Dilip Final

8/6/2019 Dilip Final

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INTRODUCTION

The emergence of the market for derivative products, most notably forwards,

futures and options, can be traced back to the willingness of risk-averse economic agents

to guard themselves against uncertainties arising out of fluctuations in asset prices. By

their very nature, the financial markets are marked by a very high degree of volatility.

Through the use of derivative products, it is possible to partially or fully transfer price

risks by locking-in asset prices. As instruments of risk management, these generally do

not influence the fluctuations in the underlying asset prices. However, by locking-in asset

prices, Derivative products minimize the impact of fluctuations in asset prices on the

profitability and cash flow situation of risk-averse investors.

Derivatives are risk management instruments, which derive their value from an

underlying asset. The underlying asset can be bullion, index, share, bonds, currency,

interest, etc., Banks, Securities firms, companies and investors to hedge risks, to gain

access to cheaper money and to make profit, use derivatives. Derivatives are likely to

grow even at a faster rate in future.

Derivatives are a product whose value is derived from the value of one or more

basic variables, called bases (underlying asset, index, or reference rate) in a contractual

manner. The underlying asset can be equity, forex, commodity or any other asset. For

example, wheat farmers may wish to sell their harvest at a future date to eliminate the

risk of a change in prices by that date. Such a transaction is an example of a derivative.

In the last 20 years derivatives have become notably important

in the world of finance. Futures and options are now globally traded

on many exchanges. Forward contracts , Swaps and many different

types of options are regularly conducted by outside exchanges by

financial institutions, fund managers and corporate treasurers in

what i s termed the over the counter market. Derivat ives are a lso

sometimes added to a bond or stock issue. Further, the very nature of

volatility in the financial markets, the use of derivative products, it is


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possible to partially or fully transfer price risks by locking in asset

prices. But these instruments of risk management are generally do not

influence the fluctuations in the underlying asset prices. However, by

lo cking asset p rices, the derivative prod ucts minimize th efluctuations in the asset prices on the profi tabil i ty and cash flow

situations on risk to the investor.

The derivatives are becoming increasingly important in world

of markets as a tool for risk management. Derivative instruments can

be used to minimize risk. Derivatives are used to separate the risks

and transfer them to parties willing to bear these risks. The kind of

hedging that can be obtained by using derivatives is cheaper and

more c onve nie nt t ha n w ha t c ou ld be obt ai ne d by usi ng ca sh

instruments. It is so because, when we use derivatives for hedging,

actual del ivery of the underlying asset i s not a t a ll essential for

set t lement purposes. The profi t or loss on derivative deal alone is

adjusted in the derivative market.

Derivative contracts have several variants. The most common

variants are forwards, futures, options and swaps. The following

three broad categories of part icipants hedgers, speculators , and

arbi trageurs t rade in the der ivat ives market. Hedgers face r isk

associated with the price of an asset . They use futures or options

markets to reduce or eliminate this risk. Speculators wish to bet on

future movements in the price of an asset.

Futures and Options contracts can give them an extra leverage;

that is, they can increase both the potential gains and potential losses

in a specula tive venture . Arb it rageurs and in bus iness to t ake

advantage of a discrepancy between prices in two different markets.


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If, for example, they see the futures price of an asset getting out of

line with the cash price, they will take offsetting positions in the two

markets to lock in a profit.

Derivat ive products ini tial ly emerged as hedging devices

against f luctuations in commodity prices, and commodity-l inked

derivatives remained the sole form for such products for almost three

hundred years. Financial derivatives came into spotlight in the post-

1970 per iod due to growing ins tabil ity in the f inancia l markets.

However, s ince their emergence, these products have become very

popular and by 1990s, they accounted for about two-thirds of total

transactions in derivative products.

In the class of equity derivatives the world over, futures and options on stock

indices have gained more popularity than on individual stocks, especially among

institutional investors, who are major users of index-linked derivatives. Even small

investors find these useful due to high correlation of the popular indexes with various

portfolios and ease of use. The lower costs associated with various portfolios and ease of

use. The lower costs associated with index derivatives vis--vis derivative products based

on individual securities is another reason for their growing use.

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the

prohibition on option in securities. The market for derivatives, however, did not take off,

as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-

member committee under the Chairmanship of Dr. L.C. Gupta. On November 18, 1996 to

develop appropriate regulatory framework for derivatives trading in India.


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INTRODUCTION TO THE TOPIC

DERIVATIVES:

Derivatives are defined as financial instruments whose value derived from

the prices of one or more other assets such as equity securities, fixed-income

securities, foreign currencies, or commodities. Derivative is also a kind of contract

between two counter parties to exchange payments linked to the prices of

underlying assets.

DEFINITION:

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R) A)

defines derivative to include-

1. A security derived from a debt instrument, share, and loan whether secured

or unsecured, risk instrument or contract for differences or any other from

of security.

2. A contract which derives its value from the prices, or index or prices, of

underlying securities

The above definition conveys that

Derivatives are financial products and derive its value from the underlying assets.

Derivatives are derived from a matter financial contract called the underlying.


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DIFFERENCE BETWEEN DERIVATIVES AND SHARES:

The subtle, but crucial, difference is that while shares are assets, derivatives

are usually contracts (the major exception to this are warrants and convertible

bonds, which are similar to shares in that they are assets).

INVESTING IN DERIVATIVES:

If one is interested in getting directly involved with futures or options, then

the idea to incest is inappropriate they are traded. This implies that one monitors

the price more closely, and uses more sophisticated trading techniques (for

example, the use if stop orders). There are a number of brokers that specialize in

private client futures/options trading; list of these can usually be requested from

futures exchanges.

USAGE OF DERIVATIVES:

Any person who has funds invested, (e.g. an insurance policy or a pension

fund), are mostly exposed to derivatives in some or other way. Due to its great

flexibility, derivatives are used by many different types of investors. From this

stand point, derivatives will allow the modern investor the full range of investment

strategy: speculation, hedging, arbitrage and all of the possible combinations

thereof.

MEASURES OF DERIVATIVES:

The value of a derivatives contract equals the difference between the value

of the underlying asset and the cost of financing a purchase of the asset, Further

the value also depends on the price of the underlying asset and the level of interest

rates.

PARTICIPANTS OF DERIVATIVES:

The following are the three broad categories of participants in the derivative

market.


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Hedgers:

Hedgers are parties who ate exposed to risk because they have a prior position in

the commodity or the financial instrument specified in the futures contract. They

use futures or options marked to reduce or eliminate this risk. Since one can take

neither a long position nor a short position in the futures contract, there are two

basic hedge positions:

1. The short (sell) hedge: A party who has a long cash position, current or

potential, may sell (short) the futures.

2. The long (buy) hedge: A party who is not currently in cash but who expects

to be in cash in the future may buy a futures contract to eliminate uncertainty

about the price.

Speculators:

Speculators are those who do not have any position on which they enter in

futures and options market. They only have a particular view on the market, stock,

commodity etc. In short speculators put their money a risk in the hope of profiting

from an anticipated price change. They consider various factors such as demand

supply, market positions, open interests, economic fundamentals and other data totake their positions.

They play very important role in the proper functioning of futures market.

The futures market offers the following attraction to the speculator:

Leverage

Ease of transactions

Lower transaction costs

ARBITRAGEURS:

An arbitrageur is basically risk averse. To earn risk free profits by exploiting

market imperfections. Arbitrageurs make profit from price differential existing in


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to markets by simultaneously operating in the two different markets. There are

two main kinds of arbitrage transactions. They are

A futures-futures arbitrage: It occurs when a dealer exploit the price

differential between two future markets.

A cash-futures arbitrage: It occurs when a dealer exploits price misalignment

between the cash market and the futures market.

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