DERIVATIVES

INTRODUCTION
Financial derivatives like stock futures, stock options, swaps etc. have been developed to
mitigate the risk level of derivative traders. Increased financial risks have threatened the very
existence of business firms. Financial derivatives came up as a mode of reducing these risks.
Transactions in derivatives market are used to offset the risk of price changes in the underlying
assets. Every business firm is at high risk due to the uncertainty in price fluctuations. Derivatives
provide them a valuable set of tools to manage this risk. New products and different combinations
of existing products are widely used to cope with the changing environment.
DERIVATIVES - CONCEPTS AND THEORY
Derivative‘ is a financial instrument, an agreement between two parties, whose value is
derived from the value of something else called the underlying. Derivatives simply mean one which
is derived. It indicates that it has no independent value, which means its value is entirely derived
from the value of an underlying asset. This underlying can be financial products like shares and
securities, currency, interest rates, index of prices, exchange rate, etc. or other products like
commodities, bullion and livestock or anything else or a combination of these. Weather derivatives
and Carbon credit derivatives are new introductions into the field of derivatives trading. As
derivatives can be created keeping anything under the sky as its underlying, there is endless scope
for derivatives. The Securities Contract Regulation Act 1956 defines derivative as under:
1. Security derived from a debt instrument, share, loan whether secured and unsecured, risk
instrument or contract for differences or any other form of security.
2. A contract which derives its value from the prices or index of prices of underlying securities.

Need for a Derivatives Market

Derivatives perform two important economic functions namely hedge and price discovery.
Investment in financial market is a risky affair due to the uncertainty about future. Most of the
financial transactions deal with investment in uncertain cash inflows. For instance, an investor
holding diversified portfolio is still exposed to market risk which cannot be diversified. Stock
market movements are unpredictable and hence great risk is involved in share trading. Derivatives
help to reduce this uncertainty as the investors can fix their trade at a standard predetermined price
which is comfortable for them. Thus, by using derivatives investors get a chance to reduce their
price risk. Firms also use derivative products since it reduces interest rate risks, foreign exchange
risks and commodity price risks.
Another important function is price discovery. It is the process of discovering future prices
of a financial asset. Firms need to allocate their resources efficiently and for this purpose future
price of products play a significant role. The prices in derivatives markets are fixed by demand and
supply and hence it gives advance information to the traders regarding the future demand and price.
A firm cannot estimate its future production cost and revenues due to the increased price
fluctuations. Derivatives provide them a valuable set of tools to manage this risk .Theoretical
Framework 110 advantage of leverage which means a small change in the value of the underlying
can cause a larger difference in the value of the derivative. It is also being used as a hedge tool to
mitigate the risk associated with the price fluctuations of the underlying. It is also beneficial to the
investors to make profit if the price of the underlying asset moves according to their expectation.
Specific conditions or event is linked to the value of derivatives to create option ability. Thus,
derivatives control, avoid, shift and mange different types of risks through various strategies like
hedge, arbitrage, spreading etc. These are useful in highly volatile financial market conditions like
erratic trading, highly volatile interest rates and monetary chaos. Its contribution in disseminating
information on futures trading and establishing equilibrium price is highly appreciable.
Derivatives assist even large fund managers, to allocate their assets in an efficient way to
achieve their diversified investment goals. Any market will be efficient only if there is large number
of players in the market with different risk perception. In such a case, there will be large number of
transactions with price differences and investors will get a chance to follow different strategies.
Large number of players had entered into stock market trading after the introduction of derivatives
because derivatives provide the facility of trading with smaller amount. Derivatives are traded based
on margin money. Full amount of transaction is not required initially. As a result large number of
operators like hedgers, arbitragers, speculators operates in the market. This will enhance liquidity
and reduce transaction cost. This will also increase the total trading volume of the country and
thereby contribute to the growth of financial markets. Moreover derivative markets contribute
towards the formation of a ‗complete market‘ where no single investor is better than no undue
advantage can be taken from the market. All will have equal chance. In short, the need for
derivatives can be summarised as below:
1. It helps in price discovery – discovery of future as well as current prices
2. It helps to mitigate the future loss which is uncertain
3. They catalyse entrepreneurial activity
4. They increase savings and investment in the long run
5. Risk will be transferred from risk averse people to risk takers
6. Increases the volume of trade in stock market due to the increased number of participants
7. Investors can take advantage of leverage
Participants of Derivatives Market
There are different participants in the derivatives market. All of them play a significant role in the
performance of derivatives market.
Hedgers:
Hedgers take positions in derivatives market for reducing or eliminating the risk associated
with the price of an asset. Thus, he takes a position in the derivatives market that is opposite to the
one he is exposed to. Hedgers are risk averse traders who want to reduce the risks. Hedge is meant
only to reduce risk but not to make profit. In many of the cases, the returns on hedge position will
be less than the un hedged position. Thus, derivatives help traders to hedge some pre-existing risk
by taking positions in derivatives market that offset potential losses in the spot market.

Speculators
Speculators are just opposite to hedgers; they are risk lovers not risk averse. Speculators use
futures and options contracts to get extra leverage in betting on future movements in the price of an
asset. Speculators are risk seeking traders who believe that they have some specialised knowledge
about the market. They predict the future price movements and act accordingly. Speculators forecast
the future economic conditions and decide which position, long or short, is to be taken to earn
profit. They buy and sell the securities with a motive to make profit. If their prediction turns true,
they get profit and vice versa. They are traders who are willing to assume risk. Speculators want to
buy an asset at low price in the future, when the actual spot price of that asset is high and want to
sell an asset at high price when the actual spot market price of that asset is low. Role of speculators
are also essential for the active functioning of the market.
Arbitragers:
Like speculators, arbitragers are also traders who wish to make profit but unlike speculators,
arbitragers are not risk seekers. Thus, they attempt to make profits by locking in a riskless trading of
simultaneously entering into transactions in two or more markets. They are risk neutral traders who
exploit any mispricing in the markets. They try to earn riskless profit from discrepancies between
spot and futures prices and among different futures prices. They will carefully watch the market
movements and if they see future price is getting out of line with the cash price, they will take
offsetting positions in two markets and lock their profit. For example, futures price of a lot of 100
shares is Rs 5100 and spot price of those 100 shares are only Rs 5000. In this case the trader can
buy shares from spot market at Rs 5000 and go short in futures market at Rs 5100 immediately and
can gain a 113 profit of Rs 100, ignoring other cost. Anyway this opportunity will not last for a long
period. Arbitragers keep the futures and spot price in line to each other and the principle of cost of
carry gets worked here. Thus arbitragers enhance liquidity, ensure accurate pricing and provide
price stability in the market.
Financial Derivatives
Financial derivatives are instruments whose value is derived from one or more underlying
financial assets. Here the underlying can be equity shares, stocks, bonds, debentures, treasury bills,
foreign currency or even another derivative asset. The term financial derivative relates with a
variety of financial instruments which include stock, bonds, treasury bills, interest rates, foreign
currencies and other hybrid securities. Financial derivatives can also be derived from a combination
of cash market instruments or other financial derivative instruments. Financial derivatives are
characterised by following features:
- It is a future contract between two parties
- Its value is derived from the value of underlying financial asset
- Both parties to the contract have specified obligation, though its nature may differ according
to the type of contract.
- These contracts can be undertaken directly between the parties or through exchanges.
- Usually, there is no delivery of underlying assets rather than offsetting of positions
- These are carried as off- balance sheet item.
- These are mostly secondary market instruments and have less use in mobilising capital.
Types of Financial Derivatives
An exact classification of derivatives is difficult due to the complexity of the product. Some
of the popular types of derivatives are described below

Derivatives
Financials
Commodities
Basic, Complex, Forwards Futures, Options, Warrants , Swaps, Exotics
Derivatives
Financials Commodities Basic Complex Forwards Futures Options Warrants Swaps Exotics Types
of Derivatives
Broader classification of derivatives can be on the basis of the