DERIVATIVE MARKET

Presented by : Swapnil Chavan (03) Javed Shaikh (32) Kiran Thakur (38)

INTRODUCTION
A financial contract of pre-determined duration, whose value is derived from the value of an underlying asset: Securities Commodities Bullion Precious metals Currency Livestock Index such as interest rates, exchange rates .

What do derivatives do?

Derivatives attempt either to minimize the loss arising from adverse price movements of the underlying asset. Or maximize the profits arising out of favorable price fluctuation. Since derivatives derive their value from the underlying asset they are called as derivatives.

How are derivatives used?

Derivatives are basically risk shifting instruments. Hedging is the most important aspect of derivatives and also their basic economic purpose. Derivatives can be compared to an insurance policy. As one pays premium in advance to an insurance company in protection against a specific event, the derivative products have a payoff contingent upon the occurrence of some event for which he pays premium in advance.

What is Risk?
The concept of risk is simple. It is the potential for change in the price or value of some asset or commodity. The meaning of risk is not restricted just to the potential for loss. There is upside risk and there is downside risk as well.

What is a Hedge ?
To be cautious or to protect against loss. In financial, hedging is the act of reducing uncertainty about future price movements in a commodity, financial security or foreign currency . Thus a hedge is a way of insuring an investment against risk.

Types of Derivative Market Players

Hedgers: These are investors with a present or anticipated exposure to the underlying asset which is subject to price risks. Hedgers use the derivatives markets primarily for price risk management of assets and portfolios.

Speculators: These are individuals who take a view on the future direction of the markets. They take a view whether prices would rise or fall in future and accordingly buy or sell futures and options to try and make a profit from the future price movements of the underlying asset.

Arbitrageurs: They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long positions in the same or different contracts at the same time to create a position which can generate a riskless profit.

Derivative Instruments
Forward contracts Futures :
Commodity (agricultural commodities to minerals and metals) Financial (Stock index, interest rate & currency )

Options :
Put Call

Swaps :
Interest Rate Currency

FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. The forward contracts are normally traded outside the exchanges.

FUTURES CONTRACTS
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in future at a certain price. Futures are standardized forward contracts, traded in organized exchanges and ensured by a central clearing house. The buyers of futures contracts are considered having a long position whereas the sellers are considered to be having a short position. Futures contracts are available on variety of commodities, currencies, interest rates, stocks and other tradable assets.

OPTIONS CONTRACTS
Options give the right but not the obligation to
buy or sell an asset at a future date. Options are either call or put options. Call option: An option contract giving the owner the right to buy a specified amount of an underlying security at a specified price within a specified time. Put Option: An option contract giving the owner the right to sell a specified amount of an underlying security at a specified price within a specified time.

SWAPS CONTRACTS
An agreement between two parties to exchange one set of cash flows for another. In essence it is a portfolio of forward contracts. While a forward contract involves one exchange at a specific future date, a swap contract entitles multiple exchanges over a period of time. The most popular are interest rate swaps and currency swaps.

Interest Rate Swaps

Interest rate swaps are derivatives that exchange cash flows from fixed to floating or floating to fixed. An example is the Overnight Index Swaps (OIS), the floating rate benchmark being the NSE Mibor. The payer of OIS pays fixed rate while receiving the floating rate or Mibor. The receiver of an OIS receives fixed rate while paying the floating rate .

Currency Forwards
Currency forwards are the most widely used currency derivatives. The currency forwards are basically futures contracts where the payers or receivers of forwards contract to buy or sell a currency pair at a future date. The prices are determined by the cost of carry that is the interest payable on paying or receiving forwards.

Equity Derivatives
Equity derivatives can be classified into single stock derivatives and index derivatives. Single stock derivatives are derivatives on specific stocks eg. Reliance. Index derivatives are derivatives on stock exchange indices eg- nifty. Hybrid derivatives on equity include convertible shares (partly or fully). Employee stock options are also equity derivatives

Interest Rate Derivatives

Interest rate derivatives have many different types: Derivatives on government bonds. Derivatives on bond indices/ benchmark. Derivatives on short term money market benchmarks. Examples are bond futures and interest rate swaps based on benchmarks such as libor/ mibor.

Currency Derivatives
Currency derivatives are based on currency pairs. Currency forwards and options eg- USD/INR forwards and options. Currency derivatives are combined with interest rate derivatives to offer exotics. Exotics include principle only swaps, currency swaps.

Exchange Traded and OTC Derivatives

Derivatives traded on an exchange such as NSE are exchange traded derivatives. Derivatives not traded on exchange are over the counter derivatives eg- Overnight index swaps (OIS). Exchange traded derivatives are standardised in contract size, settlement, maturity. Over the counter (OTC) derivatives can be structured to suit different needs. Equity and bond derivatives are usually exchange traded while interest rate swaps, currency derivatives and exotics are usually OTC derivatives.

Derivative Exchanges
Derivative exchanges are separate from stock exchanges. In US CBOT and CME are the largest exchanges for derivatives. In UK LIFFE is the premier derivative exchange In India NSE is the largest equity derivative exchange while commodity exchanges are NCDEX and MCX.

Derivatives in India
The structured derivative market in India is relatively new (about 7 years old). However derivatives have caught the fancy of the market and exchange traded equity and commodity derivatives are vibrant. Interest rate derivatives have not taken off on an exchange platform though the OTC market for Interest rate derivatives is active. Currency derivatives are dominated by currency forwards though options are starting to come of age at present.

Equity Derivatives in India

Equity index futures are the most widely traded futures contract while single stock futures on the whole contribute to a larger percentage of the traded volumes. Equity index options are the most widely traded options contract in the exchange. FIIs are very active in the equity derivative markets in India. Retail presence is also high in the equity derivative market.

Interest Rate and Currency Derivatives in India

The market for Overnight Index Swaps (OIS) is the most active interest rate derivative . OIS is based on the overnight call money benchmark, NSE Mibor. Other interest rate derivatives include swaps on government bond benchmarks. Currency derivatives is dominated by forward market though options are picking up.