Derivatives

A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties.A derivative instrument can be created for any underlying that has any real effect on the bottom line of business where in parties involved take opposite positions and this derivative can be traded. The overall derivatives market has five major classes of underlying asset:
y y y y y

interest rate derivatives (the largest) foreign exchange derivatives credit derivatives equity derivatives commodity derivatives Exchangetraded futures Exchangetraded options Option on DJIA Index future Single-share option Equity swap Back-to-back Repurchase agreement Stock option Warrant Turbo warrant OTC swap OTC forward OTC option

UNDERLYING

Equity

DJIA Index future Single-stock future

Interest rate

Eurodollar future Euribor future

Option on Eurodollar future Option on Euribor future

Interest rate swap

Back-to-back Repurchase agreement

Interest rate cap and floor Swaption Basis swap Bond option

Credit

Bond future

Option on

Credit default

Forward rate

Credit default

Bond future

swap Total return swap

agreement

option

Foreign exchange

Currency future

Option on currency future

Currency swap

Repurchase agreement

Currency option

Commodity

WTI crude oil futures

Weather derivatives

Commodity swap

Currency forward

Gold option

examples of underlying exchangeable are: y y Property (mortgage) derivatives Economic derivatives that pay off according to economic reports[18] as measured and reported by national statistical agencies y y y y y y y y y y Freight derivatives Inflation derivatives Weather derivatives Insurance derivatives[19] Emissions derivatives[20] Hurricanes Movies Payroll Figures Insurance Derivatives Movie Derivatives

Reasons Why Derivatives Exists

Derivatives markets exists because of following reasons: y Provide risk protection with minimal upfront investment and capital consumption.

y y

Allow investors to trade on future priceexpectations. Have very low total transaction costs comparedto investing directly in the underlying asset.

y y y

Allow fast product innovation because newcontracts can be introduced rapidly. Can be tailored to the specific needs of any user. Fundamentally, derivatives as instruments that permit the transfer of risk from one party to another. Each derivative transaction has two parties, a buyer and a seller. Typically the buyer pays to transfer the risk to the seller. The seller accepts payment to compensate for the assumption of risk. Its like an insurance contract one party pays or gives up something to get another party to accept the risk.

They are generally a much more efficient means of transferring risk. Because derivative markets require so much less capital than do spotmarkets, they are usually more liquid. Higher liquidity means more efficiency therefore prices change more rapidly in response to new information

Derivatives are also a much easier mechanism to sell short. There are significant regulatory impediments to short sellingstocks. For some large and heavy assets such as oil and gold, it is verydifficult if not impossible to sell short while derivatives on these assets are aseasy to sell short. Taking a short position is sometimes the only possible way to hedge a risk, so this feature of derivatives is a very valuable.

Derivatives in India

Derivatives markets have been in existence in India in some form or other for a long time. 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.

A series of reforms of the stock market between 1993 and 1996 paved the way for the development of exchange-traded equity derivatives markets in India.In 1999, the Securities Contracts (Regulation) Act of 1956, or SC(R)A, was amended so that derivatives could be declared securities. This allowed the regulatory framework for trading securities to be extended to derivatives. The Act considers derivatives to be legal and valid, but only if they are traded on exchanges. Finally, a 30-year ban on forward trading was also lifted in 1999. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange as opening up of economy had caused volatility of the exchange rate between the Indian Rupee and the U.S. dollar. The easing of various restrictions resulted in the need to manage interest rate risk. In recent years, government policy has changed, allowing for an increased role for marketbased pricing and less suspicion of derivatives trading. For eg : In August 2011 the Reserve Bank of India (RBI) on Tuesday modified its guidelines for banks for offering derivative products.Foreign banks operating in India can be market makers for specific products only if they have the ability to price the products locally in India, the central bank said in a statement. It also said no bank can be a market maker in a product it cannot price independently. The ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. Derivatives Instruments Traded in India In the exchange-traded market, the biggest success story has been derivatives on equity products. Index futures were introduced in June 2000, followed by index options in June 2001, and options and futures on individual securities in July 2001 and November 2001, respectively. As of 2011 , the NSE trades futures and options on 226 individual stocks andstock indices like S&P CNX Nifty, Bank Nifty, CNX IT , Nifty Midcap 50 and other global indices . All these derivative contracts are settled by cash payment and do not involve physical delivery of the underlying product (which may be costly).

Single stock futures have become hugely popular, accounting for about half of NSE s traded value in October 2005. NSE ranks among the top three stock exchanges in terms of number of contracts traded in single stock futures, index futures and stock options. Regulation Indian laws generally require that derivatives be used for hedging purposes only . The regulatory framework in India is based on recommendations of the L. C. Gupta Committee (LCGC) .The Committee ensured that regulation should be designed to achieve specific, well-defined goals. Committee proposed regulation designed to encourage healthy activity and behaviour. It has been guided by the following objectives: (a) Investor Protection: Attention needs to be given to the following four aspects: (i) Fairness and Transparency: The trading rules should ensure that trading is conducted in a fair and transparent manner. Experience in other countries shows that in many cases, derivatives brokers/dealers failed to disclose potential risk to the clients. In this context, sales practices adopted by dealers for derivatives would require specific regulation. In some of the most widely reported mishaps in the derivatives market elsewhere, the underlying reason was inadequate internal control system at the user-firm itself so that overall exposure was not controlled and the use of derivatives was for speculation rather than for risk hedging. These experiences provide useful lessons for us for designing regulations. (ii) Safeguard for clients moneys: Moneys and securities deposited by clients with the trading members should not only be kept in a separate clients account but should also not be attachable for meeting the broker s own debts. It should be ensured that trading by dealers on own account is totally segregated from that for clients. (iii) Competent and honest service: The eligibility criteria for trading members should be designed to encourage competent and qualified personnel so that investors/clients are served

well. This makes it necessary to prescribe qualification for derivatives brokers/dealers and the sales persons appointed by them in terms of a knowledge base. (iv) Market integrity: The trading system should ensure that the market s integrity is safeguarded by minimising the possibility of defaults. This requires framing appropriate rules about capital adequacy, margins, clearing corporation, etc. (b) Quality of markets: The concept of "Quality of Markets" goes well beyond market integrity and aims at enhancing important market qualities, such as cost-efficiency, price-continuity, and price-discovery. This is a much broader objective than market integrity. (c) Innovation: While curbing any undesirable tendencies, the regulatory framework should not stifle innovation which is the source of all economic progress, more so because financial derivatives represent a new rapidly developing area, aided by advancements in information technology. Users Restricted From Entering Into Derivative Market y Banks and mutual funds are only allowed to use derivatives to hedge their existing positions in the spot market, or to rebalance their existing portfolios. Since banks have little exposure to equity markets due to banking regulations, they have little incentive to trade equity derivatives. y Foreign investors must register as foreign institutional investors (FII) to trade exchangetraded derivatives, and be subject to position limits as specified by SEBI. Uniqueness of Indian Derivative Markets Success of single stock futures in India is unique, as this instrument has generally failed in most other countries ,reason for this success may be retail investors prior familiarity with badla trades which shared some features of derivatives trading. Another reason may be the small size of the futures contracts, compared to similar contracts in other countries. Retail investors also dominate the markets for

commodity derivatives, due in part to their long-standing expertise in trading in the havala or forwards markets.

International Derivative Markets Around 25 years ago, the derivatives market was small and domestic. Since then it has grown impressively around24 percent per year in the last decade into a sizeable and truly global market with about US$708 trillion of notional amount outstanding

Across the board, the derivatives market has been highly innovative. Both product and technology innovation have driven the impressive growth of the market.Product innovation can take many different forms, for example, the creation of a derivative on a new underlying or a new product type with different payoff characteristics. For egFollowing are few highly innovative derivative products Freight Derivatives The London-based Baltic Exchange offers trading on swaps for specific trading routes, known as Forward Freight Agreements (FFAs). One party makes a bet as to whether the rate to transport something - such as crude oil from Brazil to Singapore - will be higher or lower in the future.

Another party takes the other side of the bet, and the swap is settled in cash when the future date arrives. Derivatives are assets that "derive" their value from something else. In the case of FFAs, the value of a contract is derived from the actual spot shipping rates as displayed daily by the Baltic Exchange. Many companies trade in freight derivatives to hedge against things like rising oil prices (a major driver of freight rates) and geopolitical risks (which can affect global trading routes). Shipping rates are notoriously volatile; it's not at all uncommon for rates to swing 100% or more in a matter of months. Weather Derivatives It may seem strange to bet on something so far out of our control as the weather. But weather has a huge impact on business, especially industries like agriculture, construction, energy, travel and insurance. Weather derivatives aren't as simple as buying "rain tomorrow" and selling "a chilly Thursday". Instead, temperatures are averaged over a time period, such as the three months of summer and winter. These temperatures are then sliced into "ranges" and packaged for trade. For example, local power company could see its bottom line negatively affected if the winter is unseasonably warm, thereby lowering the demand for heating oil and gas. The power company could hedge against this outcome by purchasing a contract that would pay out cash if the temperature averaged five degrees above the historical average for the duration of winter. On the other side of that trade could be a hedge fund that was betting on the seasonal patterns, rather than the unseasonable. The Chicago Mercantile Exchange (CME) has a wide variety of weather derivatives available for trade, covering multiple continents and over 40 global cities. These futures cover temperature ranges, snowfall amounts and frost

Hurricanes From weather to dangerous weather, bets are placed on how many hurricanes will crash against our shores in the coming year. Contracts are based on the number of hurricanes that hit specific geographic regions of the country, such as the east coast and the gulf regions. Besides being a possible destination for the macabre speculator, these contracts are useful to insurance companies and oil producers, both of which can suffer massive losses if several big hurricanes cause damage or shut down operations during the annual hurricane season. These futures are offered on the CME alongside the temperature-based futures. Carbon Credits Companies that emit carbon dioxide as a course of business are given an initial allowance of carbon credit. If they produce more carbon than allowed, they must purchase carbon credits to make up the difference. While the carbon credit system is enforced in Europe, in North America we are just beginning to test out some pilot programs, such as the Regional Greenhouse Gas Initiative, or RGGI. The CME is setting itself up to trade RGGI futures (pending regulatory approval), while European-based futures can already be traded. In the future, the value of carbon credits will depend on many moving parts, such as environmental legislation, geopolitical issues and the price of fossil fuels like crude oil and natural gas. Movies Movie derivatives are a new financial product designed to hedge the considerable financial risks associated with producing, distributing and exhibiting movies. These risks include:
y y y y

Risk that the production schedule is not met "Release schedule risk" that release of the film to theaters is late Risk that production and distribution budgets are exceeded "Revenue risk" that box office receipts fail to meet expectations

Movie derivatives, in their initial form, will be futures contracts whose value is tied to box office receipts for a given movie. The inaugural players in this market, due to start operations by April 2010, are:
y y

Trend Exchange, or TrendEx Cantor Exchange

Trend Exchange, based in Phoenix, is being launched by private equity firm Veriana. The Minneapolis Grain Exchange will clear and settle TrendEx trades. Cantor Exchange is being organized by brokerage and trading firm Cantor Fitzgerald, within its Cantor Entertainment division. The exchanges will offer film studios a way to hedge against the risk of a bust. And like other futures markets, trading will be open to outside speculators who can strike it big betting on unlikely hits. Pros & Cons Cons Predicting box office success can be risky business for eg :Hype over Matt Damon's "Green Zone" sent shares of the Iraq war flick as high as $74.64 in the run-up to the film's U.S. premier on March 12. After a lacklustre opening weekend, though, the film's stock plunged 51 per cent to $36.24 just three days later. The product of the industry is an artistic or entertainment product that derives its value not from any intrinsic utilitarian use, but from emotional sentiment The ability to trade on a film s box office receipts through movie futures contracts contracts where the creation of a negative perception of a film can be extremely lucrative to those shorting it puts the commercial success of the film at an even greater risk Pros y y In the face of mounting production and marketing costs, Hollywood studios have increasingly turned to outside financiers to help limit their losses from potential flops For individual investors film derivatives are a great idea for a highly speculative investment because there has never been an organized way for a private individual to really bet on their own instincts in connection with a movie's performance.

After much debate and testimony from proponents and opponents, the CFTC approved Media Derivatives Inc. s application for Weekend Motion Picture Revenue futures and options contracts, which allows investors to gamble on the risk of success or failure of an upcoming movie release.But the euphoria was short-lived, as the Dodd-Frank Wall Street Reform and Consumer Protection Act contained specific wording that barred such movie derivatives trading, merely a month after it was approved by the CFTC.

But a film is not a commodity. A commodity, such as corn, allows investors and traders to understand associated risks, such as adverse weather conditions, spoiling rate, and so on. In the movie industry, there are only a few who could possibly predict the intrinsic value of a motion picture the few in the know, such as the studio, the exhibitors, and marketers, according to MPAA s Pisano. He suggests, for example, that the marketing, release date of a film, and the number of movie theaters have a great bearing on the success or failure of a movie release. Therefore, movies simply could not be considered a commodity. The general lesson is that, as an individual investor, you should be suspicious of investing in any individual contract where the seller has a lot more information than you, suggests the KW article.

Payroll Figures The CME also offers trading on derivatives based on one of the most sensitive parts of our struggling economy - jobs. Non-farm payrolls are a highly watched economic indicator that tracks the change in jobs from month to month. The derivatives based on this indicator see their value rise $25 for every 1,000 new jobs over the prior month. Non-farm payrolls are published by the Bureau of Labor Statistics during the first week of each month, and lately it has been one of the most important figures on Wall Street. With these products, the CME lets you hedge or wager on movements in this all-important statistic.

Conclusion
The derivatives market is very dynamic and has quickly developed into the most important segment of the financial market. Competing for business, both derivatives exchanges and OTC providers, which by far account for the largest part of the market, have fuelled growth by constant product and technology innovation. Strong European players have emerged that today account for around 44 per cent of the global market in terms of notional amount outstanding. The derivatives market functions very well and is constantly improving. It effectively fulfils its economic functions of price efficiency and risk allocation. The imperatives for a well-functioning market are clearly fulfilled: The exchange

segment, in particular, has put in place very effective risk mitigation mechanisms mostly through the use of automation and CCPs. For its users, the derivatives market is highly efficient. Transaction costs for exchange-traded derivatives are particularly low. Innovation has been the market s strongest growth driver and has been supported by a regulatory framework. In terms of the growth of derivatives markets in India , and the variety of derivatives users, the Indian market has equalled or exceeded many other regional markets While the growth is being spearheaded mainly by retail investors, private sector institutions and large corporations, smaller companies and state-owned institutions are gradually getting into the act. Foreign brokers such as JP Morgan Chase are boosting their presence in India in reaction to the growth in derivatives. The variety of derivatives instruments available for trading is also expanding. There remain major areas of concern for Indian derivatives users. Large gaps exist in the range of derivatives products that are traded actively. In equity derivatives, NSE figures show that almost 90% of activity is due to stock futures or index futures, whereas trading in options is limited to a few stocks, partly because they are settled in cash and not the underlying stocks. Exchange-traded derivatives based on interest rates and currencies are virtually absent. Liquidity and transparency are important properties of any developed market. Liquid markets require market makers who are willing to buy and sell, and be patient while doing so. In India, market making is primarily the province of Indian private and foreign banks, with public sector banks lagging in this area (FitchRatings, 2004). A lack of market liquidity may be responsible for inadequate trading in some markets. Transparency is achieved partly through financial disclosure. Financial statements currently provide misleading information on institutions use of derivatives. Further, there is no consistent method of accounting for gains and losses from derivatives trading. Thus, a proper framework to account for derivatives needs to be developed. Further regulatory reform will help the markets grow faster. For example, Indian commodity derivatives have great growth potential but government policies have resulted in the underlying spot/physical market being fragmented (e.g. due to lack of free movement of commodities and differential taxation within India). Similarly, credit derivatives, the fastest

growing segment of the market globally, are absent in India and require regulatory action if they are to develop.14 As Indian derivatives markets grow more sophisticated, greater investor awareness will become essential. NSE has programmes to inform and educate brokers, dealers, traders, and market personnel. In addition, institutions will need to devote more resources to develop the business processes and technology necessary for derivatives trading.