Basics of Financial Derivatives

1. Financial Derivatives
Module-1

2. Introduction
• Farmers are exposed to
– Price Risk
– Quantity Risk
• Financial markets have been marked by excessive
volatility.
• As foreign exchange rates, interest rates and
commodity prices continue to experience sharp
and unexpected movements, it has become
increasingly important that corporations exposed
to these risks be equipped to manage them
effectively.

3. Definition
• The term “Derivative” indicates that it has no
independent value, i.e., its value is entirely
derived from the value of the underlying
asset. The underlying asset can be securities,
commodities, bullion currency, livestock or
anything else.
• It is a financial instrument, which derives its
value from the underlying asset.

4. • The Securities Contracts (Regulation) Act 1956
defines “derivative” as under: “Derivative” includes:
• Security derived from a debt instrument, 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.
The above definition conveys that:
• The derivatives are financial products.
• Derivative is derived from another financial
instrument/contract called the underlying. In the
case of Nifty futures, Nifty index is the underlying. A
derivative derives its value from the underlying
assets.

5. The underlying securities for
derivatives are:
• Commodities (Castor seed, Grain, Coffee
Beans, Pepper, Potatoes)
• Precious Metals (Gold, Silver)
• Short-term Debt Securities (Treasury Bills)
• Interest Rate
• Common Shares/Stock
• Stock Index Value (NSE Nifty)

6. Features of financial derivatives
• It is a contract
• Derives value from underlying asset
• Specified obligation
• Direct or exchange traded
• Related to notional amount
• Delivery of underlying asset not involved
• Exposure to risk

7. Classification of Derivatives
• Commodity derivatives and
• Financial derivatives.
• The basic difference between these is the nature
of the underlying instrument or asset.
• In a commodity derivative, the underlying
instrument is a commodity which may be wheat,
cotton, pepper, sugar, jute, turmeric, corn, soya
beans, crude oil, natural gas, gold, silver, copper
and so on.
• In a financial derivative, the underlying
instrument may be treasury bills, stocks, bonds,
foreign exchange, stock index, gilt-edged
securities, cost of living index, etc

8. Participants in derivatives market
• Banks, financial institutions, corporate,
brokers and individuals are the participants of
the derivative market in India.
• Hedgers: These are investors with a present or
anticipated exposure to the underlying asset
which is subject to price risks. Hedgers use the
derivatives markets primarily for price risk
management of assets and portfolios.

9. Participants in derivatives market
• Speculators: These are individuals who take a
view on the future direction of the markets. They
take a view whether prices would rise or fall in
future and accordingly buy or sell futures and
options to try and make a profit from the future
price movements of the underlying asset.
• Arbitragers: These are the third important
participants in the derivatives market. They take
positions in financial markets to earn risk less
profits. The arbitragers take short and long
positions in the same or different contracts at the
same time to create a position which can
generate a risk less profit.

10. Economic Function of the Derivative
Market
• Detection of Prices: Prices in an organized derivatives
market reflect the perception of the market participants
about the future and lead the prices of underlying to the
perceived future level.
• Transfer of Risk: The derivatives market helps to
transfer risks from those who have them but do not like
them to those who have an appetite for them.
• Liquidity and Volume Trading: Third, derivatives due to
their inherent nature are linked to the underlying cash
markets. With the introduction of derivatives, the
underlying market witnesses higher trading volumes.
• Encourages participating more people: An important
incidental benefit that flows from derivatives trading is
that it acts as a catalyst for new entrepreneurial activity.

11. Types of Derivatives

12. • Forwards: A forward contract is a customized contract
between two entities, where settlement takes place on
a specific date in the future at today’s pre-agreed price.
• Futures: A futures contract is an agreement between
two parties to buy or sell an asset at a certain time in
the future at a certain price. Futures contracts are
special types of forward contracts in the sense that the
former are standardized exchange-traded contracts.
• Options: An option represents the right (but not the
obligation) to buy or sell a security or other asset
during a given time for a specified price (the “strike
price”).
• Swaps: Swaps are private agreements between two
parties to exchange cash flows in the future according
to a prearranged formula.

13. Forward Contracts
• A forward contract is a simple customized contract
between two parties to buy or sell an asset at a certain
time in the future for a certain price.
• A forward contract is an agreement between two
parties to buy or sells, as the case may be, a
commodity (or financial instrument or currency) at a
predetermined future date at a price agreed when the
contract is entered into.
The key elements are:
• The date on which the commodity will be bought/sold
is determined in advance.
• The price to be paid/received at that future date is
determined at present.

14. Features of a Forward Contract
• Forward contracts are bilateral contracts, and
hence, they are exposed to counter party risk.
• Each contract is custom designed, and hence, is
unique in terms of contract size, expiration date,
the asset type, quality, etc.
• In forward contract, one of the parties takes a
long position and other party assumes a short
position.
• The specified price in a forward contract is
referred to as the delivery price.
• In the forward market, the contract has to be
settled by delivery of the asset on expiration
date.

15. Benefits and Limitations of Forward
Markets
The following are some of the benefits of the forward markets:
• Forward contracts can be used to hedge or lock-in the price
of purchase or sale of commodity or financial asset on the
future commitment date.
• On forward contracts, generally, margins are not paid and
there is also no upfront premium. So, it does not involve
initial cost.
• Since forwards are tailor-made, price risk exposure can be
hedged up to 100%, which may not be possible in futures or
options.
The following are some of the limitations of the forward
markets worldwide:
• Lack of centralization of trading,
• Illiquidity, and
• Counterparty risk

16. Futures Contracts
• A future contract is a standardized agreement
between the seller (short position) of the
contract and the buyer (long position), traded
on a futures exchange, to buy or sell a certain
underlying instrument at a certain date in
future, at a pre-set price.

17. Characteristics of Futures Contracts
• Futures are highly standardized contracts.
• These contracts trade on organized futures
exchanges.
• Contract seller is called ‘short’ and purchaser
‘long’. Both parties pay margin to the clearing
association.
• Margins paid are generally marked to market-
price everyday;
• Each futures contract has an associated month
that represents the month of contract delivery or
final settlement

18. Categories of Futures Contracts
• Financial Futures
• Commodity Futures

19. Distinction between Futures and
Forwards Contracts

20. Options
• Option may be defined as a contract, between
two parties whereby one party obtains the right,
but not the obligation, to buy or sell a particular
asset, at a specified price, on or before a
specified date.
• The person who acquires the right is known as
the option buyer or option holder, while the
other person (who confers the right) is known as
option seller or option writer.
• The seller of the option for giving such option to
the buyer charges an amount which is known as
the option premium.

21. Types of options
• Call option gives the holder the right to buy an
asset at a specified date for a specified price.
• Put option, the holder gets the right to sell an
asset at the specified price and time.
• A European option can be exercised on the
expiration date only.
• American option can be exercised at any time
before the maturity date.

22. Features of the Options Contracts
• Option contract gives the holder the right to do
something.
• The holder may exercise his option or may not.
• The holder can make a reassessment of the
situation and seek either the execution of the
contracts or its non-execution as be profitable to
him.
• He is not under obligation to exercise the option.

23. Option Terminology
• Buyer of an option: The option buyer is the person who
acquires the rights.
• Writer of an option: The option seller (also known as
the option writer or option grantor) is the party that
conveys the option rights to the option buyer.
• Option price: Option price is the price which the option
buyer pays to the option seller. It is also referred to as
the option premium.
• Expiration date: The date specified in the options
contract is known as the expiration date, the exercise
date, the strike date or the maturity.

24. Option Terminology
• Strike Price (K): Also known as the “exercise
price,” this is the stated price at which the
buyer of a call has the right to purchase a
specific contract or at which the buyer of a put
has the right to sell a specific contract.