Derivatives have become extremely important in finance over the last forty years. They derive their value from an underlying asset like a stock or commodity. The most commonly used derivatives are futures contracts, options contracts, and forward contracts. Futures and options are generally traded on exchanges while forwards are over-the-counter. Exchanges ensure standardized contracts and trading while over-the-counter allows customization but with dispute risk. Traders use derivatives for hedging to protect asset values, speculation to profit from price movements, or arbitrage to exploit temporary price mismatches. Derivatives require understanding to use properly given associated risks.

1. Derivatives: Introduction (D:00:00)
Ashok Kanetkar
April 2013
Over the last about forty years, derivatives have become extremely impor-
tant in the world of finance. Though people mainly use them for preventing
losses due to volatility in the financial markets,–what is known as hedging–
there are also speculators and arbitrageurs in the market place, who use them
for financial gains.
A derivative can be defined as a financial instrument which derives it
value from another undelying, or more basic, asset. Generally the value of
the underlying asset is the traded price of the underlying asset in the spot
market. A stock option, for example, derives its value from the price of the
stock, which is the underlying asset, in the stock market. A futures contract
in say, wheat, derives its value from the price of wheat in the spot market.
The most commonly used derviatives are Futures Contracts, Option Con-
tracts and Forward Contracts. The first two are generally traded in an ex-
change while a Forward Contract is traded Over The Counter (OTC).
1 Exchanged–Traded
Markets
A derivatives exchange is a market where individuals trade standardized
contracts that have been defined by the exchange. The exchange decides
the specifications of the underlying asset and the quantity per contract. In
addition the exchange also decides some key parameters and the opening and
expiry dates of the contract.
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2. Derivatives: Introduction: Ashok Kanetkar
Individuals book their orders through brokers and market makers, who
are members of the exchange. Such a system ensures smooth trading without
any disputes. Traditionally derivatives traders have met on the floor of the
exchange and through loud calls and gestures arrived at mutually accept-
able prices. These days, of course, most exchanges trade through computer
networks.
2 Over The Counter
Markets
Based upon the price of the underlying asset, two parties arrive at a deriva-
tive price with mutual understanding. For example a bank or a large financial
institution can arrive at some understanding with its client for the exchange
price of a foreign currency. Such a deal is called as Over The Counter (OTC).
Most of the deals in the foreign exchange market are OTC.
A key advantage of OTC deal is that market participants are free to
negotiate any attractive deal. Thus the constraints imposed by an exchange
do not exist. On the other hand there is a disadvantage of one party walking
out of the deal and thereby giving rise to a dispute.
3 Commonly Traded
Derivatives
The commonly traded derivatives are described below.
Futures Contracts: These are contracts where an investor agrees to buy
or sell an underlying asset at a certain price at some future date. Such
derivatives are traded on all commodity exchanges, where futures con-
tracts in consumption assets like steel, rubber, coffee etc. are traded
and contracts in investment assets like gold, silver and currency are
also traded.
Option Contracts: These are contracts where an investor agrees to buy or
sell an underlying asset at a certain price on or before a certain date
in the future but without any obligation to do so. This means that an
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3. 4 TYPES OF TRADERS Derivatives: Introduction: Ashok Kanetkar
investor may have a contract to buy or sell but he has no obligation to
buy or sell.
Forward Contracts These are OTC contracts. A forward contract, like a
futures contract, is a contract to buy or sell an underlying asset at a
certain price on a certain date in the future. Contracts to buy or sell
foreign currency are the most common type of forward contracts.
4 Types of Traders
Three broad categories of traders are active in the derivatives market. These
are described below.
Hedgers: Hedgers use the derivatives market to protect the value of the
asset they are already holding, from adverse movements in the spot
market or to lock into a price for future purchase of an asset. The
basic thought behind hedging is that a loss should be avoided even
though this may lead to sacrificing profit.
Speculators: Speculators are those who take a position in the market based
upon what they think. Either they are betting that the prices will
go up or they are betting that the prices will go down. The futures
market allows the speculator to assume large bets without putting up
any money up-front. Only a small percentage of the amounts involved
is paid as margin money.
Arbitraguers: Very often a mismatch in the spot price and the derivatives
contract arises, which can be exploited to make risk–less profit. Such
opportunities are available for a very short time but when they are, the
arbitraguers take advantage of them to make money.
Derivatives, when used with circumspection, help in avoiding losses or un-
necessary purchase and hoarding. However, in the recent past they have also
acquired some notoreity due to indiscriminate use. Derivatives can also be
constructed for the benefit of the investors but it requires a sound under-
standing of the mathematical and trading aspects of the derivatives. Those
who deal in derivatives should do so with complete understanding. Fortu-
nately, considerable mathematical assistance is available to do meaningful
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4. Derivatives: Introduction: Ashok Kanetkar
scenario analysis.
The field of derivatives has also given rise to considerable research. We
often notice statisticians and mathematicians doing deep research in various
aspects of derivatives. Such efforts have also led to Nobel prizes in Economics.
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