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 Derivatives

A financial derivative is a financial instrument whose

value is derived from the value of an underlying
assets.

Underlier can be -

1.Commodities
2.Mortgages
3.Stock
4.Bonds
5.Currency

Derivative Market is a market where exchange of

derivatives takes place.
Derivatives instrument relates to future contract between
two parties

Change in the value of derivatives

Counter parties have specified obligations

Derivatives can be undertaken in many ways

Derivatives Contract depends upon its notional amount.

Derivative instruments used to clear up the balance sheet.

 Participants in Derivatives Market

Hedgers - use futures or options markets to reduce

or eliminate the risk associated with price of an
asset.

Speculators - use futures and options contracts to

get extra leverage in betting on future movements
in the price of an asset.

Arbitrageurs - are in business to take advantage of

a discrepancy between prices in two different
markets
 Types of Derivative Market

Derivative Market can be classified as Exchange Traded

Derivatives Market and Over the Counter Derivative Market.

Exchange Trade Derivative –

Exchange Traded Derivatives are those derivatives which are

traded through specialized derivative exchanges

Over the Counter Derivatives -

Over the counter derivative which are privately traded

between two parties and involves no exchange or
intermediary.

Main participants of OTC market are the Investment Banks,

Commercial Banks, Govt. Sponsored Enterprises and Hedge
funds
 Types of Derivatives

Forward Contract –
• A forward contract is a customized contract between two
entities, where settlement takes place on a specific date in the
future at today’s pre-agreed price.

 Contract details like delivery date, price and quantity are

negotiated bilaterally by the parties to the contract

 Forward contracts are traded outside the exchanges

Future Contract –
•Future contract is an agreement between two parties to buy or sell a specified
quantity of an asset at a specified price and at a specified time and place.

•Futures contracts are exchange traded derivatives

Terminology In Future contract

1.Futures price : The pre-set price is called the futures price.

2.Settlement price : The price of the underlying asset on the delivery date is
called the settlement price.

3.Margin Money : When a person enters into a contract he is required to deposit

fund with the broker which is called margin money.

4. Clearing house : The Exchange clearing house is an adjunct of the exchange

and act as an intermediary or middlemen in future.
An option is a contract which gives the buyer the
right, but not the obligation, to buy or sell shares
of the underlying security or index at a specific
price for a specified time.

The price at which the underlying is traded is called the

‘strike price’.

There are two types of options: Calls and Puts

CALL OPTION
A call option gives the buyer the right, but not
the obligation, to buy the underlying security
at a specific price for a specified time.

PUT OPTION
A put option gives the buyer the right, but not
the obligation, to sell an underlying security at
a specific price for a specified time.
 PROFIT LOSS BEP
Current Price 500 500 500
Strike Price 520 520 520
Orig Value after 2mnths 550 510 535

Lot size (QTY) 50 50 50

Premium 15 15 15

Total Premium Paid 750 750 750

Example -
Profit 30 -10 15
1500 -500 750

Net Earnings 750 -1250 0

-750
 In ‘European’ options, a buyer can exercise his
option only on the expiration date, that is, the
last day of the contract tenure.

 Whereas in ‘American’ options, a buyer can

exercise his option any day on or before the
expiration date.

 In the Indian equity market context, index

options are European style, while stock options
are usually American in nature.
 In futures, both the buyer and the seller are
obligated to buy and sell, respectively.

 In case of options, however, the buyer has the

right, but is not obliged to exercise it.
 Swaps are transactions which obligates the two
parties to the contract to exchange a series of cash
flows at specified intervals known as payment or
settlement dates.

 Swaps are customized contracts that are traded in

the over-the-counter (OTC) market between
private parties.

 Recently, swaps have grown to include currency

swaps and interest rate swaps.
Currency SWAP –
Currency swaps is an arrangement in which
both the principle amount and the interest on
loan in one currency are swapped for the
principle and the interest payments on loan in
another currency.

Interest SWAP –
Interest rate swaps is an arrangement by which
one party agrees to exchange his series of fixed
rate interest payments to a party in exchange for
his variable rate interest payments.
 If firms in separate countries have comparative
advantages on interest rates, then a swap could
benefit both firms.

 For example, one firm may have a lower fixed

interest rate, while another has access to a
lower floating interest rate. These firms could
swap to take advantage of the lower rates.
 Initiated in 1950s but declined in 1960.
 A ban was imposed on trading by Central Bank
in 1969 which was lifted in October, 1995.
 Civil Supplies agreed for futures trading in
Basmati Rice.
 In 1996 IPSTA converted its national futures
exchange into international futures exchange.
 India’s first international futures exchange
IPSTA-ICE was established at Kochi on
November 17, 1997.
 Trading in Coconut oil was shown a green
signal in 1996.
 CFEI was established in Bangalore.
 RBI accepted the recommendations of Sodhani
Expert Group in August, 1996.
 SEBI appointed a committee LGCG on
November 18, 1996 to develop regulatory
framework for derivatives trading in India.
 SEBI appointed J. R. Verma Committee to look
into the operational aspects of derivatives
markets.
 Derivatives were accorded a status of Securities
in December, 1999.
 In June, 2000 NSE and BSE started stock index
based futures trading in India.
 Need for equity derivatives, interest rate
derivatives and currency derivatives.
 Futures trading should be introduced in
phased manner starting with stock index
futures then options on index and later options
on stocks.
 Complete segregation of client money at level
of trading/clearing member.
 Creation of a Derivation Cell, a Derivative
Advisory Committee and Economic Research
Wing by SEBI.
 The operations of the cash market needed
improvements.
 The Trading and Clearing member will have
stringent eligibility conditions.
 The clearing members should deposit
minimum Rs. 50 lakh with clearing corporation
and should have a net worth of Rs. 3 crore.
 Growth of Derivative Market
Yea r No. of contra cts
2003-04 5,68,86,776
2004-05 7,70,17,185
2005-06 15,76,19,271
2006-07 21,68,83,573
2007-08 42,50,13,200
2008-09 11,91,71,008
Year Turnover (Rs. cr.)
2003-04 2130610
2004-05 2546982
2005-06 4824174
2006-07 7356242
2007-08 13090477.75
2008-09 2648403.3
 Taxation of Derivative Income

The income-tax Act does not have any specific provision

regarding taxability from derivatives. The provision which have
an indirect bearing on derivative transactions are sections 73(1)

•Section 73(1) provides that any loss, computed in respect of

a speculative business carried on by the assessee, shall not be
set off except against profits and gains, if any, of speculative
business.

•Losses from Derivative Market can be carried forward and set

off against speculative income only up to a maximum of eight
years.
 The need for a derivatives market

• They help in transferring risks from risk averse people to risk

oriented people
• They help in the discovery of future as well as current prices

• They increase the volume traded in markets because of

participation of risk averse people in greater numbers

• They increase savings and investment in the long run

 FACTORS CONTRIBUTING TO THE GROWTH OF
DERIVATIVES

PRICE VOLATILITY
‘Demand’ and ‘supply’ in the market are causes changes in the price .
Such changes are known as ‘price volatility’.

These price changes expose individuals and firms to significant risks.

Thus the price volatility risks pushed the use of derivatives like
futures and options. These instruments can be used as hedge to
protect against adverse price changes in commodity, foreign
exchange, equity shares and bonds.

TECHNOLOGICAL ADVANCES –
technological developments causes price volatility and thus
derivatives and risk management products have become much more
important.
GLOBALISATION OF MARKETS
Globalization has exposed the modern business to significant risks
and, in many cases, led to cut profit margins.

Steel industry in 1998 suffered its worst set back due to cheap
import of steel from south East Asian countries.

Thus globalization of industrial and financial activities have made

the use of derivatives to guard against future losses

ADVANCES IN FINANCIAL THEORIES

Initially only the forward contracts was the only hedging tool
available but now the work of economic theorists gave rise to new
products for risk management which led to the growth of derivatives
in financial markets.
 BENEFITS OF DERIVATIVES

RISK MANAGEMENT
Futures and options contract can be used for altering the risk of
investing.

For instance, an investor who owns an asset will always be

worried that the price may fall before he can sell the asset.

So he can protect himself by selling a futures contract, or by

buying a Put option.

MARKET EFFICIENCY
Since it is easier and cheaper to trade in derivatives. So the
availability of derivatives makes markets more efficient.
PRICE DISCOVERY
Price discovery refers to the markets ability to determine true
equilibrium prices.

Accurate prices are essential for correct allocation of resources.

And thus Options markets provide information about the volatility

or risk of the underlying asset.

OPERATIONAL ADVANTAGES
As opposed to spot markets, derivatives markets involve lower
transaction costs.

They offer greater liquidity.

And it is easier to take a short position in derivatives markets

than it is to sell short in spot markets.
 Recommendations
RBI should play a greater role in supporting derivatives.

Derivatives market should be developed in order to keep it at par

with other derivative markets in the world.

Speculation should be discouraged

There must be more derivative instruments aimed at individual

investors.

SEBI should conduct seminars regarding the use of derivatives to

educate individual investors.
Thank you

SOURCES –

 www.nse-india.com
 www.bseindia.com
 www.sebi.gov.in
 www.ncdex.com
 www.google.com
 www.derivativesindia.com