Financial Derivatives Unit I

1. Derivatives--Meaning
“Something from something else”.
 Its value is entirely derived from the values of the underlying
asset.
 Underlying asset can be securities, commodities, bullion,
currency, livestock or anything else.
 Derivative means Forward, Future, Option or any other
contract of predetermined fixed duration.

2. Financial Derivatives--Meaning
 Financial derivatives are financial instruments whose prices or
values are derived from the prices of other underlying
financial instruments or financial assets.
 Underlying financial instrument can be equity share, stock,
bond, debenture, treasury bill, foreign currency etc.
 Financial derivatives are not revolutionary new instruments
rather they are merely combination of older generation
derivatives.

3. Derivatives--Features
 Future contract between two parties.
 Based on underlying assets.
 Counter parties specifies obligation under derivative contract.
 Contract undertaken directly between two parties or particular
exchange.
 Financial derivatives are carried off-balance sheet.
No asset or liability underlying the contract was put on B/S.
It is treated as contingent asset or liability.
 Taking or making of delivery of underlying assets is not
involved.

4.  It is known as deferred delivery or deferred payment.
 Mostly it is a secondary market instrument and have little
usefulness in mobilizing fresh capital by corporate.
 Standardized, general and exchange-traded derivatives are
being increasingly evolved.

5. Type of financial derivatives
Forward contract—Meaning:
 A forward contract is a simple customized contract between
two parties to buy or sell an assets at a certain time in the
future for a certain price.
 Not traded on an exchange , rather traded as a condition to the
contract by the parties concerned.
 Forward contract can be of cash settled or based on physical
delivery.

6. Features of Forward contract
 Bilateral contract, they are exposed the counter party risk for
non-performance of obligation either of the parties.
 Each contract is custom designed, is unique in terms of
contract size, expiration date, the asset type, quality etc.
 A party with no obligation off setting the forward contract is
said to have an open position. A party with a closed position is
called hedger.
 The contract has to be settled by delivery of the assets on
expiration date.
 It is popular in foreign exchange market as well as interest rate
bearing instruments.

7. Contd:
• Indian forward contract Act 1952:
 Hedge contract are freely transferable and do not specific, any
particular lot, consignment etc.
 Transferable specific delivery contracts– are freely
transferable from one party to another, but are concerned with
a specific and predetermined consignment.
 Non- transferable specific delivery contract– are contracts, are
not transferable at all and as such, they are highly specific.
 Specified price in a forward contract is referred to as the
delivery price.
 Forward price for a particular forward contract at a particular
time. As time passes the forward price is likely to change
whereas the delivery prices remains the same.

8. Contd:
Future contract--Meaning
 A Future contract is an agreement between two parties to buy
or sell a specified quantity of an asset at a specified price and
at a specified time and place.
 Traded on an exchange which sets certain standardized norms
for trading in the future contract.

9. Features of future contract
 They are traded on an exchange.
 Standardized norms.
 Liquidity problem, which persists in the forward market, does
not exist in the future market.
 Credit risk of the transactions is eliminated by the exchange
through the clearing house.

10. Option--Meaning
 A contract between two parties whereby one party obtains the
rights, but not the obligation, to buy or sell a particular asset,
at a specified price, on or before a specified date.
 Person who acquires the right is know as the option buyer or
option holder, while the other person is know as option seller
or option writer.
 The seller of the option for giving such option to the buyer
charges an amount which is known as the option premium.

11. Type of option—Call option and Put option:
 Call option:----gives the holder the right to buy an asset at a
specified date for a specified price.
 Put option:---the holder gets the right to sell an asset at the
specified price and time.
 Specified price in a contract is known as the exercise price or
strike price.
 The date in the contract is known as expiration or exercise or
maturity date.
 Assets or security instruments or commodity covered under
the contract is called as the underlying assets.
 It includes shares, stock, foreign currencies, bonds,
commodities.

12. Option further divided into—European and American
option
 European option:--can be exercised on the expiration date
only.
 American option:--can be exercised at any time before the
maturity date.

13. Swap--Meaning
 A Swap is an agreement between two counter parties to
exchange cash flows in the future.
 Terms like the dates when the cash flows are to be paid, the
currency in which to be paid and the mode of payment are
determined and finalized by parties.
 Calculation of cash flows involves the future values of one or
more market variables.

14. Types of Swap—Interest rate and currency swap
 Interest rate swap:
One party agrees to pay other party at a fixed rate on a
principal amount, and in return, it receives interest at a floating
on the same principal amount for a specified period.
Currencies of the two sets of cash flow are the same.
 Currency swap:
It involves in exchanging of interest flows in one currency for
interest flows in other currency, it requires the exchange of
cash flows in two currencies.

15. Use of Derivatives
 Provides services to control, avoid, shift and manage
efficiently different type of risk through hedging, arbitraging,
spreading, etc.
 Serve as barometer of the future trends in price, to discover the
new prices both on the spot and future market.
 No immediate full amount of the transaction is required for
trading.
 Trading enhance liquidity and reduce transaction costs in the
markets for underlying assets.
 Assist the investors, traders, managers of large pools of funds,
to make proper asset allocation, increase their yields and
achieve investment goals.

16. Contd:
 Helps in disseminating information regarding the future
markets trading of commodities and securities.
 Attract young investors, professionals, and experts who will
act as catalysts to the growth of financial markets.
 Observed that smoothen out price fluctuations, squeeze the
price spread, integrate price structure at different points time
and remove shortages in the markets.
 Encourage the competitive trading in the market, different risk
taking by the market operators like speculators, hedgers,
trader,
 Assists the holders to shift or modify suitably the risk
characteristics of their portfolios.

17. Critiques of derivatives
Speculative and gambling motives:
 Trading volumes have increase in multiples of the values of
the underlying assets and one to two percent are settled the
actual delivery of the underlying assets.
 Speculative buying and selling by professionals and amateurs
affect the genuine producers and distributors.
Increase in risk:
 Observed –especially OTC markets, particularly customized,
privately managed and negotiated and they are highly risky.
 Powerful leveraged mechanism used to create risk.

18. Instability of the financial system:
 Argued that increased risk not only for the users but for the
whole financial system.
 Malpractices, desperate behavior and fraud by the users, have
threatened the stability of the financial markets and financial
system.
Price instability:
 Helpful in price stabilization ,if exist a properly organized,
competitive and well-regulated market, trader behave and
function in professional manner and standard code of conduct.
 All these are not frequently practiced in the market, and cause
to price instability rather than stability.

19. Displacement effect:
 Growth of derivative will reduce the volume of the business in
the primary or new issue market specifically for the new and
small corporate units.
 Most of investors will divert to the derivative market, raising
fresh capital is difficult, and will create displacement effect in
the financial market.
Increased regulatory burden:
 Instability in financial system, as a result more burden on the
government or regulatory to control the activities of the traders.
 Financial crisis and scams in the market from time to time and
regulatory authorities spent on to find out new regulatory,
supervisory and monitoring tools, for to lead on fall of the
financial system.

20. Risk in derivatives
 Derivatives trading has become a powerful segment of the
international financial market.
 Trading in equity derivatives have begun at different centers
of global financial markets.
 Derivatives are powerful tools for risk management, they turn
out to be disastrous weapons, if not used properly.
Nature of derivative trading:
 Handling the derivatives are just like handling dangerous
chemicals, or explosive device.
 Markets move at fast speed, market is highly liquid but too
risky.
 Used for different purpose like hedging the risk, speculation,
arbitraging, trading, etc.

21. Contd:
 Essential to implement as independent management function
to identity, monitor, control, and report all its aspects.
 High level of competent persons in his field.
Setting the risk vision:
 Setting policies
 Commercial objectives
 Risk tolerance
 Capital efficiency
 Financial capability
 Enhance competence
 Reviews

22.  Increase in complexity of financial market:
 Business firm operates in dynamic business environment.
 Due to globalization and liberalization, the domestic financial
market are linked with the international financial market.
 Optimization of capital:
 Earning through derivatives is a very risky venture, because
derivative are used as powerful risk-management tools.
 Miscalculation of prices of derivative products has created
disaster for the creators.
 Optimum use of capital and financial resources, derivatives
should be used judiciously and carefully.
Reasons for managing derivatives risk:

23.  Technology advances:
 Increased sophistication and new information technology have
created complications and insecurity in the business.
 Market events:
 Derivative products are in all spheres like agricultural product,
metals, commodities and financial product.
 Activities and development are increasing in different market
at fast rate all over, it will rise a market risk.
 Changes in accounting practices:
 To measure the value, there is need of sound techniques and
other statistical tools.
 Accounting standard and practice for the derivative are
relative new and in a process of evolution.

24. Types of risks in derivatives trading
 Credit risk:
 Also called as default risk.
 A counter party default its obligation is called credit risk.
 Exchange-traded future contract is likely to have significantly
less counter party risk in comparison to OTC contract.
 Market risk:
 Market risk exposes a firm to uncertainty, due to changes in
market factors, like foreign exchange rates, commodity prices,
equity prices, etc.
 To over come the market risk, the factor like risk strategy and
policy, organization and culture, executive skill, procedure and
control port folio characteristic, etc.

25.  Liquidity risk:
 Refers to the fluctuation of derivative instruments prices for
not quickly sold or purchased in the market.
 Liquidity risk is higher in OTC market in comparison to the
exchange traded derivatives.
 A rise out of relative ability of an organization and mismatch
between the bank cash inflows and out flows arising out of
derivative activity.
 Legal risk:
 Risk relating to change in law or a regulatory rule, cause an
adverse financial impact on derivative.
 Global data base and the legal and regulatory compliance.

26.  Operational risk:
 Risk relates to errors or frauds, which occurs in carrying out
operations, placing orders, making payment, taking deliveries,
accounting for derivatives transactions.
 Manual and automated control through out the organization,
play in creating a secure operational environment.
 Model risk(formal risk):
 Derivative instrument are priced or valued through specific
complicated mathematical formula, based on assumption.
 Observed that models, or formula fail to give accurate results
regarding price data.
 Due to changes in assumptions or other environment factors or
undetected flaws in the models.eg financial risk, interest rate
risk, etc.