Derivatives are financial instruments whose value is derived from an underlying asset. The four main types of derivatives are forwards, futures, options, and swaps. Forwards and futures are contracts to buy or sell an asset at a future date, while options give the right but not obligation to buy or sell. Swaps involve exchanging cash flows of one party's financial instrument for those of another party. Derivatives are traded both over-the-counter and on exchanges, and provide economic benefits like risk management and market liquidity.

1. Financial Derivatives
⁃ Definition
⁃ Participants
⁃ Markets
⁃ Benefits
⁃ Types
What are derivatives?
• A derivative is a financial instrument

2. whose value is derived from the value of
another asset, which is known as
underlying asset.
• When the price of the underlying
changes, the value of the derivative also
changes.
• A derivative is not a product. It is a
contract that derives its value from
changes in the price of the underlying.
• The value of the gold futures contract is

3. derived from the value of the underlying
asset, which is gold.
Traders in the derivatives market.
• Hedger - A hedger faces the risk
associated with price movement of an
asset and who uses derivatives as
means of reducing risk.
• Speculator - A trader who enters the
futures market in pursuit of profit,

4. accepting risk in the endeavour.
• A r b i t r a g e u r - A p e r s o n w h o
simultaneously enters into transactions in
two or more markets to take advantage
of the discrepancies between prices in
the market.
⁃ Arbitrage involves making profits from
relative mis-pricing.
⁃ It also help to make markets liquid,
ensure accurate and uniform pricing, and

5. enhance price stability.
Types of Derivatives Market
• OTC
⁃ In over-the-counter market derivatives
are traded between two counter-parties
without going through an intermediary.
⁃ The contract is privately negotiated and
thus customised.
⁃ T h e s e m a r k e t s a r e g e n e r a l l y

6. unregulated.
• Exchange-Traded
⁃ The exchange acts as an intermediary
whenever a contract is negotiated
between two counter parties.
⁃ The trading is standardised and
regulated.
⁃ The KOSPI of South Korea is the world's
largest derivatives exchange (by the

7. number of transactions)
Economic benefits of derivatives
⁃ Reduces risk.
⁃ Enhances liquidity of the underlying
asset.
⁃ Lowers transaction cost.
⁃ Enhances the price discovery process.
⁃ Portfolio management.
⁃ Provides signals for market movements.

8. ⁃ Facilitates financial markets integration.
Types of derivatives
1. Forward
2. Futures
3. Options
4. Swaps
What are forward contracts?
⁃ A forward is a contract in which one

9. party commits to buy and the other party
commits to sell a specified quantity of an
agreed upon asset for a pre-determined
price at a specified date in the future.
⁃ It is a customised contract, in the sense
that the terms of the contract are agreed
upon by the individual parties.
⁃ Hence, it is traded at OTC.
Risks in forward contract

10. • Credit risk - Does the other party have
the means to pay?
• Operational risk - Will the other party
make delivery? Will the other party
accept delivery?
• Liquidity risk - In case either party wants
to opt out of the contract, how to find
another counter party?
What are Futures contract?

11. ⁃ A future is a standardised forward
contract.
⁃ It is traded on an organised exchange.
⁃ It is standardised in terms of - quantity,
price and date of delivery of the
underlying.
Types of futures contracts
⁃ Stock futures trading
⁃ Commodity futures trading

12. ⁃ Index futures trading
Closing a futures position
⁃ Most futures contracts are not held till
expiry, but closed before that.
⁃ If held till expiry, they are generally
settled by delivery (2%-3%).
⁃ By closing a futures contract before
expiry, the net difference is settled
between traders, without physical

13. delivery of the underlying.
Terminology
⁃ Contract size - The amount of the asset
that has to be delivered under one
contract. All futures are sold in multiple of
lots which is decided by the exchange
board.
⁃ Contract cycle - The period for which a
contract trades. The futures on the NSE

14. have one (near) month, two (next) month
and three (far) month expiry cycles.
⁃ Expiry date - Usually last thursday of
each month or previous day if thursday is
a public holiday.
⁃ Strike price - The agreed price of the deal
is called the strike price.
⁃ Cost of Carry -Difference between strike
price and current price.

15. Margins
⁃ A margin is an amount of a money that
must be deposited with the clearing
house by both buyers and sellers in a
margin account in order to open a futures
contract.
⁃ It ensures performance of the terms of
contract.
⁃ It aims to minimise the risk of default by
either counterparty.

16. Types of margins
• Initial margin - Deposit that a trader must
make before trading any futures. Usually,
10% of the contract.
• Maintenance margin - When a margin
reaches a minimum maintenance level,
the trader is required to bring the margin
back to its initial level. The maintenance
margin is generally about 75% of the
initial margin.

17. • Variation margin - Additional margin
required to bring an account up to the
required level.
• Margin call - If amount in the margin A/C
falls below the maintenance level, a
margin call is made to fill the gap.
Marking to Market
⁃ This is a practice of periodically adjusting
the margin account by adding or

18. subtracting funds based on changes in
market value to reflect the investor's gain
or loss.
⁃ This leads to changes in margin amount
daily.
⁃ This ensures that there are no defaults
by the parties.
What are options
Contracts that give the holder the option to

19. sell/buy specified quantity of underlying at a
particular price on or before the specified
time period.
The word "option" means that the holder
has the right but not the obligation to buy/
sell underlying asset.
Types of option
• Options are of two types - Call and Put.
• Call option give the buyer the right but

20. not the obligation to buy a given quantity
of the underlying asset, at a given price
on or before a particular date by paying a
premium.
• Put option gives the buyer the right, but
not the obligation to sell a given quantity
of the underlying asset at a given price
on or before a particular date by paying a
premium.
• The other two types of option are -

21. European and American options.
• European style options can be exercised
only on the maturity of the options,
known as expiry date.
• American style option can be exercised
at any time prior to the expiration date.
Features of options
⁃ A fixed maturity date on which they
expire.

22. ⁃ The price at which option is exercised is
called exercise price of an option.
⁃ The person who writes the option and is
the seller is referred to as "option writer".
⁃ The person who holds the option and is
the buyer is called "option holder".
⁃ The premium is the price paid for the
option by the buyer to the seller.
⁃ A clearing house is interposed between
the writer and the buyer which

23. guarantees performance of the contract.
What are swaps?
⁃ In a swap a counter parties agree to
enter into a contractual agreement
wherein they agree to exchange cash
flows at regular intervals.
⁃ Most swaps are traded over the counter.
⁃ Some are traded on futures exchange
market.

24. Types of Swaps
There are two main types of swaps-
⁃ Plain vanilla fixed or floating swaps or
simply interest rate swaps.
⁃ Fixed currency swaps or simply currency
swaps.
What is an Interest rate swap?
⁃ A company agrees to pay a pre-
determined fixed interest rate on a

25. notional principal for a fixed number of
years.
⁃ In return, to receives interest at a floating
rate on the same notional principal for
the same period of time.
⁃ The principal is not exchanged. Hence, it
is called a notional amount.
Floating Interest rate
⁃ LIBOR - London Interbank offered rate.

26. ⁃ Its an average interest rate estimated by
leading banks in London.
⁃ Its the primary benchmark for short term
interest rates around the world.
⁃ Similarly, there is MIBOR i.e. Mumbai
Interbank Offered rate.
⁃ It is calculated by the NSE as a weighted
average of lending rates of a group of
banks.

27. What is a Currency Swap
⁃ It is a swap that includes exchange of
principal and interest in one currency for
the same in another currency.
⁃ It is considered to be a foreign exchange
transaction.
⁃ It is not required by law to be shown in
balance sheet.
⁃ The principal may be exchanged either at
the beginning or at the end of the tenure.

28. ⁃ However, if it is exchanged at the end of
the life of the swap, then the principal
value may be very different.
⁃ It is generally used to hedge against
exchange rate fluctuations.