1.

INTRODUCTION OF DERIVATIVE MARKET

What Does Derivative Mean?
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a
contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common
underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are
characterized by high leverage. 

a.what is derivative market

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. In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fixed
duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an index
of securities.

B. Who are the operators in the derivatives market?

 Hedgers - Operators, who want to transfer a risk component of their portfolio.
 Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.
 Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate mis-
pricing.
C. What is the importance of derivatives?
There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instruments
and transfer these risks to parties willing to bear these risks.
1. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporates and financial
institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rates,
interest rates etc., as shown in the box below. They serve as insurance against unwanted price movements and reduce the
volatility of companies’ cash flows, which in turn results in more reliable forecasting, lower capital requirements, and higher
capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the world’s 500 largest
companies manage their price risks using derivatives.
2. The second use of derivatives is as an investment. Derivatives are an alternative to investing directly in assets without
buying and holding the asset itself. They also allow investments into underlying and risks that cannot be purchased directly.
Examples include credit derivatives that provide compensation payments if a creditor defaults on its bonds, or weather
derivatives offering compensation if temperatures at a specified location exceed or fall below a predefined reference
temperature.
3. Derivatives also allow investors to take positions against the market if they expect the underlying asset to fall in value.
Typically, investors would enter into a derivatives contract to sell an asset (such as a single stock) that they believe is
overvalued, at a specified future point in time. This investment is successful provided the asset falls in value. Such strategies
are extremely important for an efficiently functioning price discovery in financial markets as they reduce the risk of assets
becoming excessively under- or overvalued.7)

D.Cash flow
The payments between the parties may be determined by:

 the price of some other, independently traded asset in the future (e.g., a common stock);
 the level of an independently determined index (e.g., a stock market index or heating-degree-days);
 the occurrence of some well-specified event (e.g., a company defaulting);
 an interest rate;
 an exchange rate;
 or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future for a
predetermined price. If the price of the underlying security or commodity moves into the right direction, the owner
of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on the
terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded the
underlying security or commodity directly.
2. HISTORY OF DERIVATIVE MARKET
The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward
contracting, it was characterized by forward contracting on tulip bulbs around 1637. The first "futures" contracts are
generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which
made them much like today's futures.
In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the
International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were
not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based
on Ginnie Mae (GNMA) mortgages.
In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 1900s
India had one of the world’s largest futures industry. In 1952 the government banned cash settlement and options trading
and derivatives trading shifted to informal forwards markets.
Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been uneven.
The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004.?
Uses
Derivatives are used by investors to
 provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the
value of the derivative
 speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given
direction, stays in or out of a specified range, reaches a certain level)
 hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite
direction to their underlying position and cancels part or all of it out
 obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives)
create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching a
specific price level
Derivatives are usually broadly categorized by the:
 relationship between the underlying and the derivative (e.g., forward, option, swap)
 type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity
derivatives or credit derivatives)
 market in which they trade (e.g., exchange-traded or over-the-counter)
 pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)
Another arbitrary distinction is between:[2]
 vanilla derivatives (simple and more common) and
 exotic derivatives (more complicated and specialized)
There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of custom
Common derivative contract types
There are three major classes of derivatives:
1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futures
contract differs from a forward contract in that the futures contract is a standardized contract written by a clearing
house that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-
standardized contract written by the parties themselves.
2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell (in
the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specified
at the time the parties enter into the option. The option contract also specifies a maturity date. In the case of
aEuropean option, the owner has the right to require the sale to take place on (but not before) the maturity date; in the
case of an American option, the owner can require the sale to take place at any time up to the maturity date. If the
owner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.
3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value of
currencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.