FINANCIAL DERIVATIVES

BACHELOR OF COMMERCE FINANCIAL MARKETS SEMESTER V (2011-12)

SUBMITTED BY: Pooja Prafulla Sathe ROLL NO. 28

GUIDE NAME Mrs. Kanthi Vishwanathan

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI SOCIETY, CHEMBUR, MUMBAI 400071

FINANCIAL DERIVATIVES

BACHELOR OF COMMERCE FINANCIAL MARKETS SEMESTER V

Submitted

In Partial Fulfillment of the requirements For the Award of the Degree of Bachelor of Commerce Financial Markets

By Pooja Prafulla Sathe ROLL NO. 28

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI SOCIETY, CHEMBUR, MUMBAI 400071

V.E.S. COLLEGE OF ARTS, SCIENCE & COMMERCE, SINDHI SOCIETY, CHEMBUR, MUMBAI 400071

C E R T I F I C A T E
This is to certify that Shri/Miss B.Com Financial Markets Semester V (2010-11) has successfully completed the project on under the guidance of of

Course Coordinator

Principal

Project Guide/ Internal Examiner

External Examiner

DECLARATION

I,

, the student of B.Com Financial

Markets Semester V (2010-11) hereby declare that I have completed this project on . The information submitted is true & original to the best of my knowledge.

Students Signature Pooja Prafulla Sathe Roll No. 28

ACKNOWLEDGEMENT This project on Financial Derivatives is the result of the co-operation, hard work and good wishes of many people. I express deep gratitude and respect to my project guide Mrs. Kanthi Vishwanathan and the Course Co-ordinator of B. Com.(Financial Markets), Mrs. Sangeeta Bhattacharya, for their support and guidance. I am indebted to them for their valuable suggestions and strong motivation in the course of this project. I am grateful to VES College of Arts Science and Commerce, for giving me the opportunity to study Financial Derivatives in detail. A also kindly appreciate the involvement of the teaching and nonteaching staff as well as the library staff and others who have directly or indirectly contributed in making this project successful. Lastly, I thank my parents, friends and professors whose motivation kept me going throughout this endeavour. It was a great pleasure to work for this project with the University of Mumbai.

RESEARCH DESIGN Purpose of the study

The purpose of the study was to provide information about the various concepts in the field of Financial Derivatives, and highlight their main features.

Objectives of the study

To highlight the history and evolution of Financial Derivatives. To study the basic concepts of Financial Derivatives. To provide information about different types of financial derivative products. To get acquainted with the terminology used in various types of derivative dealings.

RESEARCH METHODOLOGY

Data Collection
The data for this project has been collected from secondary sources like books, newspapers, financial magazines and financial websites on the internet. The various facts and figures compiled in the project have been taken from secondary sources of data.

Limitations
The topic Financial Derivatives is a vast field, which is characterized with constant changes. The concepts that evolve with the course of time become obsolete within a relatively short period of time. Also, the various theories used in the functioning of the Financial Derivatives markets often have contradictory assumptions and hypothesis. Compiling the project, while balancing these factors led to a substantial amount of time being spent in research. Also, the complexity of the topic made the introduction of the basic concepts difficult.

EXECUTIVE SUMMARY
The project covers the basic concepts of financial derivatives. An introduction to financial derivatives provides the necessary knowledge to the reader about the basics of financial derivatives. The history of financial derivatives, their evolution, and their current status in the financial markets has been discussed in detail. This would help the reader get acquainted with the topic with ease. The various types of forward derivative contracts, their features and pricing method have been discussed in the first chapter. The importance of forward contracts and their merits and demerits have also been outlined. Futures derivative contracts are gaining importance in the financial world for their excellent leverage advantage. This and other benefits of futures contracts like the different products available in the futures market have been elaborated in the coming chapters. The increasing importance and profitability of options contracts has been explained in the project so that the functioning of financial options can be better understood. A relatively new concept- Financial Swaps, has been discussed in the project. The project attempts to highlight the important concepts and types of financial swaps. Furthermore, a case study on the introduction of derivatives in India helps to put the Indian perspective of derivatives forward.

Table of Contents
CHAPTER 1: INTRODUCTION TO FINANCIAL DERIVATIVES ..................................................................... 2 CHAPTER 2: FORWARD CONTRACTS ..................................................................................................... 11 CHAPTER 3: FUTURES CONTRACTS ....................................................................................................... 20 CHAPTER 4: OPTIONS CONTRACTS ....................................................................................................... 29 CHAPTER 5: SWAPS ............................................................................................................................... 37

CHAPTER 1: INTRODUCTION TO FINANCIAL DERIVATIVES

INTRODUCTION:
Derivative is a product whose value is derived from the value of one or more basic variables, called bases. The underlying variable could be an index, asset or reference rate, i.e. equity, forex, commodity or any other asset. However, Financial Derivatives have only financial instruments as the underlying variable. The emergence of the market for financial derivative products, most notably forwards, futures and options, can be traced back to the willingness of riskaverse economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices. By their very nature, 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. The concept of risk is at the heart of the Financial Markets. In a simple world where only stocks and bonds exist, the only risks are the fluctuations associated with market values and the potential for a creditor to default. But we do not live in that simple world of only stocks and bonds, and in fact investor can adjust the level of risk in a variety of ways. For example, one way to reduce risk is to use insurance, i.e. paying someone to assume a risk for you. The financial markets have found their own way of offering insurance against financial loss in the form of contracts called Derivatives.
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A derivative is a financial instrument that offers a return based on the return of some other underlying asset. In this sense, its return is derived from another instrument. As the definition suggests, a derivatives performance is based on the performance of an underlying asset. This underlying asset is often referred to simply as the underlying. It trades in a market where buyers and sellers meet and decide on a price; the seller then delivers the asset to the buyer and receives the payment. The price for the immediate purchase of the underlying asset is called the cash price or spot price. A derivative has a defined and limited life. A derivative contract initiates on a certain date and terminates on a later date. Often the derivatives payoff is determined and/or made on the expiration date, although that is not always the case. According to the usual rules of the law, a derivative contract is an agreement between two parties in which each does something for the other.

HISTORY OF DERIVATIVES:
Early forward contracts in the U.S. addressed merchants concerns about ensuring that there were buyers and sellers for commodities. However credit risk remained a serious problem, a group of Chicago businessmen formed the Chicago Board of Trade (CBOT) in 1948. The primary intention of the CBOT was to provide a centralized location known in advance for buyers and sellers to negotiate forward contracts. In 1865, the CBOT went one step ahead and listed the first exchange traded derivatives contract in the U.S. , these contracts were called futures contracts

In 1919, Chicago Butter and Egg Board, a spinoff of CBOT, was reorganized to allow futures trading. It was called the Chicago Mercantile Exchange (CME). The CME and the CBOT are the largest organised futures exchanges of any kind in the world today. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index future in the world is based on the S&P 500 index, traded on the CME. During the mid- eighties, financial futures became the most active derivative instruments, generating volumes many times more than the commodity futures. Index futures, futures on T-Bills and Euro-Dollar futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England , DTB in Germany, SGX in Singapore , TIFFE in Japan, MATIF in France, Eurex etc. The basic characteristics of derivatives contracts can be found throughout the history of human kind. Agreements to engage in a commercial transaction as well as agreements that provides the right to engage in a transaction date back hundreds of years.

DERIVATIVES IN INDIA - INITIAL DEVELOPMENTS:

India has been trading derivatives contracts in silver, gold, spices, coffee, cotton and oil etc. for decades in the grey market. Trading derivatives contracts in an organized market was legal before the Morarji Desai government (1977) banned forward contracts. Financial derivatives were traded in the form of Teji and Mandi in unorganized markets. Futures contracts in financial instruments were traded for the first time in India in June 2000, when the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE)
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started trading index futures. Options trading started in June 2001. Very soon thereafter, trading began on options and futures in 31 prominent stocks in the month of July and November respectively.

PURPOSE OF DERIVATIVES:
Derivative markets serve a variety of purposes in global social as well as economic systems. One of the primary functions of derivative markets is price discovery. Derivatives markets provide valuable information about the prices of the underlying assets on which the contracts are based. Perhaps the most important purpose of derivative markets is risk management. It helps in identifying the desired level of risk, identifying the actual level of risk, and altering the latter to equal the former.

REASONS FOR THE GROWTH OF DERIVATIVES:

1. PRICE VOLATILITY: A price is what one pays to acquire or use something of value. The objects having value may be commodities, local currency or foreign currencies. The price one pays for use of a unit of another persons money is called as interest rate and the price one pays in ones own currency for a unit of another currency is called an exchange rate. Prices are generally determined by market forces- supply and demand. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in price are known as price volatility. Price volatility risk pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against price changes in commodity, foreign exchange, equity shares and bonds.

2. GLOBALIZATION OF MARKETS: Globalization has increased the size of the markets and has greatly enhanced competition. It has benefited consumers who cannot obtain better goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cuts in profit margins. Hence,derivatives came to be used by companies to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.

3. TECHNOLOGICAL ADVANCES: A significant growth of derivative instruments has been driven by technological breakthroughs. Advances in this area include the development of high-speed processors, network systems and enhanced methods of data entry. Improvement in communications allowed for instantaneous worldwide conferencing, data transmission by satellite. Derivatives can help a firm to manage its price risk inherent in the market economy to the extent that technological developments increase volatility, derivatives and risk management products become that much more important.

4. ADVANCES IN FINANCIAL THEORIES: Advances in financial theories gave birth to derivatives. Initially, forward contracts in their traditional form, were the only hedging tools available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. The work of economic theorists gave rise to the growth of derivatives in financial markets.
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TRADERS IN DERIVATIVES MARKETS:

There are different types of traders in the derivatives markets. In other words, different traders deal in derivatives for different reasons. Following is a detailed description of each kind of trader. 1. HEDGERS: Hedgers are those traders who wish to eliminate price risk associated with the underlying security being traded. The objective of these kinds of traders is to safeguard their existing positions by reducing the risk. They are not in the derivatives market to make profits. Apart from equity markets , hedging is common in the foreign exchange markets where fluctuations in the exchange rate have to be taken care of in the foreign currency transactions or could be in the commodities market where spiralling oil prices have to be tames using the security in derivative instruments. For example, an investor holding shares of L&T and fearing that the share price will decrease in futures takes an opposite position by selling futures contracts to minimize the extent of loss if the shares prices do dwindle.

2. SPECULATORS: While hedgers might be adept at managing the risks related to their position in shares or other financial securities, there are other parties who are adept at managing and even making money out of such exogenous risks. Using their own capital and that of clients, some individuals and organizations accept such risks in expectation of returns. But unlike investing in business along with its risks, speculators have no clear interest in the underlying asset itself. For the possibility of a reward, they are willing to accept certain risks. They are traders with a view and

objective of making profits. These are people who take positions (long or short) and assume risks to profit from fluctuations in prices. They are willing to take risks and bet upon whether the markets would go up or come down. Speculators may be either day traders or position traders. The former speculate on the price movements during one trading session, while the latter attempt to gain by keeping their position for a longer time period to gain from price fluctuations. For example: In the previous example (L&T), it is also possible to short futures without actually owning shares in the spot market. The speculator does so because he expects the share price to fall and by entering into short futures, he gains if price falls. The speculator is not required to pay the entire value i.e., (No. of futures contracts * lot size*delivery price), only margin money which accounts for 5 to 10 % of the total transacted value. That is the amount paid upfront by the speculator. Thus, futures are highly leveraged instruments. For example, if margin money required is 10%, the speculator can take 10 contracts at the price of 1.

3. ARBITRAGEURS: The third kinds of players are known as arbitrageurs. From the French word for arbitrage or judge, these market participants look for mispricing and market mistakes, and by taking advantage of them, make profits. Arbitrage is the process of simultaneous purchase of securities or derivatives in one market at a lower price and sale thereof in another market at a relatively higher price. For example: if the price of L&T in the futures market is Rs. 1850 and the spot price is Rs. 1845, then arbitrageurs will buy L&T in the spot and sell futures , thereby gaining riskless profits of 1850 1845 i.e., Rs. 5 per lot.

Here the tow markets are spot market and futures market. Thus, riskless profit making is the prime goal of arbitrageurs.

TYPES OF DERIVATIVES:
Derivative contracts have several variants. The most commonly used derivatives are forwards, futures, options and swaps. Some types of derivatives that have come to be used are as follows: Forwards: It is a customized contract between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price. Futures: A futures 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 contracts are special types of forward contracts in the sense that the former are standardized exchange traded contracts. Options: Options are of two types: Calls and Puts. Call options 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. Puts 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: Options generally have lives up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer dated options are called warrants and are generally traded over-the-counter. LEAPS: The acronym LEAPS means Long Term Equity Anticipation Securities. These are options having maturity upto 3 years. Baskets: Basket options are options on portfolios of underlying assets. The underlying asset is usually a moving average of a basket of assets. Equity index options are a form of basket options. Swaps: Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula.

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CHAPTER 2: FORWARD CONTRACTS

A forward contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset or other derivative, at a future date at a price established at the start of the contract. Therefore, it is a commitment by two parties to engage in a transaction at a later date with the price set in advance. The buyer is often called the long and the seller is referred to as the short. The salient features of forward markets are: They are bilateral contracts and hence exposed to counter-party risk. The presence of credit risk in forward contracts make parties wary of each other. Consequently, forward contracts are entered into between parties who have good credit standing. Hence, forward contracts are not available to the common man. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality. The contract price is generally not available in public domain. On expiration date, the contract has to be settled by delivery of the asset. If the party wishes to reverse the contract, it has to compulsorily go to the same counter party which often results in high prices being charged. They are traded Over The Counter (OTC) Both the buyer and the seller are committed to the contract. In other words, they have to take delivery and deliver respectively, the underlying asset on which the forward contract was entered into.

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 The pay-off profiles of the borrower and seller are linear to the price of the underlying. However, forward contracts in certain markets have become very standardized, as in the case of foreign exchange, thereby reducing the transaction cost and increasing transaction volumes. This process of standardization reaches its limit in the organized futures market. Forward markets are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward , he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward. If a speculator has information and analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to rise, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront. However, this is generally a relatively small proportion of the value of the assets underlying the forward contract. The use of forward markets supplies leverage to the speculator.

PRICING OF FORWARD CONTRACTS:

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The forward price for an asset is equal to the spot price or the cash price at the time of the transaction and the cost-of-carry. The cost-of-carry includes all the costs to be incurred for carrying the asset forward in time. Depending upon the type of asset or commodity, the cost-of-carry takes into account the payments and receipts for storage, transport costs, interest payments, dividend receipts, capital appreciation etc. In case of Financial Forward contracts, however, the cost of carry does not include storage costs.

FORWARD PRICE= SPOT or CASH PRICE + COST-of-CARRY

Thus, forward contracts are contracts that are tailored to the specific needs of the parties involved in the contract. They are OTC contracts that are private in nature and are negotiated bilaterally between the parties with no exchange guarantees. Dealing in forward markets involves no margin payments. The primary function of forward contracts is that of a hedging instrument. Forward prices do are not transparent as there is no reporting requirements about the contract details. The settlement of contracts is done either by actual delivery or with cash settlement.

CLASSIFICATION OF FORWARD CONTRACTS:

1. HEDGE CONTRACTS: These contracts are freely transferable, which do not require specification of a particular lot size, quality or delivery standards for the underlying assets. Most of these are necessary to be settled through delivery of underlying assets.

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2. TRANSFERABLE SPECIFIC DELIVERY FORWARD CONTRACTS: Apart from being transferable between parties concerned, these for forward contracts refer to a specific and predetermined lot size and a variety of underlying assets. It is compulsory for delivery of the underlying asset to take place at expiration of contract.

3. NON-TRANSFERABLE SPECIFIC DELIVERY FORWARD CONTRACTS: These contracts are normally exempted from provision of regulation under Forward Contract Act, 1952 but the Central Government reserves the right to bring them back under the Act when it feels necessary. These are contracts which cannot be transferred to another party. The contracts, the consignment lot size, and quality of underlying asset are required to be settled at expiration through delivery of the assets.

PRODUCTS IN FORWARD CONTRACTS:

Following are the types of forward contracts i.e. the underlying asset groups on which forward contracts are created.

1. EQUITY FORWARDS: Equity forward is a contract calling for the purchase of an individual stock, a stock portfolio, or a stock index at a later date. For the most part, the differences in types of equity forward contracts only slight, depending on whether the contract is on an individual stock, a portfolio of stocks or a stock index.
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The effect of Dividends: It is important to note the effects of dividends in equity forward contracts. Any equity portfolio nearly always has at least a few stocks that pay dividends, and it is inconceivable that any well-known equity index would not have some component stocks that pay dividends. Equity forward contracts typically have payoffs based only on the price of the equity, value of the portfolio, or level of the index. They do not ordinarily pay off any dividends paid by the component stocks, equity forwards on stock indices based on total return indices being an exception. 2. BOND FORWARD CONTRACTS: Forward contracts on bonds are similar to those on interest rates, but the two are different instruments. Forward contracts on bonds, in fact, are no more difficult to understand than those on equities. A bond may be a coupon, which corresponds somewhat to the dividend that a stock might pay. But unlike a stock, a bond matures, and a forward contract on a bond must expire prior to the bonds maturity date. In addition, bonds often have many special features such as calls and convertibility. Also, a bond carries the risk of default. There are also forward contracts on portfolios of bonds as well as on bond indices. The technical distinctions between forward contracts on individual bonds and collections of bonds, however, are relatively minor. Forward contracts call for delivery of the bond at a date prior to the bonds maturity, for which the long pays the short, the agreed upon price 3. INTEREST RATE FORWARDS:

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Interest rate forwards, also known as forward rate agreements are a more common type of forward contract. A forward rate agreement is a simple derivative which is used when an institution is exposed to a single period interest rate risk. It allows the forward fixing of interest rates on money market transactions. The FRA is widely used by banks and to a lesser extent, by corporate for hedging, arbitrage and speculative activities. The FRA is an agreement between two parties which determines the interest rate that will apply to notional future loan/deposit of an agreed amount for a specified period. There is a large global market for time deposits in various currencies issued by large creditworthy banks. This market is primarily centred in London but also exists in other parts of the world. The primary time deposit instrument is called the Eurodollar, which is a dollar deposited outside the United States. Banks borrow dollars from other banks using Eurodollar time deposits, which are essentially short-term unsecured loans. In London, the rate on such dollar loans is called London Interbank Offer Rate (LIBOR). The functioning of interest rate forward contracts can be demonstrated as follows: A London bank ABC needs to borrow $10 million for 30 days. It obtains a quote from another bank PQR for a rate of 5.25%. Thus, the 30 day LIBOR is 5.25%. If ABC takes the deal, it will owe $10,000,000 * [1+0.0525(30/360)] =$10,043,750 in 30 days

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QUOTING BANK (ABC BANK)

NOTIONAL BORROWER (BUY QUOTE)

NOTIONAL LENDER (SELL QUOTE)

5.25%

5.30%

NOTIONAL LENDER (SELLER)

NOTIONAL BORROWER (BUYER)

PQR BANK

FRA Quotes- Implications

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4. CURRENCY FORWARD CONTRACT: Currency forward contracts, as the name suggests, are contracts that have currency as the underlying asset. Currency forwards are widely used by banks and corporations to manage foreign exchange risk. Foreign exchange risk arises out of fluctuations in the currency rates. Exchange rates are determined by demand and supply. The purchases and sales of currencies stem partly from the need to finance trade in goods and services, and substantially for the finance of investment, particularly temporary investment. For eg. If Microsoft has a European subsidiary that expects to send it 12 million Euros in three months. When Microsoft receives the euros, it will convert them to dollars. Thus, Microsoft is essentially long euros because it will have to sell euros, or equivalently, it is short dollars because it will have to buy dollars. A currency forward is especially useful in this situation, because it enables Microsoft to lock in the rate at which it will sell Euros and buy dollars in three months. It can do this by going short on the forward contract, meaning that it goes short the euro and long the dollar. This arrangement serves to offset its otherwise long -euro, short-dollar position. In other words, it needs a forward contract to sell euros and buy dollars. ADVANTAGES OF FORWARD CONTRACTS: 1. Forward contracts can be used to hedge or lock-in the price of purchase or sale of the financial asset on the future commitment date. 2. On forward contracts, generally, margins are not paid and there is also no upfront premium. So, it does not involve initial cost.

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3. Since forwards are tailor made, price risk exposure can be hedged up to 100%, which may not be possible in futures and options. DISADVANTAGES OF FORWARD CONTRACTS: 1. Counterparty risk is very much present in a forward contract since there is no performance guarantee. On the due date, the possibility of counterpartys failure to perform his obligation creates another risk exposure. 2. Forward contracts do not allow the investor to derive any gain from favourable price movement or to unwind the transactions once the contract is made. At the most, the contract can be cancelled on the terms agreed upon by the counterparty. 3. Since forwards are not exchange-traded, they have no ready liquidity. Further, it is difficult to get counterparty on ones terms. 4. One of the counterparties of these contracts is generally a bank or a trader who square up their position by entering into reverse contract. These transactions do not take place simultaneously, so these parties normally keep large bid-ask spread to avoid any loss to price fluctuations. this increases the cost of hedging.

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CHAPTER 3: FUTURES CONTRACTS

Futures contracts have evolved out of forwards and are exchange traded versions of forward contracts. They are one of the most popular and widely used derivative instruments. A futures contract is simply an agreement to buy or sell an asset at a certain time in the future at a certain price. A more comprehensive definition would be as follows. Futures are firm financial agreements to deliver or take delivery of a standardised quantity of an underlying instrument, at a pre-established price agreed on a regulated exchange at a specific future date.

HISTORY OF FUTURES:
Although vestiges of futures markets appear in the Japanese rice markets of the 18th century and perhaps even earlier, the mid-1800s marked the first clear origin of modern futures markets. For example, in the United States in the 1840s, Chicago was becoming a major transportation and distribution center for agricultural commodities. Its central location and access to the Great Lakes gave Chicago a competitive advantage over the other U.S. cities. Farmers from the mid- west would harvest their grain and take it out to Chicago for sale. Grain production, however, was seasonal. As a result, grain prices would rise sharply just prior to the harvest but then plunge when the grain was brought to the market. Too much grain at one time and too little at another resulted in severe problems. Grain storage facilities in Chicago were inadequate to accommodate the oversupply. Some farmers even dumped the grain in the Chicago River because prices were so low that they could not afford to take their grain to another city to sell.

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To address this problem , in 1848 a group of businessmen formed an organization later called Chicago Board of Trade (CBOT) and created an arrangement called to-arrive contract. These contracts permitted farmers to sell their harvest before delivering it. In other words, farmers could harvest the grain and enter into a contract to deliver it at a much later date at a price already agreed on. The transaction allowed the farmer to hold the grain in storage at some other location besides Chicago. On the other side of these contracts were the businessmen who had formed the CBOT. It soon became apparent that trading in these to-arrive contracts was more important than in trading in the grain itself. Soon the contracts began trading in a type of secondary market, which allowed buyers and sellers to discharge their obligations by passing them on, for a price, to other parties. In 1865, the CBOT went one step further and listed the first exchange traded derivatives contract in the US, these contracts were called futures contracts. In 1919, The Chicago Butter and Egg board, a spin-off of CBOT, was reorganized to allow futures trading. Its name was changed to Chicago Mercantile Exchange (CME). The CBOT and the CME remain the two largest organized futures exchanges, indeed the two largest financial exchanges of any kind in the world today. With the addition of the clearinghouse in the 1920s, which provided a guarantee against default, modern futures markets firmly established their place in the financial world. It was left to other exchanges to develop and become the global leaders in the futures markets. The first stock index futures contract was traded at Kansas City Board of Trade. Currently the most popular stock index futures contract in the world is based

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on S&P 500 index, traded on CME. During the mid eighties, financial futures became the most active derivative instruments generating volumes many times more than the commodity futures. Index futures, futures on T-bills and Euro-Dollars futures are the three most popular futures contracts traded today. Other popular international exchanges that trade derivatives are LIFFE in England , DTB in Germany , SGX in Singapore, TIFFE in Japan , MATIF in France, Eurex etc. The first exchange that traded financial derivatives was launched in Chicago in the year 1972. A division of the CME, it was called the International Monetary Market (IMM) and traded currency futures. The brain behind this was a man called Leo Melamed, acknowledged as the father of financial futures who was the chairman of the CME. Before IMM opened in 1972, the Chicago Mercantile Exchange totalled 50 trillion dollars. These currency futures paved the way for the successful marketing of a dizzying array of similar products at the Chicago Board Options Exchange. By the 1990s , these exchanges were trading futures and options on everything to from Asian and American stock indices to interest-rate swaps, and their success formed Chicago almost overnight into the risk- transfer capital of the world.

FEATURES OF FUTURES CONTRACTS:

A futures contract is not customized. In a forward contract, two parties establish all of the terms of the contract, including the identity of the underlying, the expiration date, and the manner in which the contract is to be settled (cash or actual delivery) as well as the price. The terms are customized to meet the needs of both the parties.
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In a futures contract, the price is the only term established by the two parties; the exchange establishes all other terms. Moreover, the terms that are established by the exchange are standardized, meaning that the exchange selects a number of choices for the underlying, expiration dates, and a variety of other contract-specific items. These standardized items are well known to all parties. If a party wishes to trade a futures contract, it must accept these terms. The only alternative would be to create a similar but customized contract on the forward market. With respect to the underlying, a given asset has a variety of specifications and grades. Futures contracts are available with underlying assets like commodities, stocks and stock indices

FUTURES TERMINOLOGY:
Spot Price: The price at which an asset trades in the spot market or the underlying market. Futures Price: The price at which the futures contract trades in the futures market. Contract Cycle: The period over which a contract trades. The index futures contracts on the NSE have one-month, two-months and three-month expiry cycles which expire on the last Thursday of the month. Thus a January contract expires on the last Thursday of January and a February contract ceases trading on the last Thursday of February. On the Friday following the last Thursday, a new contract having a three-month expiry is or introduced for trading.

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TYPES OF FUTURES:
1. SINGLE STOCK FUTURES: A single stock futures market in India has been a great success story across the world. The National Stock Exchange (NSE) ranks first in the world in terms of number of contracts traded in single stock futures. One of the reasons for the success of stock futures could be the ease of trading or settling these contracts. To trade securities a customer must open a security trading account with a securities broker and a demat account with a securities depository. Buying security involves putting up all the money upfront. With the purchase of shares of a company, the holder becomes a part owner of the company. The shareholder typically receives the rights and privileges associated with the security, which may include the receipt of dividends, invitation to the annual shareholders meeting and the power to vote. To trade futures, however, a customer must open a futures trading account with a derivatives broker. Buying futures simply involves putting in the margin money. They enable the futures traders to take a position in the underlying security without having to open an account with a securities broker. With the purchase of obligation to buy the underlying security at some point in the future (the expiration dates of the contract). Security futures do not represent ownership in a corporation and the holder is therefore not regarded as a shareholder.

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2. STOCK INDEX FUTURES: One of the most successful types of futures contracts of all time is the class of futures on stock indices. Index derivatives have two main types, index futures and index options. Let us first know about index futures contracts. Institutional and large equity-holders need portfolio-hedging facility. Index futures are more suited to them and more cost-effective than futures on individual stocks. Pension funds in the US are known to use stock index for risk hedging purposes. Index futures offer ease for hedging any portfolio irrespective of its composition. The stock index is difficult to manipulate as compared to individual stock prices, more so in India, and the possibility of cornering is reduced. This is partly because an individual stock has a limited supply, which can be cornered. Stock index, being an average, is much less volatile than individual stock prices. This implies much lower capital adequacy and margin requirements. Index futures are cash settled, and hence do not suffer from settlement delays and problems related to bad delivery, forged/fake certificated. 3. CURRENCY FUTURES CONTRACTS: The forward market on foreign currencies is used on a large scale. Nevertheless, the currency futures market is quite active. In fact, currency futures were the first futures contracts not based on physical commodities. Thus, they are sometimes referred to as the first financial futures contracts , and their initial success paved the way for the later introduction of interest rate and stock index futures. Compared with forward contracts on currencies, currency futures contracts are much smaller in size. In the U.S. , these contracts trade at the CME with a small amount of trading at the New York Board of Trade.
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4. INTEREST RATE FUTURES: Similar to currency futures markets, the trading in interest rate futures markets is at a relatively smaller scale than that in the interest rate forward contracts. The amount of funds involved in interest rate contracts require , more often than not, a customized agreement, which is why the need for standardized futures contracts are not as popular as their forward contracts.

FUTURES PRICING: Forwards/ futures contract are priced using the cost of carry model. The cost of carry model calculates the fair value of futures contract based on the current spot price of the underlying asset. The formula used for pricing futures is given below: F = SerT Where: F = Futures Price S = Spot price of the underlying asset R = Cost of financing (using a continuously compounded interest rate) T = Time till expiration in years E = 2.71828 (The base of natural logarithms) Example: Security of ABB Ltd trades in the spot market at Rs. 850. Money can be invested at 11% per annum. The fair value of a one-month futures contract on ABB is calculated as follows:

F = S^erT = 857.80 The presence of arbitrageurs would force the price to equal the fair value of the asset. If the futures price is less than the fair value, one can profit by
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holding a long position in the futures and a short position in the underlying. Alternatively, if the futures price is more than the fair value, there is a scope to make a profit by holding a short position in the futures and a long position in the underlying. The increase in demand/ supply of the futures (and spot) contracts will force the futures price to equal the fair value of the asset.

THE COST OF CARRY AND CONVENIENCE YIELD:

The cost of carry is the cost of holding a position. It is usually represented as a percentage of the spot price. Generally, for most investment, we consider the risk-free interest rate as the cost of carry. In case of commodities contracts, cost of carry also includes storage costs (also expressed as a percentage of the spot price) of the underlying asset until maturity. Futures prices being lower than spot price (backwardation) is also explained by the concept of convenience yield. It is the opposite of carrying charges and refers to the benefit accruing to the holder of the asset. For example, one of the benefits to the inventory holder is the timely availability of the underlying asset during a period when the underlying asset is otherwise facing a stringent supply situation in the market. Convenience yield has a negative relationship with inventory storage levels (and storage cost). High storage cost/high inventory levels lead to negative convenience yield and vice versa. The cost of carry model expresses the forward (future) price as a function of the spot price and the cost of carry and convenience yield. F = [S + PV (storage cost)] * e(r c) t Where F is the forward price, S is the spot price, r is the risk-free interest rate, c is the convenience yield and t is the time to delivery of the forward contract (expressed as a fraction of 1 year).

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BACKWARDATION AND CONTANGO: The theory of normal backwardation was first developed by J. M. Keynes in 1930. The theory suggests that the futures price is a biased estimate of the expected spot price at the maturity. The underlying principle for the theory is that hedgers use the future market to avoid risks and pay a significant amount to the speculators for this insurance. When the future price is lower than the current spot price, the market is said to be back warded and the opposite is called as a contango market. Since future and spot prices have to converge on maturity (this is sometimes called the law of one price), in the case of a back warded market, the future price will increase relative to the expected spot price with passage of time, the process referred to as backwardation. In case of contango, the future price decreases relative to the expected spot price. Backwardation and contango is easily explained in terms of the seasonal nature of commodities. Commodity futures with expiration dates falling in post harvest month would face backwardation, as the expected spot price would be lower. When hedgers are net short (farmers willing to sell the produce immediately after harvest), or the risk aversion is more for short hedgers than the long hedgers, the futures price would be a downward biased estimate of the expected spot price, resulting into a back warded market.

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CHAPTER 4: OPTIONS CONTRACTS

Options are fundamentally different from forwards and futures. An option gives the holder of the option the right to do something. The holder does not have to exercise this right. In contrast, in a forward or futures contract, the two parties have committed themselves to doing something. Whereas it costs nothing (except margin requirements) to enter into a futures contract, the purchase of an option requires an up-front payment. However, options contain several features common to forward and futures contracts. For example, options can be privately created, over-the-counter, customized instruments that are subject to credit risk. In addition, however, there is a large market for publicly traded, exchange-listed, standardized options, for which credit risk is essentially eliminated by the clearing house. Like forwards and futures, options are derivative instruments that provide the opportunity to buy or sell an underlying asset on a future date. As explained in the introduction, an option contract is a contract written by a seller that conveys the buyers a right, but not an obligation to either sell (put option) or buy (call option) a particular asset at a specified price in the future. In case of call options, the option buyer has a right to buy and in case of put options, the option buyer has a right to sell the security at the agreed upon price (called strike rate or exercise price). In return for granting the option, the party (seller) granting the option collects a payment from the other party. This payment collected is called the premium or price of the option. Options are like insurance contracts. Unlike futures, where the parties are denied of any favourable movement in the market, in case of options, the buyers are protected from downside risks and in the same time, are able to reap the
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benefits from any favourable movement in the exchange rate. The buyer of the option has a right but no obligation to enforce the execution of the option contract and hence, the maximum loss that the option buyer can suffer is limited to the premium amount paid to enter into the contract. The buyer would exercise the option only when she can make some profit from the exercise, otherwise, the option would not be exercised, and be allowed to lapse. Recall that in case of American options, the right can be exercised on any day on or before the expiry date but in case of a European option, the right can be exercised only on the expiry date. Options can be used for hedging as well as for speculation purposes. An option is used as a hedging tool if the investor already has (or is expected to have) an open position in the spot market. For example, in case of currency options, importers buy call options to hedge against future depreciation of the local currency (which would make their imports more expensive) and exporters could buy put options to hedge against currency appreciation. There are other methods of hedging toousing forwards, futures, or combinations of all threeand the choice of hedging is determined by the costs involved.

HISTORY:
Although options have existed for a long time, they were traded OTC, without much knowledge of valuation. The first trading in options began in Europe and the US as early as the 17th century. It was only in the early 1900s that a group of firms set up what was known as the Put and Call brokers and Dealers Association with the aim of providing a mechanism for bringing buyers and sellers together. If someone wanted to buy an option, he or she would contact one of the member firms. The firm would then attempt to find a seller or writer of the option either from its own clients or those of other members
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firms. If no seller could be found, the firm would undertake to write the option itself in return for a price. This market however suffered two deficiencies. First, there was no secondary market and second, there was no mechanism to guarantee that the writer of the option would honour the contract. In 1973, Black, Merton and Scholes invented the famed Black-Scholes formula. In April 1973, Chicago Board of Options Exchange (CBOE) was set up specifically for the purpose of trading options. The market for options developed so rapidly that by early 80s, the number of shares underlying the option contract sold each day exceeded the daily volume of shares traded on the New York Stock Exchange (NYSE). Since then, there has been no looking back.

USE OF OPTIONS:
Options made their first major financial history during the tulip-bulb mania in 17th century Holland. It was one of the most spectacular get rich quick binges in history. The first tulip was brought to Holland by a botany professor from Vienna. Over a decade, the tulip became the most popular and expensive item in Dutch gardens. The more popular they became, the more Tulip bulb prices began rising. That was when options came into the picture. They were initially used for hedging. By purchasing a call option on tulip bulbs, a dealer who was committed to a sales contract could be assured of obtaining a fixed number of bulbs for a set price. Similarly, tulip-bulb growers could assure themselves of selling their bulbs at a set price. Later, however, options were increasingly used by speculators who found that call options were an effective vehicle for obtaining maximum possible gains on investment. As long as tulip prices continued to skyrocket, a call buyer would realize returns far in excess of those that could be obtained by purchasing tulip bulbs themselves. The writers of the
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options also prospered as bulb prices spiralled since writers were able to keep premiums and the options were never exercised. The tulip-bulb market collapsed in 1636 and a lot of speculators lost huge sums of money. Hardest hit were put writers who were unable to meet their commitments to purchase tulip bulbs.

OPTIONS TERMINOLOGY:
Index options: These options have the index as the underlying. Some options are European while others are American. Like index futures contracts, index options contracts are also cash settled. Stock options: Stock options are options on individual stocks. Options currently trade on over 500 stocks in the United States. A contract gives the holder the right to buy or sell shares at the specified price. Buyer of an option: The buyer of an option is the one who , by paying the option premium buys the right but not the obligation to exercise his option on the seller/writer. Writer of an option: The writer of a call/put option is the one who receives the option premium and is thereby obliged to sell/buy the asset if the buyer exercises on him. There are two basic types of options, call options and put options. Call option: A call option gives the right but not the obligation to buy an asset by a certain date for a certain price. Put option: A put option gives the holder the right but not the obligation to sell an asset by a certain date for a certain price. Option price/premium: option price is the price which the option buyer pays to the option seller. It is also referred to as the option premium.
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 Expiration date: The date specified in the options contract is known as the expiration date, the exercise date, the strike date or the maturity. Strike price: The price specified in the options contract is known as the strike price or the exercise price. American options: American options are options that can be exercised any time up to the expiration date. Most exchange-traded options are American. European options: European options are options that can be exercised only on the expiration date itself. European options are easier to analyze than American options. In-the-money option: An in-the-money (ITM) option is an option that would lead to a positive cash flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money when the current index stands at a level higher than the strike price, the call is said to be deep ITM. In the case of a put, the put is ITM if the index is below the strike price. At-the-money option: An at-the-money (ATM) option is an option that would lead to zero cash flow if it were exercised immediately. An option on the index is at-the-money when the current index equals the strike price. Out-of-the-money option: An out-of-the-money (OTM) option is an option that would lead to a negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money when the current index stands at a level which is less than the strike price, the call is said to be deep OTM. In the case of a put, the put is OTM, if the index is above the strike price. Intrinsic value of an option: The option premium can be broken down into two components- intrinsic value and time value. The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero. Putting it another way, the intrinsic value of a call is Max [0,
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(St K)] which means the intrinsic value of a call is the greater of 0 or (St K). Similarly, the intrinsic value of a put is Max [0, K- St], i.e. the greater of 0 or (K- St). K is the strike price and St the spot price. Time value of an option: The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time value. An option that is OTM or ATM has only time value. The longer the time to expiration, the greater is an options time value, all else equal. At expiration, the option should have no time value.

TYPES OF OPTIONS:
1. STOCK OPTIONS: Options on individual stocks, also called equity options, are among the most popular types of financial options available. Exchange listed options are available on the most widely traded stocks.

2. INDEX OPTIONS: Stock index options are well known, not only in the investment community but also among many individuals who are not even directly investing in the market. Because a stock index is just an artificial portfolio of stocks, it is reasonable to expect that one could create an option on a stock index.

3. BOND OPTIONS: Options on bonds, usually called bond options , are primarily traded in over-the-counter markets. Options exchanges have attempted to generate interest in options on bonds, but have not been very successful. Corporate bonds are not very actively traded; most are purchased and held to expiration. Options exchanges generate much of
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their trading volume from individual investors, who have far more interest in and understanding of stocks and bonds. Thus, options are found almost exclusively in the over-the-counter market.

4. INTEREST RATE OPTIONS: Interest rate option is quite similar to Interest rate forwards in terms of their primary function. The only differences are those which exist fundamentally between customized and standardized contracts. Just as a Forward Rate Agreement (FRA) is a forward contract with an interest rate as the underlying, an interest rate option is an option in which the underlying is an interest rate. Instead of an exercise price, it has an exercise rate (or strike rate), which is expressed on an order of magnitude of an interest rate. At expiration, the option payoff is based on the difference between the underlying rate in the market and the exercise rate. Whereas an FRA is a commitment to make one interest payment and receive another at a future date, interest options are the right to make to make one interest payment and receive another at a future date. And just as there are call and put options, there is also an interest rate call and an interest rate put.

5. CURRENCY OPTIONS: The currency options market is quite large. A currency option allows the holder to buy (if a call) or sell (if a put) an underlying currency at a fixed exercise rate, expressed as an exchange rate. Many companies, knowing that they will need to convert a currency X at a future date into currency Y, will buy a call option on currency Y specified in terms of currency X.

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For example: Say that a U.S. company will be needing 50 million Euros for an expansion project in three months. Thus, it will be buying Euros and will be exposed to the risk of the euro rising against the dollar. Even though it has that concern, it would also like to benefit if the euro weakens against the dollar. Thus it might buy a call option on the euro. Let us say it specifies an exercise rate of $0.90. so it pays cash up front for the right to buy 50 million euros at a rate of $0.90 per euro. If the option expires with the euro above $0.90, it can buy euros at $0.90 per euro. If the option expires with the euro below the exercise exchange rate of $0.90, it does not exercise the option and buys euros at the market price.

Most foreign currency options activity occurs on the customized over-thecounter markets. Some exchanges-listed currency options trade on a few exchanges, but overall activity in currency futures is very low.

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CHAPTER 5: SWAPS
A swap is a method of reducing financial risks. Swap is an exchange, and in financial jargon it is an exchange of cash payment obligations, in which each party to the swap prefers the payment type or pattern of the other party. In other words, swap occurs because the counter parties prefer the terms of the others debt contract, and the swap enables each party to obtain a preferred payment obligation. Generally, one party in the swap deal has a fixed rate obligation and the other party in the same deal has a floating rate obligation, or one has an obligation denominated in one currency and the other in another currency. A swap is any agreement to a future exchange of one asset for another, one liability for another, or more specifically, one stream of cash flows for another. A swap is a private agreement between two parties in which both parties are obligated to exchange some specific cash flows at a periodic intervals for a fixed period of time. The most common swaps include currency swaps, in which one currency is exchanged for another at pre-specified terms on one or more pre-specified dates. While swaps are used for various purposes- from hedging to speculation- their fundamental purpose is to change the character of an asset or liability without liquidating that asset or liability. For example, an investor realising returns form an equity investment can swap those returns into less risky fixed income cash flows- without having to liquidate the equities. A corporation with floating rate debt can swap that debt into a fixed rate obligation- without having to retire and reissue debt. A swap is a cash settled derivative. Except for forwards, swaps are the simplest form of OTC derivatives.
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THE FIRST SWAP DEAL:

The first Interest Swap deal was struck in the year 1981 when Salomon Brothers acted as the swap intermediary between IBM and World Bank. The swaps on currency were initially in the form of back-to-back/ parallel loans. Back to-back loan is a loan arrangement involving two distinct loans between the same parties in the first loan, the first party being the lender and the second party being the borrower. In the second loan, the first party is the borrower and the second party is the lender. Currency swaps existed before the year 1981 in the form of back-to-back loans. The Swiss franc/German deutschemark/US Dollar currency swap between the World Bank and IBM generated interest in swap arrangements.

SWAP MARKET:
The swap markets did not publicly exist until 1981 when currency swaps were first introduced, although its origins can be traced back to the 1970s. Rising interest rate volatility necessitated a flexible means by which companies with floating interest rate exposure could hedge such risks. The result of which was the introduction of US interest rate swaps in 1982. The swap markets helped companies lower their funding costs. They did so by enabling companies to source capital in whatever market or currency it was found to be cheapest, and then to convert the resulting liability into whatever form made sense.

FEATURES OF SWAPS:
1. BASICALLY A FORWARD: A swap is nothing but a combination of forwards. So , it has all the properties of forward contracts.
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2. DOUBLE COINCIDENCE OF WANTS: Swaps require that two parties with equal and opposite needs come into contact with each other i.e., rate of interest differs from market to market and within the market itself. In order to work out a swap agreement, the two parties involved must require the terms of contract that the opposite party currently holds. 3. COMPARATIVE CREDIT ADVANTAGE: Borrowers enjoying comparative credit advantage in floating rate debts will enter into a swap agreement to exchange floating rate interest with the borrowers enjoying comparative advantage in fixed rate debt, like bonds. In the bond market, lending is done at a fixed rate for a long duration , and therefore the lenders do not have the opportunity to adjust the interest rate according to the situation prevailing in the market. 4. FLEXIBILITY: In short term market, the lenders have the flexibility to adjust the floating interest rate (short term rate) according to the conditions prevailing in the market as well as the current financial position of the borrower. 5. NECESSITY OF AN INTERMEDIARY: Swaps require the existence of two counterparties but matching needs. This has created a necessity for an intermediary to arrange the agreement. By arranging swaps, the intermediaries can earn income too. Financial companies, particularly banks can play a key role in this innovative field by virtue of their special position in the financial market and their knowledge of the diverse needs of customers. 6. SETTLEMENTS: Though a specified principal amount is mentioned in the swap agreement; there is no exchange of principal. On the other hand, a
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stream of fixed rate interest is exchanged for a floating rate of interest, and thus, there are streams of cash flows rather than a single payment. 7. LONG TERM AGREEMENT: Generally, forwards are arranged for a short period only. Long dated forward rate contracts are not preferred because they involve more risks like risk of default, risk of interest rate fluctuations etc. But swaps are in the nature of long term agreements and they are just like long dated forward rate agreement. The exchange of a fixed rate for a floating rate requires a comparatively longer period.

SWAP TERMINOLOGY:
The commonly used terms in the swap market are discussed as follows. 1. PARTIES: Generally, there are two parties in a swap deal, and this excludes the intermediary. For example, in an interest rate swap, the first party could be a fixed rate payer/receiver and the second party could be a floating rate payer/receiver. 2. SWAP FACILITATORS: Swap facilitators are generally referred to as Swap Banks or simply Banks. There are two kinds of swap facilitators i.e., Swap Broker and Swap Dealer. 3. SWAP BROKER: Also known as an intermediary, a swap broker as an economic agent, helps in identifying the potential counterparties in a swap deal. The swap brokers only acts as a facilitator charging a commission for his services and does not take any individual position in the swap contract. 4. SWAP DEALER: A swap dealer associates himself with the swap deal and often becomes an actual party to the transaction. Also known as market maker, the swap dealer may be actively involved as a financial intermediary for earning a profit.
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5. NOTIONAL PRINCIPAL: The underlying amount in a swap contract which becomes the basis for the deal between counterparties is known as the notional principal. It is called notional because this amount does not vary, but the cash flows in the swap are attached to this amount. For example, in an interest rate swap, the interest is calculated on the notional principal. 6. TRADE DATE: The date on which both parties enter into the contract is known as the trade date. 7. EFFECTIVE DATE: It is also known as the value date, and is the date when the initial cash flows in a swap contract begin. For example, initial fixed and floating payments, for interest rate swaps. The maturty of a swap contract is calculated from this date. 8. RESET DATE: Reset date is that date on which the LIBOR rate is determined. The first reset date will be generally two days before the first payment date and the second reset date will be two days before the second payment date and so on. 9. MATURITY DATE: The date on which the outstanding cash flows stop in the swap contract is referred to as the maturity date.

TYPES OF SWAPS:
The two basic categories of swap contracts are Commodity Swaps and Financial Swaps. A detailed description of financial swaps is given below. The two major types of Financial Swaps are: 1. Interest Rate Swaps (Coupon Swaps) 2. Currency Swaps

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1. Interest Rate Swaps: A standard fixed-to-floating interest rate swap, known in market jargon as a Plain Vanilla Coupon (exchange borrowing) is an agreement between two parties in which each contracts to make payments to the other on particular dates in the future till a specified termination date. One party, known as the fixed rate payer, makes fixed payments, all of which are determined at the outset. The other party known as the floating rate payer will make payments the size of which depends upon the future evolution of a specified interest rate index (6-month LIBOR). An interest rate swap is an agreement between two parties to exchange U.S. Dollar interest payments for a specific maturity on an agreed upon notional amount. The term notional refers to the theoretical principal underlying the swap. Thus, the notional principal is simply a reference amount against which the interest is calculated. No principal ever changes hands. Maturities range from less than a year to more than 15 years; however, most transactions fall within a 2-year to 10 period. Two main types of interest rate swaps are: Coupon swap and Basis swap. 1. Coupon Swap: In a coupon swap, one party pays a fixed rate calculate at the time of trade as a spread to a particular Treasury Bond, and the other side pays a floating rate that resets periodically throughout the life of the deal against a designated index. 2. Basis swap: In a Basis swap, two parties exchange floating interest payments based on different reference rates. Using this relative straight forward mechanism, interest rate swaps transform debt issues, assets, liabilities, or any cash flow from type to type and- with some variation in the transaction structure- from currency to currency.

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2. CURRENCY SWAPS: Swap contracts also can be arranged across currencies. Such contracts are known as currency swaps and can help to manage both interest rate and exchange rate risk. Currency swaps are derivative products that help to manage exchange and interest rate exposure on long-term liabilities. A currency swap involves exchange of interest payments denominated in two different currencies for a specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed rate, or a floating rate indexed to some reference rate, like the LIBOR. In a typical swap, counterparties will perform the following Exchange equal initial principal amounts of two currencies at the spot exchange rate. Exchange a stream of fixed or floating interest payments in their swapped currencies for the agreed period of the swap and then, Re-exchange the principal amount at maturity at the initial spot rate. The currency swap provides a mechanism for shifting a loan from one currency to another, or shifting the currency of an asset. It can be used, for example, to enable a company to borrow in a currency different from the currency it needs for its operations, and to receive protection from exchange rate changes with respect to the loan. A currency swap is an agreement between two parties to exchange a given amount in one currency for another, and to repay these currencies with interest in the future. 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 amounts

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swapped. Currency swaps can be negotiated for a variety of maturities up to at least 10 years.

PURPOSE OF CURRENCY SWAPS:

The motivations for the various forms of currency swap are similar to those that generate a demand for interest rate swaps. The incentive may arise from a comparative advantage that a borrowing company has in a particular currency or capital market. It may result from a companys desire to diversify and spread its borrowing around to different capital markets, or to shift a cash flow from foreign currencies. It may be that a company cannot gain access to a particular capital market. Or, it may reflect a move to avoid exchange controls, capital controls or taxes. Any number of possible market imperfections or pricing inconsistencies provide opportunities for arbitrage. Before currency swaps became popular, parallel loans and back-to-back loans were used by market participants to circumvent exchange controls and other impediments. Offsetting loans in two different currencies might be arranged between two parties; for example, a U.S. firm might make a dollar loan to a French firm in the United States, and the French firm would lend an equal amount to the U.S. firm or its affiliate in France. Such structures have now largely been abandoned in favour of currency swaps.

CROSS- CURRENCY INTEREST RATE SWAP:

As its name implies, an interest rate/currency swap combines the features of both a currency swap and an interest rate swap. This swap is designed to convert a liability in one currency with a stipulated type of interest payment into one denominated in another currency with a different type of interest payment. The most common form of interest rate/currency swap converts a
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fixed rate liability in one currency into a floating-rate liability in the second currency (liability swap). The same structure happens for an asset swap. A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swap and a fixed-to-floating interest rate swap. Here, one payments stream is at a fixed rate in currency X while the other is at a floating rate in currency Y.

OTHER TYPES OF DERIVATIVE PRODUCTS:

WARRANTS: In finance, a warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date. Warrants and options are similar in that the two contractual financial instruments allow the holder special rights to buy securities. Both are discretionary and have expiration dates. The word warrant simply means to "endow with the right", which is only slightly different to the meaning of an option. Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends. They can be used to enhance the yield of the bond, and make them more attractive to potential buyers. Warrants can also be used in private equity deals. Frequently, these warrants are detachable, and can be sold independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Thus, it is sometimes beneficial to detach and sell a warrant as soon as possible so the investor can earn dividends.

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Warrants are actively traded in some financial markets such as Deutsche Brse and Hong Kong. In Hong Kong Stock Exchange, warrants accounted for 11.7% of the turnover in the first quarter of 2009, just second to the callable bull/bear contract. Warrants are very similar to call options. For instance, many warrants confer the same rights as equity options, and warrants often can be traded in secondary markets like options. However, there also are several key differences between warrants and equity options: Warrants are issued by private parties, typically the corporation on which a warrant is based, rather than a public options exchange. Warrants issued by the company itself are dilutive. When the warrant issued by the company is exercised, the company issues new shares of stock, so the number of outstanding shares increases. When a call option is exercised, the owner of the call option receives an existing share from an assigned call writer (except in the case of employee stock options, where new shares are created and issued by the company upon exercise). Unlike common stock shares outstanding, warrants do not have voting rights. Warrants are considered over the counter instruments, and thus are usually only traded by financial institutions with the capacity to settle and clear these types of transactions. A warrant's lifetime is measured in years (as long as 15 years), while options are typically measured in months. Even LEAPS (long-term equity anticipation securities), the longest stock options available, tend to expire in two or three years. Upon expiration, the warrants are worthless unless the price of the common stock is greater than the exercise price.
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Warrants are not standardized like exchange-listed options.

LEAPS:
In finance, LEAPS (an acronym for Long Term Equity Anticipation Security) are options of longer term until expiry than other, more common, options. LEAPS are available on approximately 2500 equities and 20 indexes. As with traditional short term options, LEAPS are available in two forms, calls and puts. Options were originally created with expiry cycles of 3, 6, and 9 months, with no option term lasting more than a year. Options of this form, for such terms, still constitute the vast majority of options activity. LEAPS were created relatively recently and typically extend for terms of 2 years out. Equity LEAPS always expire in January. For example, if today were November 2005, one could buy a Microsoft January call option that would expire in 2006, 2007, or 2008. (The further out the expiration date, the more expensive the option.) The latter two are LEAPS. When LEAPS were first introduced in 1990, they were derivative instruments solely for equities; however, more recently, equivalent instruments for indices have become available.

BASKET OPTIONS:
A basket option is an option with an underlying asset "basket" of securities, currencies or commodities. Basket options are a popular way to hedge portfolio risk. Meanwhile, using the basket option costs significantly less than buying an option on the individual components of the portfolio. Basket options often are used as a cost-effective way for portfolio managers to consolidate multicurrency exposures. This works because a basket option offers the unique characteristic of a strike price based on the weighted value of
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the basket of currencies, calculated in the buyer's base currency. The buyer chooses the maturity of the option, the foreign currency amounts for the basket and the aforementioned strike price.

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CASE STUDY: INTRODUCTION OF DERIVATIVES TRADING IN INDIA

ABSTRACT: The case discusses the introduction and growth of the derivatives market in India. It describes in detail the reasons that led to the introduction of derivatives trading in India and why it faced opposition by a section of industry analysts and media. The case then describes the issues that still remain to be addressed by the regulatory authorities to accelerate the long-term growth of the derivatives market. Finally, the case mentions a few steps taken by the concerned authorities in early 2004. ISSUES: Main objectives and reasons for the introduction of derivatives trading in India The factors that can accelerate/suppress the growth of the derivatives market in a country INTRODUCTION: The plan to introduce derivatives in India was initially mooted by the National Stock Exchange (NSE) in 1995. The main purpose of this plan was to encourage greater participation of foreign institutional investors (FIIs) in the Indian stock exchanges. Their involvement had been very low due to the absence of derivatives for hedging risk. However, there was no consensus of opinion on the issue among industry analysts and the media. The pros and cons of introducing derivatives trading were debated intensely. The lack of transparency and inadequate infrastructure of the Indian stock markets were cited as reasons to avoid derivatives trading. Derivatives were also considered risky for retail investors because of their poor knowledge about their operation. In spite of the opposition, the path for
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derivatives trading was cleared with the introduction of Securities Laws (Amendment) Bill in Parliament in 1998. BACKGROUND NOTE The initial steps to launch derivatives were taken in 1995 with the introduction of the Securities Laws (Amendment) Ordinance, 1995 that withdrew the prohibition on trading in options on securities in the Indian stock market. In November 1996, a 24-member committee was set up by the Securities Exchange Board of India (SEBI)6 under the chairmanship of LC Gupta to develop an appropriate regulatory framework for derivatives trading. The committee recommended that the regulatory framework applicable to the trading of securities would also govern the trading of derivatives. THE DEBATE AND THE RESULT Those who opposed the introduction of derivatives argued that these instruments would significantly increase speculation in the market. They said that derivatives could be used for speculation by investors by taking large price positions in the stock market while committing only a small amount of capital as margin. For instance, instead of an investor buying stocks worth Rs.1 million (mn), he could buy futures contracts on Rs.1 mn of stocks by investing a few thousand rupees as margin. Thus, trading in derivatives encouraged investors to speculate - taking on more risk while putting forward less investment. They were quick to point out some of the disasters of the past that had occurred due to the mismanagement of trading in derivatives (Refer Exhibit III)... UNRESOLVED ISSUES By January 2004, more than three and a half years of derivatives trading had been completed. However, according to several analysts and media reports, SEBI, NSE and BSE had still to resolve many issues so that the derivatives market could realize its full potential.
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For instance, the issue of imposing taxes on income arising from derivatives trading still remained to be sorted out. The Income Tax Act of India did not have any specific provision regarding taxability of derivatives income. The tax authorities were still undecided on the issue, and in the absence of any provision, derivatives transactions were held on par with transactions of a speculative nature (in particular, the index futures/options which were essentially cash settled, were treated this way). Therefore, the loss, if any, arising from derivatives transactions, was treated as a speculative loss and was eligible to be set off only against speculative income upto a maximum period of eight years. NEW INITIATIVES As of early 2004, derivatives trading in India had been restricted to a limited range of products including index futures, index options and individual stock futures and options limited to certain select stocks. Analysts felt that index futures/options could be extended to other popular indices such as the CNX Nifty Junior . Similarly, stock futures/options could be extended to all active securities. Efforts were also on to encourage participation from domestic institutional investors. SEBI had authorized mutual funds to trade in derivatives, subject to appropriate disclosures. A broader product rollout for institutional investors was also on the cards. Steps were taken to strengthen the financial infrastructure. These included developing adequate trading mechanisms and systems, and establishing proper clearing and settlement procedures. Regulations hampering the growth of derivative markets were being reviewed.

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CONCLUSION:
Financial derivative products have served and will continue to serve as excellent investment avenues. Their growth and evolution indicate their strong foundation. Although the risk involved in trading derivative products is among the highest of all the financial instruments, they provide healthy returns if used effectively. Financial derivatives have helped increase and maintain the volume of transactions in the security markets. They serve as excellent hedging devices and facilitate foreign portfolio investment. This proves to be a great benefit for emerging markets. Thus, financial derivatives products are among the top asset classes for investments. The financial derivative markets have tremendous scope in the near future, and further advancement in technology and communication would minimize the transaction costs as well as transaction time. Financial derivatives are, hence, the most recommended investment instruments for an efficient and optimal investment portfolio.

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RECOMMENDATIONS AND SUGGESTIONS:

Based on the information collected for this project and the observations I made while it was underway, I would like to make the following suggestions: 1. The concept of Financial Derivatives is a relatively new concept in India; moreover, Indian investors do not possess adequate information so as to make informed and profitable investments in Financial Derivatives. Thus, initiatives to educate investors such as the NSEs Investor Education Program and SEBIs initiatives towards investor protection should be encouraged and spread nationwide. 2. The average Securities Transaction Tax (STT) paid on an amount of Rupees 1 Crore is Rs.1500. Inorder to make financial derivatives a more lucrative investment option, the level of taxes charged on derivative transactions should be revised downwards. 3. Greater transparency and Know Your Client (KYC) norms have taken markets a long way, therefore, such measures should be continued and amended if required, so as to restore the faith of investors in the financial markets.

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BIBLIOGRAPHY:
REFERENCE BOOKSTITLE Derivatives and Alternative Investments Derivatives Markets (Dealers module) Financial Derivatives Bishnupriya Mishra, Sathya Swaroop Debashish Excel Publications NSEs NCFM AUTHOR CFA Institute (U.S.A.) PUBLISHING HOUSE Pearson Custom Publishing -

WEBSITES:
1. www.nseindia.com 2. www.investopedia.com 3. www.rediffmoney.com 4. www.google.com

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