The Derivatives Market

Introduction- Derivatives are one of the most complex instruments. The word
„derivative‟ comes from the verb „to derive‟, indicating that it has no independent
value of its own but it derives its value from an underlying asset like stocks, shares,
bonds, currency, commodity etc. The Indian derivative market has become multi-
trillion dollar markets over the years.
According to John C. Hull, “A derivative can be defined as a financial instrument
whose value depends on (or derives from) the values of other, more basic underlying
variables.”
Marked with the ability to partially and fully transfer the risk by locking in assets
prices, derivatives are gaining popularity among the investors. Since the economic
reforms of 1991, maximum efforts friendly and rigorous efforts have been made
to reinforce the investor assurance. Financial markets are very inventive in
augmenting the popularity of derivatives instruments which exemplifies how
resourcefully markets are capable to package and manage risk.

WHAT ARE DERIVATIVES MARKETS?

Derivatives are tradable instruments that are based on other markets. So the
derivatives market is based on any kind of other markets like stock markets,
currency markets and stock indexes. There are several types of derivatives market
consisting of thousands of individual derivatives that can be traded. So the
derivatives market is mainly investment markets where derivatives trading take
place. In India, the available derivatives instruments are currency, stocks, commodity
and bonds. The BSC and the NSC are the two main exchanges that facilitates the
derivative trading.

FEATURES OF DERIVATIVE MARKET:

1. Derivatives have a maturity or expiry date post which they terminate
automatically.
2. Derivatives are of three types i.e. forward, future and swaps and these assets
can equity, commodities, foreign exchanges or financial bearing assets.
3. All the transaction in the derivatives takes place in a future specified date.
Doing this makes it easier to sell because an individual can take of markets
and take the position accordingly because one has more time in derivatives.
4. A derivative can be used as leverage instruments. The value of the derivative
can move exponentially in comparison to the value of its underlying.
5. There are no specified limits on the number of units that can be transacted in
the derivative market as there are no physical assets for transactions.
6. The derivatives market is liquid and thus the transaction can be effected
easily.
FUNCTIONS OF DERIVATIVE MARKETS
1. Since the implementation of globalization and liberalization we have
experienced rapid variation in interest rate, exchange rate and stock market
prices which state the growing financial risk in India as well as abroad. In such
a scenario, it is important to regulate or manage this risk. And derivatives act
as risk management tools. For example: to reduce the risk you may choose to
purchase a spot item and sell a future contract. If the spot price falls, the
corresponding futures or options contract will help to cope up with the loss.
2. As a risk management tool, it helps in transferring the risk from risk averse
people to the risk oriented people.it shifts the risk from the buyer of the
derivative product to the seller.
3. Price discovery- it acts as a key source of information about prices. The prices
of the derivative instruments can be used to determine what the market
expects the future spot prices to be.
4. Operational advantage-the derivative market is more liquid as compared to
the spot market. So the transaction costs are lower in this market. Other
related costs like commission are also lower than the spot market.
5. It increases savings and investments in the long run since it allows the
investors to make more informed decisions so as to make more their
securities more secured. It increases the volume traded in markets because
of participation of risk-averse people in greater numbers.

Participants of the Derivative Market

1. Hedgers

Hedgers use forward contracts and options to reduce or eliminate financial exposure.
An investor or business with a long exposure to an asset can hedge exposure by
either entering into a short futures contract or by buying a put option. An investor or
business with a short exposure to an asset can hedge exposure by either entering
into a long futures contract or buying a call option.

Hedgers use forward contracts to lock in the price of the underlying security. Forward
contracts do not require an initial investment, but hedgers give up any price
movement that may have had positive results in the event that the position was left
unhedged. Option contracts on the other hand function as insurance for the
underlying by providing the downside protection that the hedger seeks and allowing
for price movement in the direction that could yield positive results. This insurance
does not come without a cost, as we described earlier, since hedgers are required to
pay a premium to purchase options.

2. Speculators
Speculators have a different motivation for using derivatives than hedgers. They use
derivatives to make bets on the market, while hedgers try to eliminate exposure.

The motivation for using futures in speculation is that the limited amount of initial
investment creates significant leverage. The amount of investment required for
futures is the amount of the notional value of the underlying and Treasury securities
can typically be posted as margin. Futures contracts can result in large gains or large
losses, and contract payoffs are symmetrical.

3. Arbitrageurs

Arbitrageurs are also frequent users of derivatives. Arbitrageurs seek to earn a risk
free profit in excess of the risk free rate through the delivery and manipulation pf
misplaced securities. They earn a riskless profit by entering into equivalent offsetting
positions in one or more markets. Arbitrage opportunities typically do not last long as
supply and demand forces will adjust prices to quickly eliminate the arbitrage
situation.

Swaptions

A swaption is an option granting its owner the right but not the obligation to enter into an
underlying swap. Although options can be traded on a variety of swaps, the term "swaption"
typically refers to options on interest rate swaps.

Types of Swaptions

There are two types of swaption contracts (analogous to put and call options)[1]:
• A payer swaption gives the owner of the swaption the right to enter into a swap
where they pay the fixed leg and receive the floating leg.
• A receiver swaption gives the owner of the swaption the right to enter into a swap in
which they will receive the fixed leg, and pay the floating leg.
In addition, a "straddle" refers to a combination of a receiver and a payer option on the same
underlying swap.
The buyer and seller of the swaption agree on:
• The premium (price) of the swaption
• Length of the option period (which usually ends two business days prior to the start
date of the underlying swap),
• The terms of the underlying swap, including:
◦ Notional amount (with amortization amounts, if any)
◦ The fixed rate (which equals the strike of the swaption) and payment
frequency for the fixed leg
◦ The frequency of observation for the floating leg of the swap (for example, 3
month Libor paid quarterly)
There are two possible settlement conventions. Swaptions can be settled physically (i.e., at
expiry the swap is entered between the two parties) or cash-settled, where the value of the
swap at expiry is paid according to a market-standard formula.
 Difference between a cash market and a derivative
market

 In cash market, we can purchase even one share whereas in case of futures and options the
minimum lots are fixed

 In cash market tangible assets are traded whereas in derivatives contracts based on tangible
or intangible assets are traded.

 Cash market is used for investment. Derivatives are used for hedging, arbitrage or
speculation.

 In case of cash market, a customer must open a trading and demat account whereas for
futures a customer must open a future trading account with a derivative broker.

 In case of cash market, the entire amount is put upfront whereas in case of futures only the
margin money needs to be put up.

 When an individual buys shares, he becomes part owner of the company whereas the same
does not happen in case of a futures contract.

 In case of cash market, the owner of shares is entitled to the dividends whereas the
derivative holder is not entitled to dividends.

Forward contract
A forward contract is made between two parties through an agreement-for buying or
selling an asset-at a specified point of time in the future. In a forward contract, the
price which is paid or received by the parties-is mutually determined between the
parties to the contract. Forward contract is a cash market transaction in which
delivery of the instrument is deferred until the contract has been made. There are
two parties who are associated with this contract. One of the parties assumes a long
position (buyer) and agrees to buy the underlying asset at a certain future date for a
certain price. The other party assumes a short position (seller) and agrees to sell the
asset on the same date for the same price. It is to be noted that the specified price is
considered as the delivery price, which is mutually agreed upon by the parties to the
contract. Generally there is no possibility for payment of margins by either party to
the other. In fact, forward contracts are traded over the counter and are not directly
traded on an exchange. The main shortcoming of a forward contract is lack of
liquidity and counter party default risks.

EXAMPLE
A company in India is buying textiles from an exporter from England worth 1 million pounds
(payment due In 90 days).Since the importer is short of pounds, he owes pounds for future
delivery. Suppose, the cash market price of pound is INR RS 42(1 POUND=RS 42). In this
situation the importer suspects that the pound might rise against the Indian rupee in the
next 90 days which, in turn, will increase the rupee cost of the textiles. The importer may-as
a precautionary device-immediately negotiate a 90 day forward contract with a foreign bank
at a forward rate of 1 pound=INR RS42.According to the forward contract, in 90 days the
foreign bank will give the Indian importer 1 million pounds which will be used by him for the
payment of textile orders. At the same time, the bank will receive, from the importers 42
million which is the rupee cost of 1 million pounds at the forward rate of Rs 42.

DIFFERENCE BETWEEN FORWARD CONTRACTS &

FUTURE CONTRACTS
SL NO. FORWARD CONTRACTS FUTURE CONTRACTS
1 Forward contracts are traded over Future contracts are traded on an
the counter and on any recognised organised stock exchange like
stock exchanges NSE,BSE etc
2 Forward contracts are special Future contracts are standardised
purpose instruments designed to forward contracts.
fulfil the specific needs of counter
parties.
3 These are not regulated by any These are regulated by SEBI,RBI and
specific regulatory authority. other regulatory authorities.
4 There is no possibility for There is a scope for margin
payment margins by any of the requirements and daily settlements.
parties to the other
5 Most of the forward contracts are Most of the future contracts are
settled through actual delivery of settled through cash settlement
underlying assets instead of actual delivery of
underlying assets.

OPTIONS
An option gives an investor the right, but not the obligation, to buy or sell a
specified asset on a specified future date.
Strike Price: The agreed price at which the option holder has the right to buy or sell
asset.
Difference between obligation and right: The holder of the option is not obliged to
trade – hence the name „option‟ – and will only do so if it is profitable. The other
party, known as the „writer‟, is obliged to trade if the holder of the option wants to.
The writer of an option collects a premium from the holder for giving the holder the
right to exercise (or not) the option.
PARTICULARS PUT CALL

Meaning A put option gives the right, but A call option gives the right but not the
not the obligation to sell a obligation to buy a specified asset on a set
specified asset on a set date in date in the future for a specified price
the future for a specified price.

Strike price 90 110

Share price at 95 100
the time of
buying option

If share price 80 125

is
Pay off of 90-80=10 125-110=15
option holder

If share price >90 <110

Pay off of 0 0
option holder

A call option is described as:

In-the-money if the current share price > strike price.

Out-of-the-money if current share price <strike price.

 At-the-money if current share price = strike price.
A put option is described as:
In-the-money if the current share price < strike price.
Out-of-the-money if current share price >strike price.

 At-the-money if current share price = strike price.

Types of Option on the basis of timing:
A European option is an option that can only be exercised at expiry.
An American option is one that can be exercised on any date before its expiry.
Example of American option:
An investor has a solid American put option with an exercise price of 20p and an
October expiry date means The investor has given another person the right, but
not the obligation, to sell the underlying asset to the investor at a price of 20p at any
time up to a date in the following October. In return, the investor will have received
a premium.

SWAPS
Swap is a financial instrument which is used as the medium of exchange of one set
of future cash flow with another stream of cash flows having different characteristics.
Swap is a customized agreement between the buyers and the sellers to exchange
one set of financial obligations for another. The cash flows are usually determined
using the notional principal amount (a predetermined nominal value). Each stream of
the cash flows is called a “leg”.

Features

 Are customized instruments.

 Not traded in any organized secondary markets.
 Most participants in the swaps market are large
institutions.
 Individuals are rarely swap market participants.
Types of Swaps Instruments
Some popular types of Swaps Instruments are:

1. Interest Rate Swap – Counterparties agree to exchange one stream of

future interest payments for another, based on a predetermined notional
principal amount. Generally, interest rate swaps involve the exchange of a
fixed interest rate for a floating interest rate.
 2. Currency Swaps- Counterparties exchange the principal amount
and interest payments denominated in different currencies. These
swaps are often used to hedge another investment position
against currency exchange rate fluctuations.
3. Commodity Swaps- These derivatives are designed to exchange floating
cash flows that are based on a commodity‟s spot price for fixed cash flows
determined by a pre-agreed price of a commodity.

Applications of Swaps
Nowadays, swaps are an essential part of modern finance. They can be used in
following ways:

1. Risk Hedging- Interest rate swaps can hedge against interest rate
fluctuations, and Currency swaps can hedge against currency exchange rate
fluctuations.
2. Access to new markets- Companies can use swaps as a tool to access
new markets. For example, a US company can opt to enter into a currency
swap with a British company to access more attractive dollar-to-pound
exchange rate, because the UK-based firm can borrow domestically at a
lower rate.