DERIVATIVES MARKET

Dr L.Krishna veni
 It comes from the verb ‘to derive’
 A derivative is a contract whose value is

derived from the value of another asset

 Ex-Cotton is the raw material to textile mill
 Cotton price may fluctuate from time to time
 The farmer who is exposed to those
fluctuations can eliminate the risk by selling
his harvest at a future date by entering into a
forward , or future contract
 Derivatives are similar to insurance
 They protect from certain risks-volatility is fire,

floods and theft.

Derivatives on the other hand take care of the____
 Market Risks-volatility in Interest Rates, Currency

Rates, Commodity Prices & Share Prices

 Interest Rate Risk
 Exchange Rate Risk
 In the era of globalization, the world is the risker

place and expose to risk is growing .

 Risk cannot be avoided and ignored
 However man is risk averse
Economic Benefits of Derivatives
 Reduce risk
 Enhance liquidity of underlying asset
 Lower Transaction costs
 Enhance price discovery process
 Portfolio Management
 Provide signals of Market Movements
 Facilitates Financial markets integration
Types of Financial
Derivatives
Forwards
 A forward contract is a contract between two

parties obligating each to exchange a

particular good or instrument at a set price
on a future date.
 It is an Over-the-Counter agreement and has

standardized market features

Future Contract Example
 Farmer- I agree to sell 500 Kgs wheat at Rs.40

per Kg after 3 months to the Bread Maker

 After 3 months – The Farmer gives 500 Kgs

wheat to the Bread Maker

 The Bread Maker gives Rs.20,000 to the

farmer
 RATE IS FIXED
THREE RISKS are there
 Credit risk-
 Does the other party have the means to pay?
 Operational risk-

1. Will the other party make the delivery?

2. Will the other party accept the delivery?
Liquidity Risk-
Incase either party wants to opt out of the
contract, how to find another counter party?
Futures
 They are standardized that will take place

between the buyers and the sellers, which

fix the terms of exchange that will take place
between them at some fixed future date.
 Date is fixed
 It is a legally binding agreement
Options
 They are contracts between the option writers
and buyers which obiligate the former and
entitles(without obligation) the latter to sell/buy
stated assets as per the provisions of contracts
 They are two types:

CALLS –
 A call option gives a buyer a right but not an

obligation to buy the underlying on or before a

specified time at a specified price
 (Buyer’s Choice)
PUTS
 Put option gives a holder/Seller of that option

a right but not an obligation to sell the

underlying on or before a specified time at a
specified price and quantity
 (Seller’s Choice)
Warrants
 Warrants are long term options with 3-7
years of expiration
Swaps
 Swaps are generally customized
arrangements between counter parts or
exchange one set of financial obligations for
another as per the terms of agreement
Swaptions
 It is the culmination of Options and Swaps
 http://oyc.yale.edu/economics/econ-252-08

 http://www.austrade.gov.au/news/video/transc
ripts/financial-services-council-fsc