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1/7/2019 MS 224 Financial Derivatives 1

Introduction
 Literal meaning of derivative is that something which
is derived. Now question arises as to what is derived?
From what it is derived? Simple one line answer is that
value/price is derived from any underlying asset.
 The term ‘derivative’ indicates that it has no
independent value, i.e., its value is entirely derived
from the value of the underlying asset. The underlying
asset can be securities, commodities, bullion,
currency, livestock or anything else.
 Financial Derivative is defined as a contract which
derives its value from the prices, or index of prices of
underlying securities.

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Contd…
 The term financial derivative denotes a variety of financial
instruments including stocks, bonds, treasury bills,
interest rate, foreign currencies and other hybrid securities.
Financial derivatives include futures, forwards, options,
swaps, etc.
 Futures contracts are the most important form of
derivatives, which are in existence long before the term
‘derivative’ was coined. Financial derivatives can also be
derived from a combination of cash market instruments or
other financial derivative instruments.
 In fact, most of the financial derivatives are not new
instruments rather they are merely combinations of older
generation derivatives and/or standard cash market
instruments.
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Features of Financial Derivatives
 It is a contract.
 Derives value from underlying assets.
 Specified obligation.
 Direct or exchange traded.
 Delivery for underlying assets is not involved.
 Secondary market instruments.

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Purpose of Financial Derivatives
 Risk aversion tool
 Prediction of future prices
 Enhance liquidity
 Assist investors
 Integration of price strucuture
 Catalyze for growth of financial markets

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Types of Derivatives

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Financial Derivative Market
 A derivatives exchange is a market where individuals trade
standardized contracts that have been defined by the exchange.
Derivatives exchanges have existed for a long time.

 The Chicago Board of Trade (CBOT) was established in 1848 to


bring farmers and merchants together. Initially its main task was to
standardize the quantities and qualities of the grains that were traded.
Within a few years the first futures-type contract was developed.

 It was known as a to-arrive contract. Speculators soon became


interested in the contract and found trading the contract to be an
attractive alternative to trading the grain itself. A rival futures
exchange, the Chicago Mercantile Exchange (CME), was established
in 1919. Now futures exchanges exist all over the world.

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Financial Derivative Market:
Past and Present Scenario
 Derivatives markets in India have been in existence in one form
or the other for a long time. In the area of commodities, the
Bombay Cotton Trade Association started futures trading way
back in 1875. In 1952, the Government of India banned cash
settlement and options trading.
 Derivatives trading shifted to informal forwards markets. In
recent years, government policy has shifted in favour of an
increased role of market-based pricing and less suspicious
derivatives trading.
 The first step towards introduction of financial derivatives
trading in India was the promulgation of the Securities Laws
(Amendment) Ordinance, 1995. It provided for withdrawal of
prohibition on options in securities. The last decade, beginning
the year 2000, saw lifting of ban on futures trading in many
commodities.

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Contd…
 Around the same period, national electronic commodity
exchanges were also set up. Derivatives trading commenced
in India in June 2000 after SEBI granted the final approval
to this effect in May 2001 on the recommendation of L. C
Gupta committee.
 Securities and Exchange Board of India (SEBI) permitted
the derivative segments of two stock exchanges, NSE and
BSE , and their clearing house/corporation to commence
trading and settlement in approved derivatives contracts.
 Initially, SEBI approved trading in index futures contracts
based on various stock market indices such

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Contd….
 as, S&P CNX, Nifty and Sensex. Subsequently, index-based
trading was permitted in options as well as individual securities.
The trading in BSE Sensex options commenced on June 4, 2001
and the trading in options on individual securities commenced
in July 2001. Futures contracts on individual stocks were
launched in November 2001. The derivatives trading on NSE
commenced with S&P CNX Nifty Index futures on June 12, 2000.
 The trading in index options commenced on June 4, 2001 and
trading in options on individual securities commenced on July 2,
2001. Single stock futures were launched on November 9, 2001.
The index futures and options contract on NSE are based on S&P
CNX. In June 2003, NSE introduced Interest Rate Futures which
were subsequently banned due to pricing issue.

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