Derivatives,types of derivatives and its signifi

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Table of Contents
What is a Derivative( Understanding)...................................................................................................2
Exchange-traded Derivatives:..............................................................................................................3
Over-the-counter derivatives: .............................................................................................................4
Types of Derivatives Contracts:............................................................................................................4
Forward and Futures:......................................................................................................................4
OPTIONS:.......................................................................................................................................5
SWAPS:..........................................................................................................................................6
COMMONLY USED DERIVATIVES..........................................................................................................6
SIGNIFICANCE OF DERIVATIVE MARKETS IN PAKISTAN..........................................................................7
REFERENCES...........................................................................................Error! Bookmark not defined.

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Group members:
Shaikh Abdul Hadi (22383)
Abu Bakr
What is a Derivative( Understanding)
A derivative is a financial instrument that has value determined or derived by some
underlying variable in it. A bushel of corn is not a derivative; it is a commodity
whose value is determined in corn market. However, if a person let’s say A says
that if a price of a bushel of cornwill be greater than $4 after 6 months so he will
pay his friend B 50 cents and if the price will be less than $4 after 6 months so his
friend B will pay him 50 cents. A has entered in an agreement with B. This is
called a derivative since it’s an agreement with a value depending upon the
underlying variable which is corn in this caseand its price will vary.
This may sound as a bet on the price of corn. A derivative can be thought of as a
bet on price of corn but the term “bet” does not necessarily a pejorative term. A bet
that provides insurance and reduce the risk. Forexample, if me and my friend’s
family is involved in car selling business. If my family sells cars at low price so I
will get $20 so this supplements me income. If my friend’s family buys cars in
high prices to sell so he will get $20. In this way, it offsets the high costof cars and
viewed in this context, this bet hedges us both against unfavorable outcomes. This
contract has reduced risk for both of us.
Another example to understand how derivative is somewhat different from bet and
is not pejorative. SupposeI make a contractwith my friend on temperature of
Karachi in next 4 months. I am a marketing manager of an Air Conditioning

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Company. I make an agreement that if a temperature of Karachi in next 4 months
goes beyond 32 degrees so for every degree it goes beyond 32 degrees, I will give
him 100,000 and vice versa. Considering the fact that I am a marketing manager of
Air Conditioning Company so I should make a contract of temperature going
beyond 32 degrees as going below 32 degrees is my fear because in this situation
the sales of my company will go down leading low profits and stockprice decline.
If the temperature goes up above 32 degrees I will have to pay the amount but it
will be compensated by the increase in profits due to higher sales of ACs. So in
both cases, the outcomes are in my favor and I have hedged my risk.
The trade of derivatives is carried out in two ways.
1. Exchange Traded derivatives
2. (OTC)Over-the-counter derivatives
Exchange-tradedDerivatives:
A derivative exchange market where individuals trade standardized contracts that
have been defined by exchange. It acts as a venue for trading and sets rules to
govern what to trade and how trading occurs. Thesederivative exchanges have
existed for long period of time. A very old exchange traded market was set up in
1948 namely The Chicago Board of Trade (CBOT). Initially, its major task was to
standardize the quantities and the qualities of grain that were traded. Once two
traders have agreed on a trade, it is handled by exchange clearing house.
This exchange stands between the two traders and manages risks. For instance,
trader X makes a contract a contract to buy 100 ounces of gold for $200 per ounce
from the clearing house and trader Y has a contract sell 100 ounces of gold for
$200 per ounce to the clearing house. Here, the traders do not have to worry about
the creditworthiness of each other. The exchange takes the responsibility of default
or credit risk involved by requiring them to depositfunds to the clearing house also
known as margin to make sure the that bothtraders live up to their obligations. The
traders who directly deal with clearing house are called clearing members.

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Over-the-counter derivatives:
Unlike Exchange traded derivatives, the OTC derivatives markets are contracts that
are traded and privately negotiated directly between two parties without going
through intermediary. This market is usually unregulated and involves less
disclosure of information to both parties. They are not easy to observeor measure.
Banks, fund managers and corporations are main participants of OTC markets.
Traditionally, participants in the OTC derivatives markets used to contacteach
other directly by phone or email. The benefit of OTC derivative market is that it is
easier to trade a large quantity directly with another party avoiding the exchange
fees as well as market tumult and uncertainty in the market. Also, someone might
want to trade a custom financial claim that may not be available on exchange.
Types ofDerivatives Contracts:
Forwardand Futures:
Forward or Futures Contract is an agreement to buy or sell a specific quantity of
an asset at a specified price with delivery at a specified date in the future. They
are in similar in nature but there are some differences in how they are
transacted. Forward contracts are customized contracts to meet the special
needs of two parties involved (Counterparties). They involve transaction that
requires cash settlement of contract at delivery and are settled between the
counterparties. Moreover, Forward contracts are mostly traded in Over-the-
counter markets (OTCs), hence they are less regulated and possessdefault risk.
On the other hand, Futures are standardized contracts where the losses and
gains are released on daily basis. The futures are transacted through an
established clearing house so it is regulated and does not involve default risk
usually. The exchange mechanism provides a guarantee to both parties that
contract will be honored. Futures prices are regularly reported in the financial
press and these prices are exclusive of commissions and movement of these

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prices are determined in the same way as other prices that is by the forces of
demand and supply.
Futures contract is referred to by its delivery month. The exchange must specify
the precise period during the month when delivery can be made. Here, the word
delivery for futures implies the quantity of financial instrument or commodities
contracted to be delivered at future date. For most of the future contracts,
delivery period is one month but they may vary from contract to contract and
are set by exchange to meet the needs of market participants.
OPTIONS:
Options Contracts can either be standardized or customized. Unlike forwards
or futures, an Option contract does not involve both sided contract. There are
two types of options. Call Option which is a contract that gives the right to buy
a s specified quantity of commodity or a financial asset at particular price
known as strike price on or before a certain date that is called expiration
date/Maturity date. Likewise, a Put option gives the buyer the right to sell a
quantity of a commodity or a financial asset at a particular price on or before a
certain future date.
The European Options are required to be only exercised on expiration date
whereas American options can be exercised at any time up to expiry date. The
distinguishing fact between futures/forwards and options is that option gives the
holder a right to do something. The holder does not have to exercise this right.
In contrary, forwards and futures obliged the holder to buy or sell underlying
asset. It costs nothing to enter in forwards or futures contractbut there is costto
acquire an option. This costis called option premium that is an amount for the
right to buy or sell that is paid to writer of options.
Moreover, the Option does not require the buyer to buy or sell underlying
asset under all circumstances. In the case, the option is not exercised at
expiration date; the purchaser simply loses the premium paid only. In the event
that options are not exercised at expiration, the purchaser simply loses the
premium paid. If the options are exercised, however, the option writer will be

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liable for covering the costs ofany changes in the value of the underlying that
benefit the purchasers.
SWAPS:
Swaps are customized contracts between two parties on over-the-counter to
exchange a series of cashpayments for a stated period of time. Basically, Swap
is a portfolio of forwards contracts. Swaps are usually done on interest rates and
the cash flows normally respond to interest payments that are based on the
notional principal amount of swap. Back in 1981, IBM and World Bank were
the first two parties who made an agreement of swap. Today, swaps are one of
the heavily traded financial contracts in the world according to Bank of
International Settlements (BIS).
COMMONLY USED DERIVATIVES
EQUITY DERIVATIVES:
CREDIT DERIVATIVES:
INTEREST RATE DERIVATIVES
COMMODITY DERIVATIVES
FOREIGN EXCHANGE DERIVATIVES

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SIGNIFICANCE OF DERIVATIVE MARKETS IN PAKISTAN
Changes in the international business environment and the increased volatility of
interest rate movements have profound implication on the way in which giant
commercial banks in Pakistan deal with their risk. Since 1970, Derivatives have
become important part of financial markets; future and option were traded actively
in many stock exchanges within the world. (Hull 2006). Due to high volatility in
financial securities, industries in that era created a demand for hedging instrument
that is used by financial institutions to handle risk. At that period emergence of
financial derivative is the most significant expansion in the financial sector.
The recent economic meltdown in Pakistan requires modern and superior
way to tackle a high point of instability. Markets for derivatives started in Pakistan
in the year 2003. The country first transaction was “cross currency swap” arranged
and executed by National Bank of Pakistan (NBP) and Citibank of Rs 4.4 billion
with Pak-Arab Refinery Company (PARCO). At that time, the market was slim
and uneducated. Customers were not complicated enough to manage the
transaction.
Under the cross-currency coupon swap transaction, PARCO has managed to
hedge its interest rate exposure perfectly on both its assets and liabilities to the
extent of the amount of this transaction. After PARCO, forward rate agreement
took place in 2004 which were apparently termed as the first derivatives in the
market done by UBL.2004 was the year in which State Bank of Pakistan focused
on derivatives. SBP gave approval for FX options, interest rate swaps on a case-to-
case basis. At that time, there used to be four active players in the market, Standard
Chartered Bank, City Bank, ABN Amro and Deutsche Bank.
Although the Pakistan stock exchange (PSE) formerly Karachi stock
exchange (KSE) generally showed healthier growth in outlook of financial
derivative market but in addition PSE, put up with high degree of volatility.
However, PSE is considered highest volatile market in derivative all over the world
these days. The foremost user of derivatives is Telecom Sector, transportation
Sector, Banking Sector, financial institution and power sector in Pakistan during
2007-2012. In Pakistan, the derivative market is promising phase. However, the

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investors are reluctant to use derivative instruments due to lack of appropriate
understanding to use such instruments. Several financial and non- financial firms,
manufacturing sector and mutual firms are using financial derivative instruments.
A few recommendations may help in promoting and developing the nascent
Pakistani derivatives markets. First, it is appropriate to understand and address the
concerns of the supply-side market participants. Second, a comparative analysis of
regulatory frameworks in neighboring countries, other emerging markets, and
developed markets would help in formulating the regulatory levels that not only
safeguard investors’ interest but also promotethe derivatives markets.Third; the
innovation of Shariah-compliant derivatives contracts may attract investors who
view derivatives as purely speculative instruments.
Fourth, appropriate measures to promote the marketability of derivatives, as
well as cash liquidity of the supply-side market participants, should be considered.
While the former can be achieved by low transaction costs, pricediscovery, high
volumes, and enhancement of the market’s resilience to negative shocks, the latter
can be achieved by keeping the margin requirements at a level that do not increase
the opportunity costfor retail and institutional investors.
Fifth, financial literacy and confidence building among investors, regulated
marketing campaigns in simple language, and increasing the reach of investment
companies through online platforms, satellite offices, and already established
banking networks may motivate retails investors to opt for investments in
derivatives. Lastly, encouraging investors’ participation in derivatives markets
through mutual funds and voluntary pension schemes within the realm of
respective investment policies would also deepen the derivatives markets.

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REFERENCES
 (C.Hull, john, 2016)
 (https://econpapers.repec.org/RePEc:bis:bisifc:35-01)
 (McDonald, 2008)