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Indian History of DerivativesThe Bombay Cotton trade association started futureTrading in 1875In 1952 the government banned cash settlement andOption TradingIn 1995 a Prohibition of trading options was liftedIn 1999, the Securities Contract (Regulation) Actof 1956 was amended and derivatives could beDeclared “securities”NSE Started trade in future and option by 2005
Derivative is . . . .A Derivative is a Financial Instrument whosevalue depends on – is derived from – the valueof some other financial instrument, called theunderlying asset.The value of derivative is linked to risk or volatility inEither financial asset, transaction, market rate, orcontingency, and creates a product
Features of DerivativesTraded on ExchangeAll Transaction in derivatives take place in futurespecific dateHedging Device-Reduces RiskDerivatives are often leveraged, such that a smallmovement in the underlying value can cause aLarge difference in the value of the derivative
Basic Purpose of DerivativesIn Derivative Transactions, one party’s loss is alwaysanother party’s gainThe main purpose of derivatives is to transfer riskfrom one person or firm to another, that is, to provideinsuranceIf a farmer before planting can guarantee a certainprice he will receive, he is more likely to plantDerivatives improve overall performance of theeconomy
Types of Derivatives Contract FuturesForwards Swaps Options
Futures A Financial contract obligating the buyer to purchase an asset, (or the seller to sell an Asset), such as a physical commodity or a financial instrument, at a predetermined Future date and price.Some of the most popular assets on which futuresContracts are available are equity stocks, indices,Commodities and Currency
Margin accounts and marking to marketClearing Corporation requires initial deposits in amargin accountTracks daily gains and losses and posts these to marginaccountsThe contract is settled daily basis which is known as“Marking to Market”
Practical View on Futures & Clearing Corporation
ForwardsA forward contract is a customized contract betweentwo entities, where settlement takes place as a specificdate in the future at Predetermined priceForwards are also known as Private ContractsNormally traded outside exchange
OptionsThe owner of the option has option to sell or buy assetsat a given price on or before given date American Option European OptionAn option that may be An option that may only beexercised on any trading exercised on expiry dateDay on or before expiry
OptionsCall Option – a right to buy an asset at a predeterminedprice (strike price) on or Before a specific date If asset price is higher than the strike price - Option is in the money If asset price is exactly at the strike price - Option is at the money If asset price is below the strike price - Option is out of the money Obviously would not exercise an option that is out of the money
OptionsPut Option – a right to sell and asset at a predeterminedPrice on or before a specific date If asset price is lower than the strike price - Option is in the money If asset price is exactly at the strike price - Option is at the money If asset price is higher than the strike price - Option is out of the money
Swaps Swaps are private agreement between two parties to exchange cash flows in the future according to a pre-arranged formulaThey can be regarded as portfolio of forward contractsThe two commonly used Swaps are:(i)Interest Rate Swaps : A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency.(ii) Currency Swaps : A currency swap is a foreign exchange Agreement between two parties to exchange a given amount of one currency for Another and after a specified period of time, to give back the original Amount swapped.
Types of Derivatives MarketsOver-the-Counter derivatives : Contracts that are traded between two parties directlywithout going through an exchangeForward and Swap Contracts are OTC derivativesExchange-traded derivatives : Contracts that are traded in derivatives exchanges
Market PlayersHedgers – Transfer of Risk component of their portfolioSpeculators – Intentionally taking the risk from theHedgers in pursuit of profitArbitrageurs – Operating in different marketsSimultaneously, in pursuit of profit and eliminatemis-pricing