not traded on the exchange market.
They are traded over the counter, because of the
need for swaps contracts to be customizable to
suit the needs and requirements of both parties
involved.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

14. Exchange trade V/S OTC Derivatives
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

15. Participants of Derivatives
1. Hedgers: Hedging is when a person invests in financial markets to reduce the risk
of price volatility in exchange markets, i.e., eliminate the risk of future price
movements. Derivatives are the most popular instruments in the sphere of
hedging. It is because derivatives are effective in offsetting risk with their
respective underlying assets.
2. Speculators: Speculation is the most common market activity that participants of a
financial market take part in. It is a risky activity that investors engage in. It
involves the purchase of any financial instrument or an asset that an investor
speculates to become significantly valuable in the future. Speculation is driven by
the motive of potentially earning lucrative profits in the future.
3. Arbitrageurs: Arbitrage is a very common profit-making activity in financial
markets that comes into effect by taking advantage of or profiting from the price
volatility of the market. Arbitrageurs make a profit from the price difference arising
in an investment of a financial instrument such as bonds, stocks, derivatives, etc.
4. Margin traders: In the finance industry, margin is the collateral deposited by an
investor investing in a financial instrument to the counterparty to cover the credit
risk associated with the investment.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

16. History and Evolution of Global
Derivatives market
Global nature of the market The OTC segment operates with almost
complete disregard of national borders.17) Derivatives exchanges themselves
provide equal access to customers worldwide. As long as local market regulation
does not impose access barriers,18) participants can connect and trade remotely
and seamlessly from around the world (e.g. from their London trading desk to the
Eurex exchange in Frankfurt). The fully integrated, single derivatives market is
clearly a reality within the European Union. Taken as a whole, the derivatives
market is truly global. For example, today almost 80 percent of the turnover at
Eurex, one of Europe’s major derivatives exchanges, is generated outside its home
markets of Germany and Switzerland, up from only 18 percent ten years ago.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

17. Cont.
• Europe’s leading role within the derivatives market Today, Europe is
the most important region in the global derivatives market, with 44
percent of the global outstanding volume – significantly higher than
its share in equities and bonds. The global OTC derivatives segment
is mainly based in London. Primarily due to principle-based
regulation, which provides legal certainty as well as flexibility, the
OTC segment has developed especially favorably in the UK’s
capital.20) The unrestricted pan-European provision of investment
services, in place since the introduction of the European Union’s
Investment Services Directive (ISD) in January 1996,21) has
strengthened the competitive position of Europe in the global
market environment. Many European banks are currently global
leaders in derivatives.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

18. Historically, large derivatives exchanges were
almost exclusively located in the US.23) Strong
European derivatives exchanges appeared only after
deregulation and demutualization in the 1980s and
1990s. These European exchanges were more
independent of their users, who had been less
supportive of significant changes at US exchanges. They
revolutionized trading by introducing fully electronic
trading and by setting industry standards. Over the
years European players have strengthened their
position, increasing their global market share from 24
percent in 1995 to almost 40 percent in 2007.24) They
are now among the largest exchanges worldwide in a
sector where the biggest players are international
exchange groups that offer trading globally. 18
Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

19. Derivatives market in India
• In India, commodity futures date back to 1875. The government
banned futures trading in many of the commodities in the sixties
and seventies. Forward trading was banned in the 1960s by the
government despite the fact that India had a long tradition of
forward markets. Derivatives were not referred to as options and
futures but as “tezi-mandi”.
• In exercise of the power conferred on it under section 16 of the
Securities Contracts (Regulation) Act, the government by its
notification issued in 1969 prohibited all forward trading in
securities. However, the forward contracts in the rupee dollar
exchange rates (foreign exchange market) are allowed by the
Reserve Bank and used on a fairly large scale. A future trading is
permitted in 41 commodities. There are 18 commodity exchanges
in India. The Forward Markets Commission under the Ministry of
Food and Consumer Affairs acts as a regulator.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

20. In the case of capital markets, the indigenous 125 year old badla
system was very popular among the broking and investor community. The
advent of foreign institutional investors in the nineties and a large number of
scams led to a ban on badla. The foreign institutional investors (FIIs) were not
comfortable with this system and they insisted on adequate risk-management
tools. Hence, the Securities and Exchange Board of India (SEBI) decided to
introduce financial derivatives in India. However, there were many legal
hurdles which had to be overcome before introducing financial derivatives.
The preamble of the Securities Contract (Regulation) Act, states that the Act
was to prevent undesirable transactions in Securities by regulating business
of dealing therein, by prohibiting options, and by providing for certain other
matters connected therewith. Section 20 of the Act explicitly prohibits all
options in securities. The first step therefore was to withdraw all these
prohibitions and make necessary amendments in the Act. The Securities Laws
(Amendment) Ordinance, 1995 promulgated on January 25, 1995 withdrew
the prohibitions by repealing section 20 of the SC(R) A, and amending its
preamble.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

21. Starting with a controlled economy, India has
progressed to a world where prices change on a daily
basis. Due to the liberalization process and the Reserve
Bank of India's (RBI) efforts to create a currency
forward market, risk management tools have gained
traction in India in recent years. To control risk,
derivatives are an important part of the liberalization
process. After assessing the market's needs, the NSE
began the process of establishing a derivatives market
in India. Derivatives trading began in India in July 1999.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

22. Table 1: Represents the evolution of trading in India
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

24. Spot market
A spot market is where financial
instruments are exchanged for immediate
delivery, such as commodities, currencies, and
securities.
Delivery, here, means cash exchange for
a financial tool. In comparison, a futures contract
is based on the delivery of the underlying asset at
a future date. Over-the-counter
(OTC) markets and exchanges may provide
spot trading and/or futures trading.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

25. Cont.
• Spot markets are also referred to as "liquid markets" or
"cash markets" because transactions are instantly and
essentially exchanged for the commodity. While it may take
time to legally transfer funds between the buyer and the
seller, such as T+2 on the stock market and in
most currency transactions, all parties agree to trade "right
now.“
• A non-spot or futures deal is agreeing on a price now, but
the distribution and transfer of funds will take place later.
Potential deals in contracts that are about to expire are also
sometimes referred to as spot trades since the expiring
deal means the buyer and seller can
immediately swap cash for the underlying asset.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

26. Spot price
• The current price is considered as the spot
price of a financial instrument. It is the price
that an instrument can be immediately sold or
purchased at. By posting their buy and sell
orders, buyers and sellers build the spot price.
In liquid markets, as orders are filled, and new
ones enter the marketplace, the spot price
may shift by the second.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

27. Spot Market and Exchanges
• Exchanges put brokers and traders who buy and sell
commodities, shares, futures, options, and other
financial instruments together. The exchange offers the
current price and amount available to traders with
access to the market on the basis of all orders made by
participants.
• The New York Stock Exchange (NYSE) is an example of
an exchange where traders buy and sell stocks. This is a
spot market. The Chicago Mercantile Exchange (CME) is
an example of an exchange where traders buy and sell
futures contracts; this is a futures market.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

29. Index
Index derivative is the financial derivative contract that has an
underlying asset as the index itself. This means that the investor can
trade in the group of assets the index represents without buying
each underlying security/ asset in that group or market.
Index derivative comprises futures and options. Examples of
the index derivatives along with their underlying asset (index) are
• Nifty futures and Nifty options:- for both the futures and options
the underlying asset is Nifty 50
• Nifty midcap 50 futures and options: – Nifty midcap 50 is the
underlying asset
• Sensex futures and options: – the underlying asset is Sensex.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

30. Cont.
• Futures contracts are a type of derivative where the
buyer has to speculate the price of the underlying
assets and then make a decision on buying the
particular asset from the seller at a future date on a
pre-fixed price. This asset can be anything such as
commodities like gold, grains, etc. or can be in the form
of stocks, bonds, government securities, and also
indexes.
• Index derivatives are mostly future contracts where the
underlying assets are a market index. In the index
future, the buyer of the contract has to speculate the
price of the index in the future and then decide to sell
the asset at a pre-fixed price on the specified date in
the future.
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere

31. Derivatives in Financial markets
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Ms. Tejashwini K C, Research Scholar, Department of Commerce, Davangere University, Davangere