Derivatives are financial contracts whose value is derived from an underlying asset such as a stock, bond, commodity, currency or market index. There are several types of derivatives including forwards, futures, options, and swaps. Futures contracts are standardized exchange-traded derivatives that allow participants to speculate on or hedge against the future price of the underlying asset. Index futures are futures contracts based on a stock or financial index, allowing traders to bet on the overall direction of a market index. Stock futures are futures contracts where the underlying asset is an individual stock.

1. DERIVATIVES
BY
UMAMAHESWARI GOPAL
Types, differences between types , margin and settlement mechanism.

2. DERIVATIVES
 A derivative is a financial security with a value
that is reliant upon or derived from an
underlying asset or group of assets.The
derivative itself is a contract between two or
more parties based upon the asset or assets.
Its price is determined by fluctuations in
the underlying asset.The most common
underlying assets include stocks, bonds,
commodities, currencies, interest rates and
market indexes.

3. DEFINITION
 Section 2 (ac) of securities contract regulation
act,1956 defines derivatives as:
 “a security derived from a debt instruments
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”

4. COUNTERPARTY DIFFERENCE
 Derivatives can either be traded over-the-
counter (OTC) or on an exchange. OTC
derivatives constitute the greater proportion
of derivatives in existence and are
unregulated, whereas derivatives traded on
exchanges are standardized. OTC derivatives
generally have greater risk for
the counterparty than do standardized
derivatives.

5. UNDERLYING ASSET IN
DERIVATIVES
 As defined above, the value of a derivative instrument
depends upon the underlying asset.The underlying asset
may assume many forms
 :i. Commodities including grain, coffee beans, orange juice;
 ii. Precious metals like gold and silver;
 iii. Foreign exchange rates or currencies;
 iv. Bonds of different types, including medium to long term
negotiable debt securities issued by governments,
companies, etc.. Shares and share warrants of companies
traded on recognized stock exchanges and Stock Indexvi.
Short term securities such asT-bills; andvii. Over- the
Counter (OTC) money market products such as loans or
deposits.

6. FUNCTIONS OF DERIVATIVES
MARKET
 Risk management – Price Discovery –
Transactional Efficiency – Financial
Engineering•
 Participants in the Derivatives market:
 1. Hedgers 2. Speculators 3. Arbitrageurs 4.
Intermediary participants • Brokers • Jobbers

7. Factors that influenced the financial growth of financial
derivatives:
 Increased volatility in asset prices in financial markets
 Increased integration of national financial markets with the
international markets
 Marked improvement in communication facilities and sharp
decline in their costs.
 Development of more sophisticated risk management
tools, providing economic agents a wider choice of risk
management strategies and
 Innovations in the derivatives markets, which optimally
combine the risks and returns over a large number of
financial assets, leading to higher returns, reduced risks as
well as transactions costs as compared to individual
financial assets.

8. EXAMPLE
 Wheat farmers may wish to sell their harvest
at a future date to eliminate the risk of a
change in prices by that date. Such a
transaction is an example of a derivative.The
price of this derivative is driven by the spot
price of wheat which is the ‘underlying’.

9. TYPES OF DERIVATIVES
 Derivatives is a product/contract that does
not have any value on its own i.e.derives its
value from some underlying
 Forward contracts
 Future contracts
 Options
 Swaps

10. FORWARD CONTRACTS
 A forward contract is one to one bi-partite
contract, to be performed in the future, at the
terms decided today.
 E.g. forward currency market in India.
 Forward contracts offer tremendous
flexibility to the parties to design the contract
in terms of the price, quantity, quality(in case
of commodities), delivery time and place.
 Forward contracts suffer from poor liquidity
and default risk.

11. FUTURES CONTRACT
 Future contracts are organized/standardised
contracts, which are traded on the
exchanges.
 These contracts, being standardised and
traded on the exchanges are very liquid in
nature.
 In futures market, clearing corporation/house
provides the settlement guarantee.

12. FORWARD AND FUTURE
DIFFERENCES
BASIS FOR COMPARISON FORWARD CONTRACT FUTURES CONTRACT
Meaning Forward Contract is an agreement between parties to buy
and sell the underlying asset at a specified date and agreed
rate in future.
A contract in which the parties agree to exchange the asset
for cash at a fixed price and at a future specified date, is
known as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Traded on Over the counter, i.e. there is no secondary market. Organized stock exchange.
Settlement On maturity date. On a daily basis.
Risk High Low
Default As they are private agreement, the chances of default are
relatively high.
No such probability.
Size of contract Depends on the contract terms. Fixed
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High

13. FUTURES MARKET
 A futures exchange or futures market is a
central financial exchange where people can
trade standardized futures contracts; that is,
a contract to buy specific quantities of a
commodity or financial instrument at a
specified price with delivery set at a specified
time in the future

14. TERMS OF TERMINOLOGY
 Futures Speculation
 Futures contracts are used to manage potential movements in the prices of the
underlying assets. If market participants anticipate an increase in the price of an
underlying asset in the future, they could potentially gain by purchasing the
asset in a futures contract and selling it later at a higher price on the spot market
or profiting from the favorable price difference through cash settlement.
However, they could also lose if an asset's price is eventually lower than the
purchase price specified in the futures contract. Conversely, if the price of an
underlying asset is expected to fall, some may sell the asset in a futures contract
and buy it back later at a lower price on the spot.
 Futures Hedging
 The purpose of hedging is not to gain from favorable price movements but
prevent losses from potentially unfavorable price changes and in the process,
maintain a predetermined financial result as permitted under the current market
price.To hedge, someone is in the business of actually using or producing the
underlying asset in a futures contract.When there is a gain from the futures
contract, there is always a loss from the spot market, or vice versa.With such a
gain and loss offsetting each other, the hedging effectively locks in the
acceptable, current market price.

15. STOCK FUTURES
 Stock Futures are financial contracts where the underlying
asset is an individual stock. Stock Future contract is an
agreement to buy or sell a specified quantity of underlying
equity share for a future date at a price agreed upon
between the buyer and seller.The contracts have
standardized specifications like market lot, expiry day, unit
of price quotation, tick size and method of settlement.
 In finance, a single-stock future (SSF) is a type
of futures contract between two parties to exchange a
specified number of stocks in a company for a price agreed
today (the futures price or the strike price) with delivery
occurring at a specified future date, the delivery date.

16. EXAMPLE OF STOCK FUTURES
 For example, if you plan to grow 500 bushels of wheat
next year, you could either grow the wheat and then sell it
for whatever the price is when you harvest it, or you could
lock in a price now by selling a futures contract that
obligates you to sell 500 bushels of wheat after the harvest
for a fixed price. By locking in the price now, you eliminate
the risk of falling wheat prices. On the other hand, if the
season is terrible and the supply of wheat falls,
prices will probably rise later -- but you will get only what
your contract entitled you to. If you are a bread
manufacturer, you might want to purchase a wheat futures
contract to lock in prices and control your costs. However,
you might end up overpaying or (hopefully) underpaying
for the wheat depending on where prices actually are when
you take delivery of the wheat.

17. INDEX FUTURES
 Index futures are futures contracts on a stock
or financial index. For each index, there may
be a different multiple for determining the
price of the futures contract.
 For example, the S&P 500 Index is one of the
most widely traded index futures contracts in
the United States; stock portfolio
managers who want to hedge risk over a
certain period of time often use S&P 500
futures.

18. EXAMPLES OF INDEX FUTURES
 Suppose the Nifty Index, is quoted on March 2006 at 1646. Each
point in the index is valued at Rs.50, one futures contract on NSE
Index will cost Rs.60000; if at the end of one month the index rise
to Rs. 1666, the difference in the price i.e (1666-1645=20) 50*20=
1000 is to be paid by the seller to the buyer.
 These margin money are market to the market or daily basis.
 The margins to be kept on futures are less than for normal
deliveries, as index futures do not involve full payments.
 The index futures contract is an obligation to deliver the
settlement an amount of cost, equal to the number of times of
the differences between the stock index value at the close of the
last of the contract, underlying the futures trading will determine
the number of times the difference is to be multiplied.

19. VALUATION OF INDEX FUTURES
 If an investor invests in BSE 30 index he will collect dividends on
the scrips he holds and his principal value may go up and down
depending on the index.
 In case of the futures index, the investor will get the same
outcome as if he invests all his money in riskless treasury bills and
enters into futures contract for future delivery of the index.
 The futures then must sell at price equal to today’s price of the
index plus a premium equal to risk free return plus dividend on
the index futures.
 Return to Index = Index price at expiration – current index price +
dividend.
 Return to index = Ie – Ib + d
 Returns to futures = futures prices at expiration –current futures
price + Interest on risk free asset.

20. MARGIN AND SETTLEMENT MECHANISM

21. TYPES OF MARGINS
 Initial margin:The initial deposit made by the depositor is considered as his
initial margin for the purpose of allowable exposure limits. Margin
requirements is based on the worse case of loss of a portfolio of an
individual client across various scenarios of price changes
 Portfolio based margin:The Standard portfolio analysis of risk (SPAN)
methodology is adopted to take an integrated view of the risk involved in
the portfolio of each individual client comprising his positions in futures
across different maturities.
 Calendar spread margin:A currency futures position at one maturity which
is hedged by an offsetting position at a different maturity is treated as a
calendar spread.The benefit for a calendar spread margin continues till
expiry of the near month contract.
 For a calendar spread position the extreme loss margin is charged on one
third of the mark to market value of the far month contract.
 Extreme Loss margin: Extreme loss margin is computed as percentage of
the mark to market value of the Gross open position. It shall be deducted
from the liquid assets of the clearing member.The extreme loss
percentage differs according to the different contracts.

22. THANK YOU FOR READING.
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VALUABLE.