Module 5

DERIVATIVES

INTRODUCTION

The introduction of liberalization policy has driven our economy towards a free market
economy. Integration of financial markets-both domestic and international, utilization of multi-
currency transactions, increasing foreign investments, high volatility in stock market etc. are the
resultant features of this liberalized economy. This has exposed the traders (exporters & importers),
manufactures, bank and other to various risks. Interest rate risk, foreign exchange risk, counter party
risk, economic risk, political risk are some of them.

Derivatives have emerged as the most influential tool in risk management system. SEBI has
introduced derivatives trading in stock market as a tool of risk Management.

The Concept

Derivatives are financial instruments whose value depends on some underlying basic assets.
They are basically co contracts between two parties (a buyer and a seller) which drive its value/price
from the value of an underlying asset. The underlying assets could be shares, bonds, interest rate,
exchange rate, stock index or commodity. Accordingly, there are commodity derivatives and financial
derivatives. In a commodity derivative the underlying assets will be a commodity like gold,
agriculture produce, oil, metal etc. in a financial derivative the underlying assets will be shares,
currency, stock indices etc.

Derivatives have been created to mitigate various risks like fluctuations in the value of
financial instrument like shares, bond etc., fluctuations in commodity prices, changes in foreign
exchange rates; changes I interest rates etc.

Definition

“A derivatives is simply a financial instrument (or even more simply an agreement between
two people) which has a value determined by the price of something else.”- Robert L. McDonald
Features Of Derivatives

1) Derivatives are basically instruments used for hedging the risk involved in buying, holding
and selling assets, whose price fluctuates.
2) Derivatives has no existence without an underlying asset, their value is based on the future
price movements of the underlying assets.
3) Derivatives help the market participants /traders to ‘look-in’ a particular price for underlying
asset and hence guard the assets from future price fluctuations.
4) Derivatives are of four major types, Viz. forwards, futures, options and swaps.
5) Derivatives are contracts tradable through stock exchanges. They are legally binding
contracts.

Importance / Benefits Of Derivatives

1) Risk management: Derivatives are becoming increasingly important in world markets as a

tool for risk management. They help to hedge the various risks in the financial and
commodities market. Derivatives are used to transfer the risk to other parties.
2) Easy to operate: all derivatives instruments are very simple to operate. Actual delivery of the
underlying asset is not at all essential for settlement purpose in derivatives. The profit or loss
on derivative deal alone is adjusted (cash settlement) in the derivative exchanges. Thus,
treasury managers and portfolio managers can hedge all risks without going through the
tedious process of hedging.
3) Low cost: all derivative products are low cost products. Greater liquidity and lower
transaction costs make derivatives attractive. By paying a margin amount traders can enter
into derivatives contact. The cost of trading the asset underlying the instrument is higher than
trading the derivatives.
 Types Of Derivatives

Commodity derivatives and financial derivative are two major classes of derivatives. This
classification is based on the type of underlying assets.

Based on the operational structure, there are four major types of derivatives (derivative instruments),
viz.

1) Forwards
2) Futures
3) Options
4) swaps
1. Forward Contracts
Forward contracts or forwards are the oldest and simplest form of derivatives contracts. It is
an agreement between two parties to buy/sell a specified quantity of an asset at a certain future date
at a specified price. The promised asset may be currency, commodity or financial instruments.
Example (i): a wheat trader make contract with a farmer much in advance of the harvesting
season and negotiates a price for the crop. The trader agrees to pay the farmer an agreed price on
a specified date. In returns the farmer agrees to supply fixed quantity of wheat on the specified date.
This is a forward contract. In certain cases he may give an advance too.
Thus, in a forward contract, one of the parties agrees to buy the underlying asset on a
specified future date for a predetermined price, while the other party agrees to sell the asset on the
same date and same price as mentioned in the contract.

Over the Counter contracts

Both the parties to a forward contract are under an obligation to perform the contract. Forward
contracts are privately arranged bilateral contracts. There is no central place where such contracts
are made. They are not transacted in stock exchanges. Therefore these forwards contracts are called
over the counter contract, or OTC contracts.
Example(ii): on 1st April Mr. ‘A’ enters into forwards contract with Mr. and agrees to
purchase 1000 shares of Tata Ltd. For a pre-determined price of 10 three months forward. On the
fixed future date, Mr. ‘A’ will get the 1000 shares and will pay the price i.e. 10,000 and Mr. will
deliver the shares and will receive the money.
Forwards And Hedging
Forwards contracts are widely used for hedging. Hedging is a method to protect against the
future fluctuation in the pieces of commodities or assets. Example, a mill owner in U.S orders
wheat from France, at 80 a tonn. The shipping time taken to get the wheat would be one month.

However, when he sells the goods on arrival in U.S., he will get only the then existing price. If
that price is $70, he will lose $10 per tonn. To get over this uncertainty. H enters into a derivative
contract with a local dealer. He agrees to sell the goods to him at a fixed price of $ 85 after one
month. This is a typical forward contract and can be used for hedging, that is insurance against
uncertainty in prices.
Features Of Forward Contract
1) Customized contracts: Each forward contract is custom designed (tailor made) to the needs
of the parties , hence is unique in terms of contract size, maturity date, asset type, quality etc.
Hence, they are not standardized one.
2) Over the counter contracts: Forwards contracts are privately arranged agreements. They are
not usually traded in organized exchanges. Therefore they are known as over the counter
contracts.
3) Counter party risk: Forwards contacts are bilateral agreement. If the other party backs out,
there is risk. If the other party does not honour the agreement, there is no organized body or
intermediary to solve the problem.
4) Payment in future only: Forwards contract contains only a promise to supply or receive a
specified asset at an agreed price at a future date. The contracting partied usually need not pay
ant down payment at the time of agreement.
5) Settlement at maturity: The important feature of a contract is that no money or commodity
is transferred when the contract is signed. It takes place on the date of maturity only as given
in the contact. Delivery of the asset is essential at maturity date.
6) Symmetrical gain or loss: The gain or losses due to price fluctuation of the underlying asset
will be symmetrical in forward contract. When the spot price (of the underlying asset) in
future exceeds the contract price, the forward buyer stands to gain. The gain will be equal to
spot price, minus contact price, if the spot price in future falls below the contract price, he
incurs a loss. The gain which one can get when the price moves in one direction will be
exactly equal to the loss when the price moves in the other direction. It means that the loss of
the forward buyer is the gain of the forward seller and vice versa.
 7) No secondary market: A forward contract is a purely private contract, and hence, it cannot
be traded on an organized stock exchange. As such, there is no secondary market for forwards.

2. Futures
A futures contract is a refined forward contract. It is a standardized contract between two
parties to buy or sell an underlying asset (a commodity or a financial asset) for an agreed price at
a specified future date. Futures are traded in stock exchanges. The agreed price is known as the
‘strike price’. Stock exchanges set the standardized terms of the futures contract (like quality,
quantity and price of underlying asset and delivery date) and guarantees the execution of contract
by both the parties (buyer and seller).
Unlike forward contract (which insist on physical delivery of assets at maturity), future are
usually performed by the payment of difference between the strike price and the market price
(cash settlement) on the fixed future date.
Example: if a future contract is for Rs.500/- (strike price) and price of the assets for a
particular day(market price) was Rs.550/- when the contract was conducted, the party agreeing
to sell should immediately pay the difference of Rs.50/- this will be adjusted daily to the margin
maintained (called ‘market to market’) till the fixed date of completion.
Features Of Future
a) Standardized: Futures contracts are made in organized exchange. The terms and conditions
are standardized and legally enforceable. Standardization is generally in quantity, quality,
delivery terms, delivery date, expiry date etc. once the agreement is entered into it is difficult
to modify it.
b) No down payment: The contracting parties need not pay any amount (for the value of the
asset) at the time of agreement. However, he may have to deposit a certain percentage of the
contract price as initial margin money. This give guarantee that the contract will be honoured.
c) Liquidity: Futures contract, being traded on organized Exchanges, impart liquidity to
transaction. The clearing house acts as a counter party to both sides of transaction. This
provided guarantee that the contract will be honoured. This also ensure very low level of
default.
d) Secondary market: Futures are dealt in organized exchanges. Therefore they can be sold
and bought in these markets. Thus, unlike forwards, futures have secondary market.
e) Settlement: The transactions are settled on a daily basis. Different types of margin are
required for transactions. Delivery of the assets is not necessary for futures settlement. Only
the price difference is settled.
 f) Hedging: The buyers of a future contract hope to protect themselves from future spot price
increases and the sellers from future spot price decreases. Parties enter into futures
agreements on the basis of their expectations of the future price in the spot market for their
assets. This id hedging.
g) Symmetrical gain or loss: Future contract is similar to forward contract. Therefore, parties
to the contract get symmetrical gains or losses due to price fluctuation. It means that the loss
of the buyer will be the gain of the seller and vice versa.
h) Non-delivery of the Asset: The delivery of the asset in question is not essential on the date
of maturity of the contract in the case of futures contract. Generally, parties simply exchange
the difference between the future and spot prices on the date of maturity.

Types Of Futures

Futures contract can be in commodities like agricultural products, metals and

minerals ,petroleum etc. financial futures includes futures in foreign exchange, stock market index,
interest rate etc.

Commodity Futures

Price fluctuation of commodities is a major problem faced by producers, traders and

consumers. They are exposed to price risk and thereby the possibility of suffering loss due to adverse
price movements of commodities. Commodity futures contract are derivative instruments which can
be used for hedging the price risk involved in commodity trading.

Futures contract whose underlying assets are commodities( agricultural commodities or

industrial commodities) such as sugar, wheat, rubber, gold, barley, cotton seeds ,soy bean, guar seeds,
potato etc., referred to as commodity futures. It is an agreement to buy or sell a specified quantity of a
commodity at predetermined price at a future date.

The essential features of commodities futures are;

a) Commodity futures are standardized agreement/contracts transacted through organized

exchange (like national or regional commodity exchanges).
b) The commodity exchanges determines the specifications of futures contract in terms of
size(quantity) of the contract, quality of commodities, delivery date, time etc.
 c) Clearing house of the exchange acts as the counterparty to the contract and guarantees the
execution of the same. Both the buyer and seller of the futures contract are required to make
margin payments to the clearing house, as it is the performance bond of the contract.
d) Commodity futures contract can be settled at maturity by physical delivery of the underlying
assets or by cash settlement (i.e., profit or loss arising on the maturity can be settled in cash).

Futures trading can be conducted in any commodity subject to the approval/recognition of

Government of India.

Important Commodity Exchange in India

Organized futures market evolved in India by the setting up Bombay Cotton Trade
Association Ltd in 1875,to trade in cotton derivative products. This was followed by exchanges for
futures trading I oilseeds, food grains, groundnut, groundnut oil, raw jute, jute goods, castor seed,
wheat, rice, sugar, precious metals like gold and silver etc. as of now there are 21 recognised
commodity exchanges out of which 5 are national multi-commodity exchanges.

Commodity Exchanges In India

1) Multi Commodity Exchange of India Ltd.(MCX)

MCX is India’s largest commodity futures exchange in terms of market share and the first
listed commodity exchange. It started operations in November 2003. MCX is promoted by
Financial Technologies(India)Ltd. (FTIL), SBI and its associates, NABARD,NSE,HDFC Bank,
SBI Life, Union Bank of India ,Bank of India etc.
MCX is the state of the art commodity futures exchange that provides online trading
facilities. The exchange has an extensive national reach with over 2100 trading members,
operations through more than 4,00,000 trading terminals, spanning over 1900 cities and towns
across India.
MCX is India’s leading commodity futures exchange with a market share of 89% in terms
of the value of contract traded. It is world’s 7th largest commodity futures exchange in terms of
the number of contracts traded. The various categories of commodity futures products traded in
MCX includes ,bullions (gold, silver, platinum etc.), metals (aluminium, copper, iorn ore, nickel,
zinc etc.), energy products(crude oil, gasoline, natural gas etc., oil and oil seeds(crude palm oil,
soya bean, soya oil etc.), cereals(barley,wheat,maize etc.), fiber(cotton),spices(cardamom,
coriander), pulses (chana), almond, potato etc.
2) National Commodity & Derivatives Exchange Ltd.(NCDEX)
NCDEX is a nation-level, demutualised online commodity exchange incorporated and
commenced operations in 2003. It provides a world class commodity exchange platform for
market participants to trade in a wide spectrum of commodity derivatives. NCDEX is
headquartered at Mumbai.
NCDEX is promoted by LIC, NABARD and NSE. NCDEX is the only commodity exchange
in the country prompted by national level institutions. It stands second in commodity futures
market in terms of volume of trade. If offers contracts in various agricultural (like cereals and
pulses, fibers, oil and oil seeds, spices, plantation products etc.) and non- agricultural products
(metals like steel copper, precious metals like gold and silver, energy products like crude oil etc.).
3) Indian Commodity Exchange Ltd.(ICEX)
Indian Commodity Exchange Limited is a nation-wide on-line trading platform in
commodity derivatives. ICEX is India’s third –largest commodities market offering contracts
on oils and seeds, coffee, rubber and spices, ranked behind the multi-Commodity
Exchange(MCX) and the National Commodity & Derivatives exchange (NCDEX). This
exchange is prompted by MMTC ltd, Indian Potash Ltd ,KRIBHCO,IDFC Bank Ltd,
Reliance Capital and India bulls Housing Finance Ltd. In addition to futures contracts on
various categories, ICEX offers diamond futures contracts.
Advantages of commodity Futures
1) Commodity Futures offers a mechanism to prevent price fluctuation so agricultural
produces/commodities, which is very useful for farmers as well as traders/dealers. Lock-in
price for the produce and assured demand for the farmer and hedge against price fluctuation
for the traders.
2) Dealings in commodity futures are easy and offers high leverage. A trader (hedger) can take a
position in a commodity by paying a fraction of its value as margin.
3) Commodity futures prices helps in price discovery and determination of the underlying
commodities in the spot market. This facilitates fetching right prices for agricultural
commodities based on demand and supply factors.
4) Commodity futures offers high returns. Since the commodity markets are volatile, they may
experience huge swings in price of underlying assets. Smart traders can the advantage of these
price swings to make gains.
5) Commodity futures offer liquidity to the traders concerned. It is easy to buy and sell
commodity futures. Existence of commodity exchanges facilitates liquidity.
 Disadvantages of Commodity Futures

1) The unique requirements of a commodity futures like; need for warehousing, which is
mandatory for those contracts requiring physical settlement. Some commodities are storable,
some are perishable, difference in quality of underlying assets etc. make commodity markets
and trading in commodity derivatives complicated.
2) Commodity futures trading and investment are highly risky. Commodities are the most
volatile asset, and make it risky. The presence of speculators and arbitragers adds to this. This
will affect the return prospects of the investors. The leverage benefits offered can magnify the
both gains and losses.

Forwards and futures distinguished

Practically speaking standardized forward contract dealt in an organized exchange is a future

contract. However, there are some distinctions between two.

1. Tailor –made and standardised: A forward contract is a tailor-made contracts. The terms of
the contract like quantity, price, periods, date, delivery conditions etc. can be negotiated
between the parties according to their convenience. A futures contracts are standardized. They
cannot be altered to the requirements of the parties to the contract.
2. Secondary Market: Forward contract is a customized contract. It is not standardized. Therefore,
it cannot be traded on an organized exchange. Hence there is no secondary market for a forward
contract. However, futures contract can be traded on organized exchanges. Hence, it has a
secondary market.
3. Settlement : A forward contract is always settled on the date of maturity. A future contract on
the other hand is settled daily. Irrespective of the maturity date. It is ‘marked to market’ on a
daily basis.
4. Operation process: Generally, parties enter into a forward agreement with the help of some
financial intermediary like a bank. Futures are facilitated through organized exchanges.
5. Payment of money: The contracting parties neednot pay any down payment in forward
contracts. However, in the case of a futures contracts, the contracting parties have to deposit a
 certain percentage of the contract price as ‘margin money’ with the exchange. It acts as a
collateral support to the contract.
6. Delivery of the Asset: the delivery of the asset on the date of maturity is essential in the case of
a forward contract. This is not necessary in futures contract. The parties merely exchange the
difference between the future and spot prices on the date of maturity in future.

Advantages of Forwards and Futures

a. Minimisation of risk: Risk due to price fluctuations in currencies and commodities could be
minimized to the minimum in forwards and futures. This is facilitated through hedging.
b. No carrying cost: A person who buys a physical commodity from the cash market may have
to meet the interest charges on the money spent, godown charges, insurance, transportation etc.
these are carrying cost. However in future and forwards the buyer need not take delivery of
the asset in advance of the time required. Thus, he can avoid many carry cost. In the cases of
stock he needed only to meet the interest on the money spent for purchasing the stock.
c. Proper Planning: the parties to the contract can plan the time to buy or sell assets depending
on their needs. They need not purchase or sell assets in advanced of future requirements. Thus,
they facilitate proper planning for future requirements.
d. Portfolio Management: portfolio managers and investors can use these contracts to hedge
against future fluctuations in price. They can confidently plan the structure of portfolios and
cover possible risk.
e. Cash Management: There is no down payment in futures and forwards. The parties can
utilize the fund for other purposes. Thus, efficient cash management is possible with the help
of these contracts.
f. Flexibility: futures and forward contracts are highly flexible. If the parties to the contract
prefer closing out their positions, they can exchange net difference between the positions.
g. They need not exchange the assets physically.
3) Option Contracts
Option is another type of derivative to manage risks. Literal meaning of the word ‘option’
is choice.
Options contracts are agreements between two parties which give the right to buy or sell
the underlying asset for a specified price within a specified date. The parties to the option
contracts are; the buyer of the options, also called an option holder. He acquires the right to
 buy or sell. The seller of the options is called option writer. He sells the right or obliged to
exercise the contract according to the choice of the buyer.
On the expiry of the contract the buyer of option contract can decide whether or not to
exercise his right to buy or sell.
The option holder (buyer) acquires the right to exercise the option by paying a
consideration called, option premium to the option writer.
Example: An investor wants to buy 1000 shares of Infosys at Rs.450 per share after one
month. He stipulates an additional condition, i.e., he will take the shares only if spot price of
the shares after one month exceeds Rs.450. In this case the seller cannot sell the shares if the
price goes below Rs.450/-. Therefore ,the seller may demand more money for such contract.
This additional amount is called the ‘premium’. If the price goes much below the expected
price, the seller may lose a substantial amount. Therefore the premium will be calculated, so
as to minimize the loses of the option writer.

Once the premium is accepted, the option seller is under an obligation to sell/buy the underlying asset
at the specifies price whenever the buyer of the option choose to exercise the right. The buyer has all the
rights and the seller has all the obligations. If the share price remains below the agreed price, the buyer
of the option forgoes his right to buy the share. In that case he may lose the premium he has paid. If the
share price goes up, the seller is under an obligation to sell the shares.

Thus, in an option contract the buyer has the choice to buy/sell an underlying asset (share, bond,
currency, commodity etc.) at a specified price on or before a specified future date. It is only a right and
not an obligation.
 Types of options
1) Call option: It is an which gives the buyer the right to buy an underlying assets (commodities, foreign
exchange, stock, shares etc.). He can buy it at a predetermined price called strike price on or before a
specified date in future. However, it is not an obligation for him to buy it. But the seller has the
obligation to sell the asset when the buyer exercises his option.
2) Put option: A put option is one which gives the seller (option holder) the right to sell an underlying
asset at a predetermined price on or before a specified date in future. It means that the buyer (option
writer) is under an obligation to buy the asset at the strike price, if the seller (option holder) exercises his
option to sell.
Example: An investor fearing fall in the price of shares can buy a put option (right to sell) on the
share at an agreed price. He pays the option premium for buying the right. Thus he is protected from a
fu premium for buying the right. Thus he is protected from a future fall in the price of shares as per the
option contract (put). Because the put option gives him a right (not an obligation) to sell the shares to
an option seller at the agreed price if the actual market price of the shares (underlying asset) falls. If the
price does not fall as he feared, he need not sell the shares, i.e. he will not exercise his right to sell the
shares. Thus in a put option the option holder has the choice, either to sell the shares. Thus in a put
option the option-holder has the choice, either to sell or not to sell. The writer of the put option will get
a premium for taking the risk of loss. If the price goes down.
3) Double option
The double option is one which gives the options, options can be American or
European. In an option contract, if the option can be exercised at any time between the
writing of the contact and its expiary, it is an American option. All contracts on individual
share at Indian stock exchange aure American options.
On the other hand, if it can be exercised only at the time of maturity, it is termed as
European option. All option contracts on stock indices are European options in India.
Features of Options
a) Premium Payment: The option holder (buyer) must pay a certain amount called ‘premium’
for holding the right of exercising the option. This is the consideration for the contact. If the
option holder does not exercise his option, he has to forego this premium. Otherwise, this
premium will be deducted from the total payoof in calculating the next payoff due to the
option holder.
b) Settlement: No money or commodity or share is exchanged when the contract is written.
Generally this option contract terminates either at the time of exercising the option by the
option holder or at maturity whichever is earlier. So, settlement is made; only when the option
holder exercises his option. Suppose the option is not exercised till maturity, then the
agreement automatically lapses and no settlement is required.
c) Variations in return: The option holder’s profit is not equal to his loss when the values of
the asset moves in the opposite direction by the same amount. It means that, profits and losses
are not symmetrical under an option contract.
d) Non-Obligatory: In all option contracts, the option holder has a right to buy or sell an
underlying asset. He can exercise this right at any time during the currency of the contract.
But, he has no obligation to buy or sell. If he does not buy or sell, the contract will be simply
lapsed.

Differences Between Futures And Options

A future owner has the obligation to buy or sell a specified quantity of an asset at a
specifies price on a specified date. In contrast, an options holder has the right (but not the
obligation) to buy or sell a specified quantity of an asset at a particular price over a specified
time period. The main fundamental difference between options and futures lies in the
obligations they put on their buyers and sellers.
 The main difference can be summarized as follows;

Futures Options

In futures contract, both the buyer and seller In options, the option holder (buyer) has a right to
have obligation to exercise the contract. exercise the contract, not any obligation. The option
writer (seller) has the obligation to exercise the
contract.

The buyer and seller of an option contact have The option writer (seller) has the risk of unlimited
the risk of unlimited loss. loss. The option buyers risk is limited to the option
premium paid to purchase the contact.

In favorable market condition, the buyer and Option holder (buyer) has the potential to make
seller of a futures contract has the potential to unlimited gain. But even in favorable market
make unlimited gain. situation, seller (option writer) has the potential to
make limited gain only.

A. Swaps
Swaps is another derivative instrument for risk management. The word ‘swap’ means to
exchange or transfer one for another.
Swaps are contracts that follow the parties to exchange their obligations. It basically
involves an exchange of one set of financial obligations with another.
In other words, a swap transaction is one where two or more parties exchange (swap)
one set predetermined payment obligations or asset or liability for another. Swaps are private
arranged long term contracts they are not traded in organized exchanges; they are OTC contracts,
tailor made to counter parties.
Two commonly used swaps are currency swaps and interest –rate swaps.
Currency Swaps
A currency swap is a derivative contract to exchange one currency or a loan in one currency. It
is a foreign-exchange agreement between two parties to exchange a given amount (of loan) in one
currency for an equivalent amount (of loan) in another currency based on present exchange rates,
terms and time period.

In simple form, currency swap involves exchange of principal and interest payment in one
currency for principal and interest payments in another currency. Hus, a currency swap is an
exchange of a liability in one currency for a liability in another currency.

The currency swap involves;

a) An exchange of principal amount today
b) An exchange of interest payments during the currency of the loans, and
c) A re-exchange of principal amounts at the time of maturity.

Currency swap is a contract or agreement and is not a loan by itself.

Interest Rate Swaps

Interest rate swap is a contract to exchange one type of interest payment with another at a
predetermined future date. It involves an exchange of interest rate obligations(fixed for floating rate
payments or vice versa) by two parties. Interest rate swaps are used by borrowers who want to alter
their interest rate or cash flow profile to suit their particular needs.
Fixed –for-floating rate swap (plain vanilla) is the most common interest rate swap. In such a
swap, one party agrees to make fixed-rate interest payments in return for floating-rate interest
payments from the counter party. The interest rate payment calculations are based on a hypothetical
amount of principal called the national amount.