DERIVATIVES - DEFINITION

A derivative is a financial instrument - or more simply, an agreement between two

people or two parties - that has a value determined by the price of something else (called
the underlying).It is a financial contract with a value linked to the expected future price
movements of the asset it is linked to - such as a share or a currency. There are many
kinds of derivatives, with the most notable being swaps, futures, and options. However,
since a derivative can be placed on any sort of security, the scope of all derivatives
possible is nearly endless. Thus, the real definition of a derivative is an agreement
between two parties that is contingent on a future outcome of the underlying.

Referring to derivatives as stand-alone assets would be a misconception, since a

derivative is incapable of having value of its own. However, some more commonplace
derivatives, such as swaps, futures, and options, (which have a theoretical face value that
can be calculated using formulas, such as Black-Scholes), have been traded on markets
before their expiration date as if they were assets. Amongst the earlier derivatives, rice
futures have been traded on the Dojima Rice Exchange since 1710.

Categorization
Derivatives are usually broadly categorized by the:

• relationship between the underlying and the derivative (e.g., forward, option,
swap)
• type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest
rate derivatives, commodity derivatives or credit derivatives)
• market in which they trade (e.g., exchange-traded or over-the-counter)
• pay-off profile (Some derivatives have non-linear payoff diagrams due to
embedded optionality)

Another arbitrary distinction is between:

• vanilla derivatives (simple and more common) and

• exotic derivatives (more complicated and specialized)

There is no definitive rule for distinguishing one from the other, so the distinction is
mostly a matter of custom.
 Uses
Derivatives are used by investors to

• provide leverage or gearing, such that a small movement in the underlying value
can cause a large difference in the value of the derivative
• speculate and to make a profit if the value of the underlying asset moves the way
they expect (e.g., moves in a given direction, stays in or out of a specified range,
reaches a certain level)
• hedge or mitigate risk in the underlying, by entering into a derivative contract
whose value moves in the opposite direction to their underlying position and
cancels part or all of it out
• obtain exposure to underlying where it is not possible to trade in the underlying
(e.g., weather derivatives)
• create option ability where the value of the derivative is linked to a specific
condition or event (e.g., the underlying reaching a specific price level)

1. Hedging
Hedging is a technique that attempts to reduce risk. In this respect, derivatives can be
considered a form of insurance.

Derivatives allow risk about the price of the underlying asset to be transferred from one
party to another. For example, a wheat farmer and a miller could sign a futures contract to
exchange a specified amount of cash for a specified amount of wheat in the future. Both
parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and
for the miller, the availability of wheat. However, there is still the risk that no wheat will
be available because of events unspecified by the contract, like the weather, or that one
party will renege on the contract. Although a third party, called a clearing house, insures
a futures contract, not all derivatives are insured against counter-party risk.

From another perspective, the farmer and the miller both reduce a risk and acquire a risk
when they sign the futures contract: The farmer reduces the risk that the price of wheat
will fall below the price specified in the contract and acquires the risk that the price of
wheat will rise above the price specified in the contract (thereby losing additional income
that he could have earned). The miller, on the other hand, acquires the risk that the price
of wheat will fall below the price specified in the contract (thereby paying more in the
future than he otherwise would) and reduces the risk that the price of wheat will rise
above the price specified in the contract. In this sense, one party is the insurer (risk taker)
for one type of risk, and the counter-party is the insurer (risk taker) for another type of
risk.
Hedging also occurs when an individual or institution buys an asset (like a commodity, a
bond that has coupon payments, a stock that pays dividends, and so on) and sells it using
a futures contract. The individual or institution has access to the asset for a specified
amount of time, and then can sell it in the future at a specified price according to the
futures contract. Of course, this allows the individual or institution the benefit of holding
the asset while reducing the risk that the future selling price will deviate unexpectedly
from the market's current assessment of the future value of the asset.

2. Speculation and arbitrage

Derivatives can be used to acquire risk, rather than to insure or hedge against risk. Thus,
some individuals and institutions will enter into a derivative contract to speculate on the
value of the underlying asset, betting that the party seeking insurance will be wrong about
the future value of the underlying asset. Speculators will want to be able to buy an asset
in the future at a low price according to a derivative contract when the future market price
is high, or to sell an asset in the future at a high price according to a derivative contract
when the future market price is low.

Individuals and institutions may also look for arbitrage opportunities, as when the current
buying price of an asset falls below the price specified in a futures contract to sell the
asset.

Speculative trading in derivatives gained a great deal of notoriety in 1995 when Nick
Lesson, a trader at Barings Bank, made poor and unauthorized investments in futures
contracts. Through a combination of poor judgment, lack of oversight by the bank's
management and by regulators, and unfortunate events like the Kobe earthquake, Leeson
incurred a $1.3 billion loss that bankrupted the centuries-old institution.

Types of derivatives

1. FUTURES
a futures contract is a standardized contract between two parties to buy or sell a
specified asset of standardized quantity and quality at a specified future date at a price
agreed today (the futures price). The contracts are traded on a futures exchange. Futures
contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still
securities, however, though they are a type of derivative contract. The party agreeing to
buy the underlying asset in the future assumes a long position, and the party agreeing to
sell the asset in the future assumes a short position.

The price is determined by the instantaneous equilibrium between the forces of supply
and demand among competing buy and sell orders on the exchange at the time of the
purchase or sale of the contract.
In many cases, the underlying asset to a futures contract may not be traditional
"commodities" at all – that is, for financial futures, the underlying asset or item can be
currencies, securities or financial instruments and intangible assets or referenced items
such as stock indexes and interest rates.

The future date is called the delivery date or final settlement date. The official price of
the futures contract at the end of a day's trading session on the exchange is called the
settlement price for that day of business on the exchange.

A closely related contract is a forward contract; they differ in certain respects. Future
contracts are very similar to forward contracts, except they are exchange-traded and
defined on standardized assets. Unlike forwards, futures typically have interim partial
settlements or "true-ups" in margin requirements. For typical forwards, the net gain or
loss accrued over the life of the contract is realized on the delivery date.

A futures contract gives the holder the obligation to make or take delivery under the
terms of the contract, whereas an option grants the buyer the right, but not the obligation,
to establish a position previously held by the seller of the option. In other words, the
owner of an options contract may exercise the contract, but both parties of a "futures
contract" must fulfill the contract on the settlement date. The seller delivers the
underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is
transferred from the futures trader who sustained a loss to the one who made a profit. To
exit the commitment prior to the settlement date, the holder of a futures position has to
offset his/her position by either selling a long position or buying back (covering) a short
position, effectively closing out the futures position and its contract obligations.

Futures contracts, or simply futures, (but not future or future contract) are exchange-
traded derivatives. The exchange's clearing house acts as counterparty on all contracts,
sets margin requirements, and crucially also provides a mechanism for settlement

Settlement - physical versus cash-settled

futures
Settlement is the act of consummating the contract, and can be done in one of two ways,
as specified per type of futures contract:

• Physical delivery - the amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the
buyers of the contract. Physical delivery is common with commodities and bonds.
In practice, it occurs only on a minority of contracts
• Cash settlement - a cash payment is made based on the underlying reference rate,
such as a short term interest rate index such as Euribor, or the closing value of a
stock market index. The parties settle by paying/receiving the loss/gain related to
the contract in cash when the contract expires. Cash settled futures are those that,
as a practical matter, could not be settled by delivery of the referenced item - i.e.
 how would one deliver an index? A futures contract might also opt to settle
against an index based on trade in a related spot market. Ice Brent futures use this
method.

Who trades futures?

Futures traders are traditionally placed in one of two groups: hedgers, who have an
interest in the underlying asset (which could include an intangible such as an index or
interest rate) and are seeking to hedge out the risk of price changes; and speculators, who
seek to make a profit by predicting market moves and opening a derivative contract
related to the asset "on paper", while they have no practical use for or intent to actually
take or make delivery of the underlying asset. In other words, the investor is seeking
exposure to the asset in a long futures or the opposite effect via a short futures contract.

Hedgers typically include producers and consumers of a commodity or the owner of an

asset or assets subject to certain influences such as an interest rate.

For example, in traditional commodity markets, farmers often sell futures contracts for
the crops and livestock they produce to guarantee a certain price, making it easier for
them to plan. Similarly, livestock producers often purchase futures to cover their feed
costs, so that they can plan on a fixed cost for feed. In modern (financial) markets,
"producers" of interest rate swaps or equity derivative products will use financial futures
or equity index futures to reduce or remove the risk on the swap.

Futures versus forwards

While futures and forward contracts are both contracts to deliver an asset on a future date
at a prearranged price, they are different in two main respects:

• Futures are exchange-traded, while forwards are traded over-the-counter.

Thus futures are standardized and face an exchange, while forwards are
customized and face a non-exchange counterparty.

• Futures are margined, while forwards are not.

Thus futures have significantly less credit risk, and have different funding.

Exchange versus OTC

Futures are always traded on an exchange, whereas forwards always trade over-the-
counter, or can simply be a signed contract between two parties.

Thus:
 • Futures are highly standardized, being exchange-traded, whereas forwards can be
unique, being over-the-counter.
• In the case of physical delivery, the forward contract specifies to whom to make
the delivery. The counterparty for delivery on a futures contract is chosen by the
clearing house.

Forward / Future Contracts

Features Forward Future Contract

Contract

Operational Not traded on Traded on exchange

Mechanism exchange

Contract Differs from Contracts are standardised contracts.

Specifications trade to trade.

Counterparty Exists Exists, but assumed by Clearing Corporation/ house.

Risk

Liquidation Poor Liquidity Very high Liquidity as contracts are standardised contracts.
Profile as contracts
are tailor maid
contracts.

Price Discovery Poor; as Better; as fragmented markets are brought to the common
markets are platform.
fragmented.

2. OPTIONS
An option is a derivative financial instrument that establishes a contract between two
parties concerning the buying or selling of an asset at a reference price during a specified
time frame. During this time frame, the buyer of the option gains the right, but not the
obligation, to engage in some specific transaction on the asset, while the seller incurs the
obligation to fulfill the transaction if so requested by the buyer. The price of an option
derives from the value of an underlying asset (commonly a stock, a bond, a currency or a
futures contract) plus a premium based on the time remaining until the expiration of the
option. Other types of options exist, and options can in principle be created for any type
of valuable asset.

An option which conveys the right to buy something is called a call; an option which
conveys the right to sell is called a put. The price specified at which the underlying may
be traded is called the strike price or exercise price. The process of activating an option
and thereby trading the underlying at the agreed-upon price is referred to as exercising it.
Most options have an expiration date. If the option is not exercised by the expiration date,
it becomes void and worthless.

In return for granting the option, called writing the option, the originator of the option
collects a payment, the premium, from the buyer. The writer of an option must make
good on delivering (or receiving) the underlying asset or its cash equivalent, if the option
is exercised.

An option can usually be sold by its original buyer to another party. Many options are
created in standardized form and traded on an anonymous options exchange among the
general public, while other over-the-counter options are customized to the desires of the
buyer on an ad hoc basis, usually by an investment bank.

Contract specifications
Every financial option is a contract between the two counterparties with the terms of the
option specified in a term sheet. Option contracts may be quite complicated; however, at
minimum, they usually contain the following specifications.

• whether the option holder has the right to buy (a call option) or the right to sell (a
put option)
• the quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B
stock)
• the strike price, also known as the exercise price, which is the price at which the
underlying transaction will occur upon exercise
• the expiration date, or expiry, which is the last date the option can be exercised
• the settlement terms, for instance whether the writer must deliver the actual asset
on exercise, or may simply tender the equivalent cash amount
• the terms by which the option is quoted in the market to convert the quoted price
into the actual premium-–the total amount paid by the holder to the writer of the
option.

Types of options
The primary types of financial options are:

• Exchange traded options (also called "listed options") are a class of exchange-
traded derivatives. Exchange traded options have standardized contracts, and are
settled through a clearing house with fulfillment guaranteed by the credit of the
exchange. Since the contracts are standardized, accurate pricing models are often
available. Exchange traded options include.
o stock options,
o commodity options,
o bond options and other interest rate options
o stock market index options or, simply, index options and
o options on futures contracts
• Over-the-counter options (OTC options, also called "dealer options") are traded
between two private parties, and are not listed on an exchange. The terms of an
OTC option are unrestricted and may be individually tailored to meet any
business need. In general, at least one of the counterparties to an OTC option is a
well-capitalized institution. Option types commonly traded over the counter
include:

1. interest rate options

2. currency cross rate options, and
3. options on swaps

Other option types

Another important class of options, particularly in the U.S., are employee stock options,
which are awarded by a company to their employees as a form of incentive
compensation. Other types of options exist in many financial contracts, for example real
estate options are often used to assemble large parcels of land, and prepayment options
are usually included in mortgage loans. However, many of the valuation and risk
management principles apply across all financial options.

Option styles
Naming conventions are used to help identify properties common to many different types
of options. These include:

• European option - an option that may only be exercised on expiration.

• American option - an option that may be exercised on any trading day on or
before expiry.
• Bermudan option - an option that may be exercised only on specified dates on or
before expiration.
• Barrier option - any option with the general characteristic that the underlying
security's price must pass a certain level or "barrier" before it can be exercised
 • Exotic option - any of a broad category of options that may include complex
financial structures.
• Vanilla option - any option that is not exotic.

Valuation models
The value of an option can be estimated using a variety of quantitative techniques based
on the concept of risk neutral pricing and using stochastic calculus. The most basic model
is the Black-Scholes model. More sophisticated models are used to model the volatility
smile. These models are implemented using a variety of numerical techniques. In general,
standard option valuation models depend on the following factors:

• The current market price of the underlying security,

• the strike price of the option, particularly in relation to the current market price of
the underlier (in the money vs. out of the money),
• the cost of holding a position in the underlying security, including interest and
dividends,
• the time to expiration together with any restrictions on when exercise may occur,
and
• an estimate of the future volatility of the underlying security's price over the life
of the option.

More advanced models can require additional factors, such as an estimate of how
volatility changes over time and for various underlying price levels, or the dynamics of
stochastic interest rates.

The following are some of the principal valuation techniques used in practice to evaluate
option contracts.

1. Black-Scholes

In the early 1970s, Fischer Black and Myron Scholes made a major breakthrough by
deriving a differential equation that must be satisfied by the price of any derivative
dependent on a non-dividend-paying stock. By employing the technique of constructing a
risk neutral portfolio that replicates the returns of holding an option, Black and Scholes
produced a closed-form solution for a European option's theoretical price. At the same
time, the model generates hedge parameters necessary for effective risk management of
option holdings. While the ideas behind the Black-Scholes model were ground-breaking
and eventually led to Scholes and Merton receiving the Swedish Central Bank's
associated Prize for Achievement in Economics (a.k.a., the Nobel Prize in Economics),
the application of the model in actual options trading is clumsy because of the
assumptions of continuous (or no) dividend payment, constant volatility, and a constant
interest rate. Nevertheless, the Black-Scholes model is still one of the most important
methods and foundations for the existing financial market in which the result is within the
reasonable range.
2. Stochastic volatility models

Since the market crash of 1987, it has been observed that market implied volatility for
options of lower strike prices are typically higher than for higher strike prices, suggesting
that volatility is stochastic, varying both for time and for the price level of the underlying
security. Stochastic volatility models have been developed including one developed by
S.L. Heston. One principal advantage of the Heston model is that it can be solved in
closed-form, while other stochastic volatility models require complex numerical methods.

Trading
The most common way to trade options is via standardized options contracts that are
listed by various futures and options exchanges. Listings and prices are tracked and can
be looked up by ticker symbol. By publishing continuous, live markets for option prices,
an exchange enables independent parties to engage in price discovery and execute
transactions. As an intermediary to both sides of the transaction, the benefits the
exchange provides to the transaction include:

• fulfillment of the contract is backed by the credit of the exchange, which typically
has the highest rating (AAA),
• counterparties remain anonymous,
• enforcement of market regulation to ensure fairness and transparency, and
• maintenance of orderly markets, especially during fast trading conditions.

Over-the-counter options contracts are not traded on exchanges, but instead between two
independent parties. Ordinarily, at least one of the counterparties is a well-capitalized
institution. By avoiding an exchange, users of OTC options can narrowly tailor the terms
of the option contract to suit individual business requirements. In addition, OTC option
transactions generally do not need to be advertised to the market and face little or no
regulatory requirements. However, OTC counterparties must establish credit lines with
each other, and conform to each others clearing and settlement procedures.

With few exceptions, there are no secondary markets for employee stock options. These
must either be exercised by the original grantee or allowed to expire worthless.

3. SWAPS
A swap is a derivative in which counterparties exchange certain benefits of one party's
financial instrument for those of the other party's financial instrument. The benefits in
question depend on the type of financial instruments involved. For example, in the case
of a swap involving two bonds, the benefits in question can be the periodic interest (or
coupon) payments associated with the bonds. Specifically, the two counterparties agree to
exchange one stream of cash flows against another stream. These streams are called the
legs of the swap. The swap agreement defines the dates when the cash flows are to be
paid and the way they are calculated. Usually at the time when the contract is initiated at
least one of these series of cash flows is determined by a random or uncertain variable
such as an interest rate, foreign exchange rate, equity price or commodity price.

The cash flows are calculated over a notional principal amount, which is usually not
exchanged between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on
changes in the expected direction of underlying prices.

Types of swaps
The five generic types of swaps, in order of their quantitative importance, are: interest
rate swaps, currency swaps, credit swaps, commodity swaps and equity swaps. There are
also many other types.

1. Interest rate swaps

A is currently paying floating, but wants to pay fixed. B is

currently paying fixed but wants to pay floating. By entering
into an interest rate swap, the net result is that each party can
'swap' their existing obligation for their desired obligation.
Normally the parties do not swap payments directly, but
rather, each sets up a separate swap with a financial
intermediary such as a bank. In return for matching the two
parties together, the bank takes a spread from the swap
payments.

The most common type of swap is a “plain Vanilla” interest

rate swap. It is the exchange of a fixed rate loan to a floating
rate loan. The life of the swap can range from 2 years to over 15 years. The reason for
this exchange is to take benefit from comparative advantage. Some companies may have
comparative advantage in fixed rate markets while other companies have a comparative
advantage in floating rate markets. When companies want to borrow they look for cheap
borrowing i.e. from the market where they have comparative advantage. However this
may lead to a company borrowing fixed when it wants floating or borrowing floating
when it wants fixed. This is where a swap comes in. A swap has the effect of
transforming a fixed rate loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a variable
interest rate of LIBOR +70 basis points. Party A in return makes periodic interest
payments based on a fixed rate of 8.65%. The payments are calculated over the notional
amount. The first rate is called variable, because it is reset at the beginning of each
interest calculation period to the then current reference rate, such as LIBOR. In reality,
the actual rate received by A and B is slightly lower due to a bank taking a spread.

Currency swaps

A currency swap involves exchanging principal and fixed rate interest payments on a
loan in one currency for principal and fixed rate interest payments on an equal loan in
another currency. Just like interest rate swaps; the currency swaps also are motivated by
comparative advantage.

3. Commodity swaps

A commodity swap is an agreement whereby a floating (or market or spot) price is

exchanged for a fixed price over a specified period. The vast majority of commodity
swaps involve crude oil.

4. Equity Swap

An equity swap is a special type of total return swap, where the underlying asset is a
stock, a basket of stocks, or a stock index. Compared to actually owning the stock, in this
case you do not have to pay anything up front, but you do not have any voting or other
rights that stock holders do have.

5. Credit default swaps

A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a
series of payments to the seller and, in exchange, receives a payoff if a credit instrument -
typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event
that triggers the payoff can be a company undergoing restructuring, bankruptcy or even
just having its credit rating downgraded. CDS contracts have been compared with
insurance, because the buyer pays a premium and, in return, receives a sum of money if
one of the events specified in the contract occur. Unlike an actual insurance contract the
buyer is allowed to profit from the contract and may also cover an asset to which the
buyer has no direct exposure.

Other variations
There are myriad different variations on the vanilla swap structure, which are limited
only by the imagination of financial engineers and the desire of corporate treasurers and
fund managers for exotic structures.

• A total return swap is a swap in which party A pays the total return of an asset,
and party B makes periodic interest payments. The total return is the capital gain
or loss, plus any interest or dividend payments. Note that if the total return is
 negative, then party A receives this amount from party B. The parties have
exposure to the return of the underlying stock or index, without having to hold the
underlying assets. The profit or loss of party B is the same for him as actually
owning the underlying asset.
• An option on a swap is called a swaption. These provide one party with the right
but not the obligation at a future time to enter into a swap.
• A variance swap is an over-the-counter instrument that allows one to speculate
on or hedge risks associated with the magnitude of movement, a CMS, is a swap
that allows the purchaser to fix the duration of received flows on a swap.
• An Amortising swap is usually an interest rate swap in which the notional
principal for the interest payments declines during the life of the swap, perhaps at
a rate tied to the prepayment of a mortgage or to an interest rate benchmark such
as the LIBOR.

4. CREDIT DERIVATIVES
A credit derivative is a securitized derivative whose value is derived from the credit risk
on an underlying bond, loan or any other financial asset. In this way, the credit risk is on
an entity other than the counterparties to the transaction itself. This entity is known as the
reference entity and may be a corporate, a sovereign or any other form of legal entity
which has incurred debt. Credit derivatives are bilateral contracts between a buyer and
seller under which the seller sells protection against the credit risk of the reference entity.

Stated in plain language, a credit derivative is a wager, and the reference entity is the
thing being wagered on. Similar to placing a bet at the racetrack, where the person
placing the bet does not own the horse or the track or have anything else to do with the
race, the person buying the credit derivative doesn't necessarily own the bond (the
reference entity) that is the object of the wager. He or she simply believes that there is a
good chance that the bond or collateralized debt obligation (CDO) in question will
default (go to zero value). Originally conceived as a kind of insurance policy for owners
of bonds or CDO's, it evolved into a freestanding investment strategy. The cost might be
as low as 1% per year. If the buyer of the derivative believes the underlying bond will go
bust within a year (usually an extremely unlikely event) the buyer stands to reap a 100
fold profit. A small handful of investors anticipated the credit crunch of 2007/8 and made
billions placing "bets" via this method.

The parties will select which credit events apply to a transaction and these usually consist
of one or more of the following:

• bankruptcy (the risk that the reference entity will become bankrupt)
• failure to pay (the risk that the reference entity will default on one of its
obligations such as a bond or loan)
• obligation default (the risk that the reference entity will default on any of its
obligations)
 • obligation acceleration (the risk that an obligation of the reference entity will be
accelerated e.g. a bond will be declared immediately due and payable following a
default)
• repudiation/moratorium (the risk that the reference entity or a government will
declare a moratorium over the reference entity's obligations)
• Restructuring (the risk that obligations of the reference entity will be
restructured)...

Where credit protection is bought and sold between bilateral counterparties, this is known
as an unfunded credit derivative. If the credit derivative is entered into by a financial
institution or a special purpose vehicle (SPV) and payments under the credit derivative
are funded using securitization techniques, such that a debt obligation is issued by the
financial institution or SPV to support these obligations, this is known as a funded credit
derivative.

This synthetic securitization process has become increasingly popular over the last
decade, with the simple versions of these structures being known as synthetic CDOs;
credit linked notes; single tranche CDOs, to name a few. In funded credit derivatives,
transactions are often rated by rating agencies, which allows investors to take different
slices of credit risk according to their risk appetite.

Types
Credit derivatives are fundamentally divided into two categories: funded credit
derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral
contract between two counterparties, where each party is responsible for making its
payments under the contract (i.e. payments of premiums and any cash or physical
settlement amount) itself without recourse to other assets. A funded credit derivative
involves the protection seller (the party that assumes the credit risk) making an initial
payment that is used to settle any potential credit events. The advantage of this to the
protection buyer is that it is not exposed to the credit risk of the protection seller[6].

Unfunded credit derivative products include the following products:

• Credit default swap (CDS)

• Total return swap
• Constant maturity credit default swap (CMCDS)
• First to Default Credit Default Swap
• Portfolio Credit Default Swap
• Secured Loan Credit Default Swap
• Credit Default Swap on Asset Backed Securities
• Credit default swaption
• Recovery lock transaction
• Credit Spread Option
• CDS index products
Funded credit derivative products include the following products:

• Credit linked note (CLN)

• Synthetic Collateralized Debt Obligation (CDO)
• Constant Proportion Debt Obligation (CPDO)
• Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

Key unfunded credit derivative products

1. Credit default swap

The credit default swap or CDS has become the cornerstone product of the credit
derivatives market. This product represents over thirty percent of the credit derivatives
market[3].

A credit default swap, in its simplest form (the unfunded single name credit default swap)
is a bilateral contract between a protection buyer and a protection seller. The credit
default swap will reference the creditworthiness of a third party called a reference entity:
this will usually be a corporate or sovereign. The credit default swap will relate to the
specified debt obligations of the reference entity: perhaps its bonds and loans, which
fulfill certain pre-agreed characteristics. The protection buyer will pay a periodic fee to
the protection seller in return for a contingent payment by the seller upon a credit event
affecting the obligations of the reference entity specified in the transaction.

The relevant credit events specified in a transaction will usually be selected from
amongst the following:

• The bankruptcy of the reference entity;

• Its failure to pay in relation to a covered obligation;
• It defaulting on an obligation or that obligation being accelerated;
• It agreeing to restructure a covered obligation or a repudiation or moratorium
being declared over any covered obligation.

If any of these events occur and the protection buyer serves a credit event notice on the
protection seller detailing the credit event as well as (usually) providing some publicly
available information validating this claim, then the transaction will settle.

This means that, in the case of a physically settled transaction, the protection buyer can
deliver an amount of the reference entity's defaulted obligations to the protection seller, in
return for their full face value (notwithstanding that they are now worth far less). In the
case of a cash settled transaction, a relevant obligation of the reference entity will be
valued and the protection seller will pay the protection buyer the full face value of the
reference obligation less its current value (i.e. compensating the protection buyer for the
decline in the obligation's creditworthiness).
Since the reference entity is not a party to agreement between the protection buyer and
seller, the seller of protection has no inherent recourse to the reference entity in the event
of default and no right to sue the reference entity for recovery. However, if the
transaction were to be physically settled the seller of protection could derive a right to
take action against the reference entity on the basis of the loan or securities acquired
during the settlement process.

2. Total return swap

A total return swap (also known as Total Rate of Return Swap) is a contract between two
counterparties whereby they swap periodic payments for the period of the contract.
Typically, one party receives the total return (interest payments plus any capital gains or
losses for the payment period) from a specified reference asset, while the other receives a
specified fixed or floating cash flow that is not related to the creditworthiness of the
reference asset, as with a vanilla Interest rate swap. The payments are based upon the
same notional amount. The reference asset may be any asset, index or basket of assets.

The TRS is simply a mechanism that allows one party to derive the economic benefit of
owning an asset without use of the balance sheet, and which allows the other to
effectively "buy protection" against loss in value due to ownership of a credit asset.

The essential difference between a total return swap and a credit default swap is that the
credit default swap provides protection against specific credit events. The total return
swap protects against the loss of value irrespective of cause, whether default, widening of
credit spreads or anything else i.e. it isolates both credit risk and market risk.

3. Collateralized debt obligations (CDO)

Collateralized debt obligations or CDOs are a form of credit derivative offering exposure
to a large number of companies in a single instrument. This exposure is sold in slices of
varying risk or subordination - each slice is known as a tranche.

In a cashflow CDO, the underlying credit risks are bonds or loans held by the issuer.
Alternatively in a synthetic CDO, the exposure to each underlying company is a credit
default swap. A synthetic CDO is also referred to as CSO.

Other more complicated CDOs have been developed where each underlying credit risk is
itself a CDO tranche. These CDOs are commonly known as CDOs-squared.

REGULATORY FRAMEWORK
L C Gupta Committee
• Appointed on 18th November 1996
• To develop appropriate regulatory framework for derivatives trading
• Focus on financial derivatives and in particular, equity derivatives
 • Submitted its report in March 1998
• Approved by SEBI in May and circulated in June 1998

Executive Summary
• Both Hedgers and speculators required for efficient markets
• Equity derivatives could begin with index futures
• Development in phased manner
• Index Options and Options on Shares to follow
• Main emphasis on exchange-level regulation
• Stricter governance by SEBI compared to Cash segment
• Stringent entry requirements
• Mutual funds should be allowed to hedge
• Derivatives Cell, Advisory Committee and Economic Research Wing to be set up
within SEBI

Report Summary
• Substantive report
• Suggestive bye-laws for regulation and control of trading and settlement of
derivative contracts

Legal Amendments
• Securities Contract Regulation Act
• Derivatives contract declared as a ‘security’ in Dec 1999
• Notification in June 1969 under section 16 of SCRA banning forward trading
revoked in March 2000

Survey Results
Committee conducted a survey amongst:

Brokers 67
Mutual funds 10
Banks/FIs 14
FIIs 12
Merchant banks 9

Total 112

• Wide recognition of need for derivatives

• Equity, Interest Rate and Currency derivative products
• Stock Index Futures most preferred
• Stock Index Options second preference
• Options on individual stocks third preference
• 70% respondents indicated hedging as their activity
• 39% speculation/dealing
• 64% broking
 • 36% option writing
• Multiple responses were permitted in the questionnaire
• 3 month Futures were most preferred
• American Options were preferred over European Options
• 33% expected fast growth in derivatives segment
• 41% expected moderate growth
• 16% expected slow growth

Derivatives Exchanges
• Existing exchanges may start Derivative segments or separate exchanges
may be set up
• On-line screen trading with disaster recovery site
• Per half hour capacity should be 4-5 times the anticipated peak load
• Independent clearing Corporation/House
• Online surveillance capability
• Real-time information dissemination over at least 2 networks
• Minimum 50 members
• Separate membership for derivative segment - no automatic membership
• Separate governing council for derivatives segment
• Common Governing Council and Governing Board members not allowed
• Percentage of broker-members in the council to be prescribed by SEBI
• Chairman cannot carry on broking/dealing business during his term
• Arbitration and investor grievances cells in 4 regions
• Adequate inspection capability

Derivatives Markets
Derivatives markets broadly can be classified into two categories, those that
are traded on the exchange and the those traded one to one or ‘over the
counter’. They are hence known as
• Exchange Traded Derivatives
• OTC Derivatives (Over The Counter)
OTC Equity Derivatives
• Traditionally equity derivatives have a long history in India in the OTC
market.
• Options of various kinds (called Teji and Mandi and Fatak) in un-
organized markets were traded as early as 1900 in Mumbai
• The SCRA however banned all kind of options in 1956.
Derivative Markets today
• The prohibition on options in SCRA was removed in 1995. Foreign
currency options in currency pairs other than Rupee were the first options
permitted by RBI.
 • The Reserve Bank of India has permitted options, interest rate swaps,
currency swaps and other risk reductions OTC derivative products.
• Besides the Forward market in currencies has been a vibrant market in
India for several decades.
• In addition the Forward Markets Commission has allowed the setting up
of commodities futures exchanges. Today we have 18 commodities exchanges
most of which trade futures.
e.g. The Indian Pepper and Spice Traders Association (IPSTA) and the Coffee
Owners Futures Exchange of India (COFEI).
• In 2000 an amendment to the SCRA expanded the definition of securities
to included Derivatives thereby enabling stock exchanges to trade derivative
products.
• The year 2000 will herald the introduction of exchange traded equity
derivatives in India for the first time.
Equity Derivatives Exchanges in India
• In the equity markets both the National Stock Exchange of India Ltd.
(NSE) and The Stock Exchange, Mumbai (BSE) have applied to SEBI for
setting up their derivatives segments.
• The exchanges are expected to start trading in Stock Index futures by mid-
May 2000.

BSE's and NSE’s plans

• Both the exchanges have set-up an in-house segment instead of setting up
a separate exchange for derivatives.
• BSE’s Derivatives Segment, will start with Sensex futures as it’s first
product.
• NSE’s Futures & Options Segment will be launched with Nifty futures as
the first product.

Development of Derivative Markets in

India

Derivatives markets have been in existence in India in some form or other for a long
time. In the area of commodities, the Bombay Cotton Trade Association started futures
trading in 1875 and, by the early 1900s India had one of the world’s largest futures
industry. In 1952 the government banned cash settlement and options trading and
derivatives trading shifted to informal forwards markets. In recent years, government
policy has changed, allowing for an increased role for market-based pricing and less
suspicion of derivatives trading. The ban on futures trading of many commodities was
lifted starting in the early 2000s, and national electronic commodity exchanges were
created.
In the equity markets, a system of trading called “badla” involving some elements of
forwards trading had been in existence for decades.6 However, the system led to a number
of undesirable practices and it was prohibited off and on till the Securities and
Exchange Board of India (SEBI) banned it for good in 2001. A series of reforms of the
stock market between 1993 and 1996 paved the way for the development of exchange-
traded equity derivatives markets in India. In 1993, the government created the NSE in
collaboration with state-owned financial institutions. NSE improved the efficiency and
transparency of the stock markets by offering a fully automated screen-based trading
system and real-time price dissemination. In 1995, a prohibition on trading options was
lifted. In 1996, the NSE sent a proposal to SEBI for listing exchange-traded derivatives.
The report of the L. C. Gupta Committee, set up by SEBI, recommended a phased
introduction of derivative products, and bi-level regulation (i.e., self-regulation by
exchanges with SEBI providing a supervisory and advisory role). Another report, by the
J. R. Varma Committee in 1998, worked out various operational details such as the
margining systems. In 1999, the Securities Contracts (Regulation) Act of 1956, or
SC(R)A, was amended so that derivatives could be declared “securities.” This allowed
the regulatory framework for trading securities to be extended to derivatives. The Act
considers derivatives to be legal and valid, but only if they are traded on exchanges.
Finally, a 30-year ban on forward trading was also lifted in 1999.
The economic liberalization of the early nineties facilitated the introduction of derivatives
based on interest rates and foreign exchange. A system of market-determined exchange
rates was adopted by India in March 1993. In August 1994, the rupee was made fully
convertible on current account. These reforms allowed increased integration between
domestic and international markets, and created a need to manage currency risk. Figure 1
shows how the volatility of the exchange rate between the Indian Rupee and the U.S.
dollar has increased since 1991.7 The easing of various restrictions on the free movement
of interest rates resulted in the need to manage interest rate risk.