Introduction

Secondary market contributes significantly to the

Indian financial market
Expansion- Variety of financial instruments vis-avis Scale of operations
Derivatives-a financial product becoming
increasingly popular
Exchange traded financial derivatives were
introduced in India in June 2000 at the two major
stock exchanges, NSE and BSE

Indian History of derivatives

The Bombay Cotton trade association started future trading in
1875
In 1952 the government banned cash settlement and option
trading.
In 1995 a prohibition on trading options was lifted.
In 1996, NSE sent a proposal to SEBI for listing exchange
traded derivatives.
In 1999, the Securities Contract (Regulation) Act of 1956 was
amended and
derivatives could be declared securities.
Index future were introduced in June 2000 and Index option
in 2001.
NSE started trade in future and option by 2005

What are Derivatives?

A derivative is a financial instrument whose value is
derived from the value of another asset, which is known
as the underlying.
When the price of the underlying changes, the value
of the derivative also changes.
A Derivative is not a product. It is a contract that
derives its value from changes in the price of the
underlying.
Example :The value of a gold futures contract is
derived from thevalue of the underlying asset i.e. Gold

Traders in Derivatives Market

There are 3 types of traders in the Derivatives Market :
HEDGER A hedger is someone who faces risk associated with
price movement of an asset and who uses derivatives as means of
reducing risk. They provide economic balance to the market.
SPECULATOR A trader who enters the futures market for pursuit
of profits, accepting risk in the endeavor. They provide liquidity and
depth to the market.

 ARBITRAGEUR
A person who simultaneously enters into transactions in two or
more markets to take advantage of the discrepancies between
prices in these markets.
Arbitrage involves making profits from relative mispricing.
Arbitrageurs also help to make markets liquid, ensure accurate
and uniform pricing, and enhance price stability
They help in bringing about price uniformity and discovery.

Economic benefits of derivatives

Reduces risk
Enhance liquidity of the underlying asset
Lower transaction costs
Enhances liquidity of the underlying asset
Enhances the price discovery process.
Portfolio Management
Provides signals of market movements
Facilitates financial markets integration

Derivatives users in India...

Financial InstitutionFinancial Institution have not been heavy users of
exchanges traded derivatives.
Financial Institution contribution to NSE trade being less than 8% in
October 2005
Banks use derivatives on interest rates and currencies to manage
credit risk
Non financial institution are regulated differently from financial
institution, and this affects their incentives to use derivatives
Foreign Investor must register as FII to trade equity derivatives and be
subject to position limit as specified by SEBI

Retails InvestorRetail Investor are the major participants in equity derivatives .

Retail Investor are familiar with BADLA trade which shared some
features of derivatives trading.
Retails Investor also dominate the market of commodity
derivatives for their long-standing expertise in trading .

Types of Derivatives

Forwards
Futures
Options
Swaps

What is a Forward?
A forward is a contract in which one party commits to buy and the
other party commits to sell a specified quantity of an agreed upon
asset for a pre-determined price at a specific date in the future.
It is a customised contract, in the sense that the terms of the
contract are agreed upon by the individual parties. Hence, it is
traded OTC.
Forward Contract Example
I agree to sell Bread Farmer 500kgs wheat at Maker Rs.40/kg after
3 months. 3 months Later 500kgs wheat Bread Farmer Maker
Rs.20,000

Futures
A future contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price.
Futures are special types of forward contracts in the sense that futures
are standardized exchange-traded contracts.
A futures contract may be offset prior to maturity by entering into an
equal and opposite transaction.

The standardized items in a futures contract are:

Quality & Quantity of the underlying
The date and month of delivery
Location of settlement

Options
An option is a contract giving the buyer the right, but not the
obligation, to buy or sell an underlying asset (a stock or index) at a
specific price on or before a certain date.
An option is a security, just like a stock or bond, and constitutes a
binding contract with strictly defined terms and properties.

Options (Contd.)
Types of options:
Call option
give the buyer the right but not the obligation to buy a given quantity
of the underlying asset, at a given price on or before a given future
date.
Put option
give the buyer the right but not the obligation to sell a given quantity
of the underlying asset, at a given price on or before a given future
date.

Warrants
Longer -dated options are called warrants and are generally traded
over-the-counter (OTC).
A warrant gives the holder the right but not the obligation to buy an
underlying security at a certain price, quantity and future time. A
warrant is issued by a company. The security represented in the warrant
(usually share equity) is delivered by the issuing company instead of an
investor holding the shares
Companies will often include warrants as part of a new- issue offering to
entice investors into buying the new security. A warrant can also
increase a shareholders confidence in a stock, if the underlying value of
the security actually does increase overtime.

Warrants (Contd.)
There are two different types of warrants:
Call warrant:
A call warrant represents a specific number of shares that can be
purchased from the issuer at a specific price, on or before a certain date.
Put warrant:
A put warrant represents a certain amount of equity that can be sold
back to the issuer at a specified price, on or before a stated date.

Swaps
Are private agreements between two parties to exchange cash flows in
the future.
A swap is a derivative, where two counterparties exchange one stream
of cash flows
against another stream. These streams are called the legs of the swap.
Agreement on formula to be used for exchange of cash- flows is
determined in advance
The cash flows are calculated over a notional principal amount. Swaps
are often used to hedge certain risks, for instance interest rate risk.
Another use is speculation.

Types of Swaps:
I.
II.

Interest Rate Swaps:

Currency Swaps

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.

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