material

1. Derivatives market
Module 2

2. what is derivatives market?
• The term derivatives stands for a contract whose
price is derived from or is dependent upon an
underlying asset.
• The underlying asset could be a financial asset
such as currency stock and market index an
interest bearing security or a physical commodity.
• The derivative itself is merely a contract between
two or more parties. Its value is determined by
fluctuations in the underlying asset.

3. Need for derivatives
• The derivatives market performs a number of
economic functions. They help in:
• Transferring risks
• Discovery of future as well as current prices
• Lower transaction costs
• Increasing saving and investments in long run.

4. Participants in derivatives
markets
• Hedgers are those who buy or sell in derivatives
market in order to reduce their risk of their
portfolio.
• Speculators are those who enter into the market
purely for making profit by buying or selling the
derivatives their only aim is to make profit based
on their judgment about the stock or market.
• Arbitrage refers to obtaining risk free profits by
simultaneously buying and selling similar
instruments in different markets

5. What is OTC( over the
counter)
• Over the counter derivatives are those which
are privately traded between two parties and
involves no exchange or intermediary.
• Non standard products are traded in the so
called over the counter derivatives mkt.
• The over the counter derivative market
consists of the investment banks and include
clients like hedge funds commercial banks
government sponsored enterprises etc.

6. Exchange traded derivatives
market
• A derivatives exchange is a market where
individuals trade standardized contracts that
have been defined by the exchange.
• A derivatives exchange acts as an intermediary
to all related transactions and takes initial
margin from both sides of the trade to act as a
guarantee.

7. Basic Terminologies
• Spot contract an agreement to buy or sell an
asset today.
• Spot price the price at which the asset changes
hands on the spot date
• Spot date is the normal settlement day for a
transaction done today.
• Long position the party agreeing to buy the
underlying asset in the future assumes a long
position
• Short position the party agreeing to sell the asset
in the future assumes a short position

8. Basic Terminologies
• Delivery prices the price agreed upon at the
time the contract is entered into.

9. Classification of derivatives
• Future contracts
• Forward contracts
• Options
• Swaps

10. Forward contracts
• Forward is a non standardized contract between
two parties to buy or sell an asset at a specified
future times at a price agreed today.
• For example if A has to buy a share 6 months
from now and B has to sell a share worth Rs. 100.
So they both agree to enter in a forward contract
of rs 104. A is at long position and B is at short
position suppose after 6 months the price of share
is rs 110 so B overall gained rs 4 but lost rs 6
while A made an overall profit of rs 6

11. Swap contract
• The derivative in which counterparties exchange
certain benefits of one party’s financial instruments
for those of the other partys financial instrument.
The benefits in question depend on the type of
financial instruments involved. The types of swaps
are
• Interest rate swaps
• Currency swaps
• Equity swap
• Credit default swaps

12. Futures contract
• Futures contract is a standardized contract between two
parties to exchange a specified asset of standardized
quantity and quality for a price agreed today (the
futures price or the strike price) with delivery occurring
at a specified future date the delivery date.
• Since such contract is traded is traded through
exchange the purpose of the futures exchange
institution is to act as intermediary and minimize the
risk of default by either party. Thus the exchange
requires both parties to put up an initial amount of cash
the margin.

13. Comparison of Future
Contract with Forward
Contracts
5/22/2023 ctsk

14. FORWARD FUTURES
DEFINITION A forward contract is an
agreement between two
parties to buy or sell an asset
(which can be of any kind) at
a pre-agreed future point in
time at a specified price.
A futures contract is a
standardized contract, traded
on a futures exchange, to buy
or sell a certain underlying
instrument at a certain date in
the future, at a specified
price.
Structure &
Purpose
Customized to customer
needs. Usually no initial
payment required. Usually
used for hedging.
Standardized. Initial margin
payment required. Usually
used for speculation.
Transaction method Negotiated directly by the
buyer and seller
Quoted and traded on the
Exchange
5/22/2023 ctsk

15. Market regulation Not regulated Government regulated market
(the Commodity Futures
Trading Commission or
CFTC in US, Forward Market
Commission or FMC in India,
Dubai Financial Services
Authority)
Institutional
guarantee
The contracting parties Clearing House
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement until the
date of maturity only the forward
price, based on the spot price of the
underlying asset is paid
Both parties must deposit an
initial guarantee (margin).
The value of the operation is
marked to market rates with
daily settlement of profits and
losses.
5/22/2023 ctsk

16. Contract Maturity Forward contracts generally
mature by delivering the
commodity.
Future contracts may not
necessarily mature by
delivery of commodity.
Expiry date
Depending on the transaction Standardized
Method of pre-
termination
Opposite contract with same or
different counterparty.
Counterparty risk remains while
terminating with different
counterparty.
Opposite contract on the
exchange.
Contract size Depending on the transaction
and the requirements of the
contracting parties.
Standardized
Market Primary & Secondary Primary
5/22/2023 ctsk