Financial derivatives derive their value from an underlying security and are used for risk management. The main types are stock, index, interest rate, and foreign currency derivatives. There are two markets - the cash market for immediate purchasing/selling of securities, and the futures and options market meant for hedging risks arising from cash market dealings. Hedging in the futures market allows buyers and sellers in the cash market to offset risks from price fluctuations. Speculation involves trading futures contracts without an underlying position, while arbitrage exploits brief price differences between markets. Options provide the right but not obligation to buy or sell an underlying asset.

1. Financial Derivatives-Theory and Concepts-B.V.Raghunandan, SVS College, Bantwal AJ Institute of Management, Mangalore August 30, 2011

2. Financial Derivatives: Meaning ” a financial asset that derives its value from an underlying security”-used extensively for risk management attributed to holding and trading in securities

3. Instruments of Financial Derivatives Stock Derivative Index Derivative Interest Derivative Foreign Currency Derivative

4. Types of Dealings in a Stock Exchange Dealings in Cash Market Dealings in Futures & Options Market

5. Cash Market Rolling Settlement T+2 Settlement Trading Day Pay-In Day Pay-Out Day

6. Futures & Options Market Meant for Risk Management Arising Out of Dealings in Cash Market Exchange Traded Big Investors and Institutions Take Positions For Protecting the Value of Holding Providing for the Risks Arising Out of Trading

7. Futures: Characteristics Standardised Features Counter-Party is the Clearing House Margin Requirement Time Spread Three Contracts for Settlement

8. Futures: Trading Mechanism Trading Strategies Uses: -Hedging -Speculation -Arbitrage Types of Futures: Stock Future and Index Future

9. Hedging A transaction in the cash market is accompanied by a contra transaction in the futures market Buyer in cash market protects against subsequent fall in the price through sale in the futures market A seller in the cash market protects against subsequent increase through buying in the futures market Objective is to maintain asset purchased at the latest value

10. Buyer in the Cash Market Buys 1000 shares of L&T in cash market @ Rs.1,500 He can protect against fall in price upto three months If he chooses protection for one month, he sells 1000 shares of L&T in September future. (Protection for two months, sell October future-for three months, sell November future) Settlement of September future on the last Thursday of September i.e 29-09-2011 Around 27th, the price in the cash market is Rs.1400. He buys 1000 shares in the cash market and settles the September future sale at Rs. 1,500, making a profit of Rs. 100

11. Position of the Buyer on September 29th Value of original purchase = Rs 1, 40,000 Cost of original purchase = Rs.1,50,000 Sale of September Future = Rs. 1, 50,000 Purchase to settle = Rs. 1, 40,000 -------------------------------------------------------------- Value of Holding on September 29 th = 1, 40,000 Cash at Bank (Profit) = 10,000 --------------- 1,50,000 --------------

12. Where the Price goes up to Rs. 1, 600 At any time before 29th September, Price of L&T goes upto Rs.1600 Cost of His original Purchase= 1500 x 100 = 1, 50,000 Value of the original Purchase=1,600 x 100 = 1,60,000 Sale of September Future = 1, 50,000 Purchase for Sept Future = 1, 60, 000 Loss on the Future Sale = 10,000 --------------------------------------------------------------------- Value of Holding on 29th = 1, 60,000 (-) Loss on September Future = (10,000) Net Value in Hand = 1,50,000

13. Speculation Original purchase will not be there in the cash market A bull buys the September future A bear sells the September future Profit made the bull when the price goes up or loss is incurred when the price comes down Profit made by bear when the price comes down and vice versa

14. Arbitrage Buying in low priced market and selling in high-priced market Between one stock exchange to another Between cash market and futures market Between future of one month and other months Between future market and a call market

15. Option A contract to buy or sell without an obligation European Option and American Option Call Option and Put Option Uses of Options: -Hedging -Speculation -Arbitrage

16. Advantages of Option No Big Investment No Margin as in Futures No Obligation No Marked-to-Market More Gain than Risk Premium paid alone is the Disadvantage

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