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DERIVATIVES - Introduction







Prof. M. Subramanian
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A Brief History of Derivatives

The history of derivatives is surprisingly longer than what
most people think. Some texts even find the existence of the
characteristics of derivative contracts in incidents of
Mahabharata.

Traces of derivative contracts can even be found in
incidents that date back to the ages before Jesus Christ.

In Genesis Chapter 29, believed to be about the year
1700 B.C., Jacob purchased an option costing him seven
years of labor that granted him the right to marry Laban's
daughter Rachel. His prospective father-in-law, however,
reneged, perhaps making this not only the first derivative
but the first default on a derivative.
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Jacob, Rachel - Pictures

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A Brief History of Derivatives
Around 580 B.C., Thales the Milesian purchased options on
olive presses and made a fortune off of a bumper crop in olives.
However, the advent of modern day derivative contracts is
attributed to the need for farmers to protect themselves
from any decline in the price of their crops due to delayed
monsoon, or overproduction.
The first 'futures' contracts can be traced to the Yodoya
rice market in Osaka, Japan around 1650.
These were evidently standardised contracts, which made
them much like today's futures.
The Chicago Board of Trade (CBOT), the largest derivative
exchange in the world, was established in 1848 where
forward contracts on various commodities were standardised
around 1865. From then on, futures contracts have remained
more or less in the same form, as we know them today.
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Thales @ Miletus

Thales of Miletus (circa 635 BC - 543 BC)
was a pre-Socratic Greek philosopher.
Generally considered the first philosopher
in the Greek tradition as well as the father
of science, he is numbered among the
Seven Sages of Greece.
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The birthplace for futures transactions:
Djima Rice Exchange (The origin of
securities exchanges stems from Edo Period,
when the exchange for rice & crop was
established in Osaka, center of Japanese
economy. Each prefecture set up its own
warehouses in Osaka for shipping &
preservation of their rice (to be taxed by the
government), and sold them to merchants.
One of the most famous merchants was
"Yodoya", which was based upon the southern
part of Yodoyabashi area. Some other
merchants gradually gathered to create one
market. This market was called "Yodoya-
Komeichi", which was the first securities
exchange in the nation.
Later on, this market was moved to Dojima in
1697, so-called "Dojimakomekaisho", which
was a physical market to trade in rice-tickets
or physical rice. In 1716, Cho-gomai
transaction was introduced and recognized by
the government in 1730, which is said to be
the origin of futures transactions in Japan. Today - Osaka Exchange
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CBOT, Chicago
CBOT - Earlier
CBOT - Today
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A Brief History of Derivatives

Trading in Stock Index Futures (SIF) contracts was
introduced by the Kansas City Board of Trade on February
24, 1982.

In 1982 April, the Chicago Mercantile Exchange began trading
a futures contract based on the Standard and Poor's Index of
500 common stocks.

The success of the first two contracts induced other major
exchanges to introduce similar instruments. NYSE Composite
Stock Index, Value Line Composite Stock Index are among
the popular stock index futures.

In India Derivatives was introduced in the year 2000
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What is a derivative?

Derivatives are defined as financial instruments
whose value derived from the prices of one or more
other assets such as equity securities, fixed-income
securities, foreign currencies, or commodities.

A derivative is also a kind of contract between two
counterparties to exchange payments linked to the
prices of underlying assets.

Derivative can also be defined as a financial
instrument that does not constitute ownership, but a
promise to convey ownership.
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TYPES OF DERIVATIVES
The following are the basic two types of derivatives:
1. Financial Derivatives ( @ NSE & BSE)
(a) Forwards
(b) Futures
(c) Options
(d) Swaps
2. Commodities Derivatives ( @ MCX & NCDEX)

PLAYERS IN DERIVATIVES MARKET
(a) Speculators
(b) Hedgers
(c) Arbitrageurs
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(a) FORWARD CONTRACTS
A forward contract is an agreement to buy or sell an
asset on a specified date for a specified price.

One of the parties to the contract assumes a long
position and agrees to buy the underlying asset on a
certain specified future date for a specified price.

The other party assumes short position and agrees to sell
the asset on the same date for the same price.

Other contract details like delivery date, price and
quantity are negotiated bilaterally by the parties to the
contract.

Forward contracts are normally traded outside the
exchanges.
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(b) FUTURES CONTRACTS
A future contract is an agreement between two parties to
buy or sell an asset at a certain time in the future at a
certain price.

Future contracts are standardized and exchange traded.

To facilitate liquidity in the futures contracts, the
exchange specifies certain standard features of the
contract.

Futures are standardized in terms of:
i. Quantity of the underlying asset
ii. Quality of the underlying asset
iii. Date of delivery
iv. Units of price quotation and mini. price
change.
v. Location of settlement.
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(c) OPT IONS - Concept

Options are contracts which provide the holder the right to sell or buy a specified
quantity of an underlying asset at a fixed price on or before the expiration of the
option date.

The person who acquires the right is known as Option Holder (or) Buyer and the
person who grants this right is known as Option Writer (or) Seller.

The price payable for this right is known as the Premium and it depends upon
the underlying assets.

The agreed price by the both the parties is called as the Strike Price

The agreed date is technically called as the Expiration Date (or) Strike Date
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OPTIONS - TYPES
Depending upon whether an option is for a right to buy or
Sell, the option can be classified into CALL and PUT:

(a) CALL OPTION
Call option provides to the holder a right to buy specified
assets at specified price on or before a specified date.
(b) PUT OPTION
Put option provides to the holder a right to sell specified
assets at specified price on or before a specified date.

EXPIRATION DATE KINDS
The expiration date can be either of
(a) American Option Style (On or before expiry date) OR
(b) European Option Style. (Only on expiry date)
(Note: In India Stock Options are of American Style and
Index options are of European Style)
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(d) SWAPS
Swaps are private agreements between two parties to
exchange cash flows in the future according to a pre
arranged formula.
Two commonly used swaps are
(a) Interest Rate Swaps These entail swapping only the
interest related cash flows between the parties in the same
currency.
(b) Currency Swaps These entail swapping both principal
and interest between the parties, with the cash flows in one
direction being in a different currency than those in the
opposite direction.
(c) Swaptions Swaptions are options to buy or sell a swap
that will become operative at the expiry of the options.
Thus a swaption is an option on a forward swap. Rather
than have calls and puts, the swaptions market receiver
swaptions and payer swaptions. A receiver swaption is an
option to receive fixed and paying floating. A payer
swaption is an option to pay fixed and receive floating.
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