Derivatives are financial instruments whose value is derived from an underlying asset such as commodities, currencies, bonds or stocks. Forwards and futures are types of derivatives that allow parties to lock in prices for assets that will be delivered or settled for in the future. Forwards are private, bilateral contracts while futures are standardized contracts traded on an exchange with clearing houses that act as intermediaries, reducing counterparty risk. Key differences between forwards and futures include their level of standardization, margin requirements, market liquidity and mode of delivery or settlement.

1. Derivatives
Dr. Kasamsetty Sailatha
HOD, PG Dept. of Commerce,
Vidya Vikas First Grade Collegel,
Mysore.

2. • Introduction
• Concept
• History
• Features
• Functions of Derivative Market
• Participants Derivative Market
• Institutional and legal framework
• Forward and Futures
• Distinction between forward and Futures

3. Introduction:
Risk is a characteristic feature of all commodity
and capital markets. Over time, variations in the
prices of agricultural and non-agricultural
commodities occur as a result of interaction of
demand and supply forces. The last two decades
have witnessed a many-fold increase in the
volume of international trade and business due
to the ever growing wave of globalization and
liberalization sweeping across the world. As a
result, financial markets have experienced rapid
variations in interest and exchange rates, stock
market prices thus exposing the corporate world
to a state of growing financial risk.

4. Increased financial risk causes losses to an
otherwise profitable organization. This underlines
the importance of risk management to hedge
against uncertainty. Derivatives provide an
effective solution to the problem of risk caused
by uncertainty and volatility in underlying asset.
Derivatives are risk management tools that help
an organization to effectively transfer risk.
Derivatives are instruments which have no
independent value. Their value depends upon the
underlying asset. The underlying asset may be
financial or non-financial.

5. For Ex. A farmer growing a crop in the month of
January. His crop is likely to harvest in the month
of April. If there is a demand for crop due to
shortage in yield, after the harvest, farmer may
get higher price. If the supply of crop is more,
farmer may sell his crop for lower rate. Therefore
there is a risk in the later situation. In such
situation, farmer may enter into a contract and
lock the price. If the prices or the crop go up, he
may lose, but if there is a fall in prices of crop, he
will stand to gain. The contract specifies the
quantity, price and the date of delivery.
This will enable you to minimize or reduce the
risk, which otherwise will be face due to
uncertain price fluctuations of the future price of
the crop.

6. • Concept:
The term ‘derivatives, refers to a broad class of
financial instruments which mainly include forwards,
futures, options and swaps. These instruments derive
their value from the price and other related variables
of the underlying asset. They do not have worth of
their own and derive their value from the claim they
give to their owners to own some other financial assets
or security. A simple example of derivative is butter,
which is derivative of milk. The price of butter depends
upon price of milk, which in turn depends upon the
demand and supply of milk. The general definition of
derivatives means to derive something from
something else.

7. • Definition of Financial Derivatives
Section 2(ac) of Securities Contract Regulation
Act (SCRA) 1956 defines Derivative as:
a) “a security derived from a debt instrument,
share, loan whether secured or unsecured,
risk instrument or contract for differences or
any other form of security;
b) “a contract which derives its value from the
prices, or index of prices, of underlying
securities”.

8. • Underlying Asset in a Derivatives Contract
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.
v. Shares and share warrants of companies traded on
recognized stock exchanges and Stock Index
vi. Short term securities such as T-bills; and
vii. Over- the Counter (OTC) money market products such as
loans or deposits.

9. • History:
The Derivatives markets can be traced back to the middle
Ages. They originally developed to meet the needs of
farmers and merchants.
The Chicago Board of Trade (CBOT) was the first derivatives
market established in 1848 to bring farmers and merchants
together. Initially, its main task was to standardize the
quantities and qualities of the grains that were traded.
Within a few years, the first futures type contract was
developed. It was known as to-arrive contract.
Speculators soon became interested in the contract and found
trading the contract to be an attractive alternative to
trading the gain itself. The Chicago Board of Trade now
offers futures contracts on many different underlying
assists, including corn, oats, soybeans, soybean oil wheat,
silver, treasury bonds, and treasury notes.

10. • The Chicago Mercantile Exchange:
In 1874, the Chicago Produced Exchange was established. This
provided a market for butter, eggs, poultry, and other perishable
agricultural products. In 1898, the butter and egg dealers withdrew
from this exchange to form the Chicago Butter and Egg Board. In
1919, this was renamed the Chicago Mercantile Exchange (CME)
and was reorganized for futures trading. Since then, the exchange
has provided a futures market for many commodities including pork
bellies (1961), live cattle (1964) live hogs (1966) and feeder cattle
(1971). In 1982, it introduced a futures contract, and a Eurodollar
futures contract on the S&P 500 Stock Index.
The International Monetary Market (IMM) was formed as a division of
the Chicago Mercantile Exchange in 1972 for futures trading in
foreign currencies. The currency traded on the IMM now include
the British Pound, the Canadian futures Dollar, the Japanese Yen,
the (Swiss Franc, the German mark) European Euro and the
Australian dollar. The IMM also trades a gold futures contract, a
treasury bill futures contract, and a Eurodollar futures contract.

11. • Other Exchanges:
Many other exchanges throughout the world now
trade futures contracts. Prominent among them
are
– Chicago Rice and Cotton Exchange (CRCE, the)
– New York Futures Exchange (NYFE),
– London International Financial Futures Exchange
(LIFFE),
– Toronto Futures Exchange (TFE),
– Singapore International Monetary Exchange (SIMEX)
and
– National Commodity and Derivative Exchange
(NCDEX) of India.

12. • Features of Derivates Market:
1. Derivatives are popular instruments traded
globally.
2. Gain or loss depends on the underlying asset’s
value.
3. Change in value of underlying asset will have
effect on values of derivatives.
4. They are traded on exchange.
5. They are liquid and transaction cost is lower.

13. • Functions of Derivatives Markets:
– Risk management
– Price Discovery
– Transactional Efficiency
– Financial Engineering
• Participants in the Derivatives market:
1. Hedgers
2. Speculators
3. Arbitrageurs
4. Intermediary participants
• Brokers
• Jobbers

14. • Institutional and Legal Framework:
1. Exchange
2. Clearing house
3. Custodian/warehouse
4. Regulatory framework

15. Forward Contracts.
• A one to one bipartite contract, which is to be
performed in future at the terms decided today.
• Eg. A and B enter into a contract to trade in one
stock on Infosys 3 months from today the date of
the contract @ a price of Rs4675/-
• Note: Product ,Price ,Quantity & Time have been
determined in advance by both the parties.
• Delivery and payments will take place as per the
terms of this contract on the designated date and
place. This is a simple example of forward
contract.

16. • Features of Forwards:
1. Forwards are transactions involving delivery of
an asset or a financial instrument at a future
date.
2. Both the buyer and seller are committed to the
contracts.
3. Forward perform the function of ‘price-
discovery’ for commodities and financial assets.
4. As there is no performance guarantee in a
forward contract, there is always counterparty
risk.

17. • Risks in a forward contract:
– Liquidity risk: these contracts a biparty and not
traded on the exchange.
– Default risk/credit risk/counter party risk.
– Say Jay owned one share of Infosys and the price
went up to 4750/- three months hence, he profits
by defaulting the contract and selling the stock at
the market.

18. Futures
• Future contracts are organized/standardized
contracts in terms of quantity, quality, delivery
time and place for settlement on any date in
future. These contracts are traded on exchanges.
• These markets are very liquid
• In these markets, clearing corporation/house
becomes the counter-party to all the trades or
provides the unconditional guarantee for the
settlement of trades i.e. assumes the financial
integrity of the whole system. In other words, we
may say that the credit risk of the transactions is
eliminated by the exchange through the clearing
corporation/house.
• The key elements of a futures contract are:
– Futures price
– Settlement or Delivery Date
– Underlying Asset.

19. • Features of futures:
1. Futures are traded on organized exchanges with
clearing associations that act as intermediaries
between the contracting parities.
2. Futures are highly standardized contracts that
provide for the performance of the contract either
through deferred delivery of an asset or a final cash
settlement.
3. Both the parties pay a margin to the clearing
association. This is used as a performance bond by
contracting parties. The margin paid is generally
marked to the market price every day.
4. Each futures contract has an association month
which represents the month of contract delivery or
final settlement.

20. • Distinction between forwards and futures
Nature of Forwards Futures
difference
1. Size of contracts Decided by buyer and Standardized in each
seller contract
2. Price of contract Remains fixed till Changes every day
maturity
3. Market to market Not done Marked to market
every day
4. Margin No margin required Margins are to be
paid by both buyer
and seller
5. No. of contracts in There can be any No. of contracts in a
a year number of contracts year are fixed
between 4 and 12

21. 6. Hedging These are tailor- Hedging is by
made for specific nearest month
date and and quantity
quantity, so contracts so
perfect hedging perfect hedging
is possible not possible.
7. Market Illiquid Liquid
liquidity
8. Nature of market Over the counter Exchange traded
9. Mode of delivery Specifically decided. Standardized, most
Most of the of contracts are cash
contracts result in settled.
deliver.