the features of financial derivatives

cuf risk spe les Cuma regular

Features of Forward Contracts

(cos co da hi li )

Key Features of Futures Contracts

SED RELI HERE

Types of Futures Contracts:

COFI CIS
Functions of Futures Contracts - heplisas

distinction between Futures and Forward Contracts:

SST RISK LI MARE PUR PRICE SIZE

Key Features of Options

OTS PULE HES LUS

Key Features of Commodity Markets

DES PR HIR MALI GP

Types of Commodities — Detailed Explanation

MEA LI
Forward Market Transactions – Definition

fufi co he risk

Key Characteristics of the Forward Market in India

cuco regular

Key Features of Currency Futures

SEDMA HE CA

Functions of a Market Index

BIM RE MAMA
Derivatives

The term “derivative” refers to a type of financial contract whose value is dependent on
an underlying asset, a group of assets, or a benchmark. Derivatives are agreements set between two
or more parties that can be traded on an exchange or over the counter (OTC)

These contracts can be used to trade any number of assets and come with their own risks. Prices for
derivatives derive from fluctuations in the prices of underlying assets. These financial securities are
commonly used to access certain markets and may be traded to hedge against risk. Derivatives can
be used to either mitigate risk (hedging) or assume risk with the expectation of commensurate
reward (speculation). Derivatives can move risk levels (and the accompanying rewards) from the risk-
averse to the risk seekers.

the features of financial derivatives with examples,

cuf risk spe les Cuma regular

1. Contractual Agreement

Derivatives are legally binding contracts between two or more parties. These contracts define
specific terms like the type of asset, quantity, price, and maturity date.
Example: A farmer enters into a forward contract with a food processing company to sell 1,000
kg of wheat at ₹25/kg after 3 months. Both parties are bound to fulfill the contract.

2. Underlying Asset Based

The value of a derivative is derived from an underlying asset such as stocks, commodities, interest
rates, or currencies. Changes in the asset’s price directly affect the derivative's value.
Example: A Reliance call option's value fluctuates based on the movement in Reliance Industries’
share price.

3. Future Settlement

Derivatives are usually settled at a future date, either by physical delivery of the asset or through
cash settlement.
Example: In a crude oil futures contract, the buyer may receive oil or a cash equivalent on expiry.

4. Risk Management Tool (Hedging)

Derivatives help businesses and investors manage risks related to price volatility, currency
fluctuations, or interest rate changes.
Example: An airline hedges against rising fuel costs by buying crude oil futures to lock in current
prices.

5. Speculative Use

Derivatives allow traders to profit from expected changes in the market without owning the
underlying asset. This increases potential profit but also increases risk.
 Example: A trader buys a gold futures contract expecting gold prices to rise. If correct, they profit
by selling at a higher price.

6. Leverage

Derivatives offer high leverage—investors can control large positions with a small margin. This
magnifies both profits and losses.
Example: With ₹10,000 margin, a trader may control ₹1,00,000 worth of Nifty futures,
magnifying returns if prices rise.

7. Standardization (Exchange-Traded Derivatives)

Futures and options traded on stock or commodity exchanges are standardized by quantity, maturity,
and asset type, ensuring uniformity and ease of trading.
Example: NSE’s Nifty 50 futures contract is standardized to 50 units per contract with fixed expiry
dates.

8. Customizability (OTC Derivatives)

Over-the-counter (OTC) derivatives are private contracts tailored to the specific needs of parties
involved, offering more flexibility.
Example: Two companies agree on a custom interest rate swap based on their unique cash flow
needs.

9. Margin Requirements

To minimize default risk, exchanges require traders to deposit an initial margin and maintain it daily
(mark-to-market).
Example: A trader needs to keep a ₹20,000 margin in a futures account to hold a position. If the
market moves against them, more margin may be required.

10. Regulatory Oversight

Exchange-traded derivatives are strictly regulated to ensure transparency, fairness, and financial
stability. OTC markets are regulated but less stringently.
Example: In India, SEBI monitors derivatives markets on NSE and BSE, while international
regulators include the CFTC (USA) and ESMA (EU).
Evolution of Derivatives: A Journey Through Time •
Derivatives aren't a new invention; their basic concept dates back centuries, evolving from
simple agreements to complex financial instruments
:

• Ancient Times (Risk Management):

• Mesopotamia (around 1750 BC): Farmers used early forms of forward contracts to lock in
future prices for their crops, protecting themselves from price drops.
• Ancient Greece: The philosopher Thales predicted a large olive harvest and negotiated the
right to use olive presses in advance, securing a future resource. •
Japan (17th Century): The Dojima Rice Exchange in Osaka developed rice futures, allowing
samurai (often paid in rice) and merchants to hedge against volatile rice prices. These were
some of the first organized futures markets
. • Medieval & Early Modern Period (Facilitating Trade):
• European Trade Fairs (12th-13th Centuries): Sellers would sign contracts for future
delivery of goods.
• Renaissance Italy & Holland (16th Century): Contracts for future delivery of securities
became more common, and even futures trading for tulips emerged (leading to the
infamous "Tulip Mania" bubble)

19th Century (Formal Exchanges):

• Chicago Board of Trade (CBOT) in 1848: This marked a significant step with the
establishment of a formal exchange for commodity forward contracts
. • Futures Contracts (1865): CBOT introduced the first "exchange-traded" derivative
contracts, known as futures.
• Mid-20th Century to Present (Financial Derivatives & Innovation):
• 1970s: The collapse of the Bretton Woods system (fixed exchange rates) led to increased
currency volatility, creating a demand for financial derivatives.
• 1972: The Chicago Mercantile Exchange (CME) introduced currency futures.
• 1973: The Chicago Board Options Exchange (CBOE) launched, making options trading
accessible. The groundbreaking Black-Scholes Model for option pricing was also published,
revolutionizing how options were valued.
• 1980s-1990s: Rapid expansion driven by technology and globalization.
 • Swaps: Interest rate swaps and currency swaps emerged, allowing companies to manage
these risks more effectively.
• Over-the-Counter (OTC) Market Growth: Customized derivative products grew outside of
formal exchanges.
• 21st Century: Derivatives became integral to global finance, with continued innovation in
products like credit default swaps and even environmental derivatives. Electronic trading
platforms have significantly increased accessibility and liquidity.

In essence, derivatives evolved from simple agreements to manage agricultural risk to

sophisticated financial instruments used for a wide range of purposes in today's global
markets.

Types of contracts
Forward Contract – Definition

A forward contract is a private agreement between two parties to buy or sell an asset at a
predetermined price on a specified future date. The asset could be anything like commodities,
currencies, or financial instruments. The terms of the contract—such as price, quantity, and delivery
date—are customized to suit both parties’ needs.

Features of Forward Contracts (cos co da hi li )

1. Customized Terms: The buyer and seller agree on specific terms such as price, quantity, and
delivery date tailored to their needs.

2. Over-the-Counter (OTC): Forward contracts are privately negotiated and traded directly
between parties, not on an exchange.

3. Settlement at Maturity: The contract is settled only on the agreed future date, either by
delivery of the asset or cash settlement.

4. Counterparty Risk: Since there is no clearinghouse, there’s a risk that one party might
default on the agreement.

5. No Daily Mark-to-Market: Unlike futures, profits or losses are realized only at the
contract’s expiration.

6. Used for Hedging: Commonly used by businesses and investors to lock in prices and protect
against price fluctuations.

7. No Initial Payment: Typically, no money changes hands when the contract is signed (except
sometimes a margin).

8. Illiquid: Forwards are less liquid because they cannot be easily sold or transferred before
maturity.
 Example

A wheat farmer agrees with a buyer to sell 1,000 kg of wheat in 3 months at ₹40 per kg. Regardless
of market price changes, the buyer will pay ₹40 per kg at the end of 3 months.

Forward Market Transactions – Definition

Forward market transactions refer to agreements made today to buy or sell an asset at a future
date for a pre-agreed price. These transactions take place in the forward market, which is an over-
the-counter (OTC) market — meaning the contracts are not traded on formal exchanges but privately
negotiated between parties.

The most common instruments used in forward market transactions are forward contracts. These
are customized derivatives used mainly for hedging against risks like price changes in commodities,
currencies, or financial instruments.

Key Features of Forward Market Transactions fufi co he risk

1. Future Settlement: Actual delivery and payment occur at a specified future date.

2. Fixed Price: Price is agreed upon at the time of the contract, regardless of future market
changes.

3. Customizable Terms: Contracts are tailored to suit the needs of both parties (quantity,
quality, date, etc.).

4. Over-the-Counter (OTC): Not traded on exchanges; privately negotiated.

5. Used for Hedging or Speculation: Businesses use them to reduce uncertainty; investors may
use them to bet on price movements.

6. Counterparty Risk: Since there's no central clearinghouse, there's a risk that one party might
default.

Example

A rice exporter in India expects to ship 10 tons of rice to a U.S. buyer in 3 months. To avoid losses
from a falling dollar, they enter a forward market transaction with a bank to sell USD at a fixed
exchange rate (say, ₹83 per USD) in 3 months. This locks in the exchange rate and protects them
from currency risk.
Forward Market in India – Overview

The forward market in India refers to the over-the-counter (OTC) trading of contracts where parties
agree today to buy or sell an asset at a future date for a fixed price. These contracts are mainly used
for hedging against price fluctuations in commodities, currencies, and interest rates. Unlike futures,
forward contracts in India are not standardized and are not traded on exchanges, but privately
negotiated.

Key Characteristics of the Forward Market in India cuco regular

1. Over-the-Counter (OTC): Contracts are private, flexible, and not regulated by stock
exchanges.

2. Used for Hedging: Mainly used by exporters, importers, and businesses to protect against
price or currency fluctuations.

3. Customized Contracts: Terms such as quantity, quality, price, and settlement date are set by
the parties involved.

4. Currency Forwards: Most common forward contracts in India involve foreign exchange, used
to lock in exchange rates.

5. Regulated by RBI: Currency forward contracts are regulated by the Reserve Bank of India
(RBI) to ensure stability and reduce speculative activity.

Example

A garment exporter in India expects to receive USD 1,00,000 in 3 months. To protect against the risk
of the US dollar falling against the rupee, they enter a forward contract with a bank to sell USD at
₹83 per dollar after 3 months. This locks the rate and protects the exporter from currency loss.

Institutions Involved

• RBI – Regulates forward currency contracts.

• Banks and Financial Institutions – Act as counterparties for forward deals.

• Corporates and Exporters/Importers – Major users of forward contracts.

Futures Contract – Definition

A futures contract is a standardized agreement traded on an exchange to buy or sell an asset (like
commodities, currencies, or financial instruments) at a predetermined price on a specific future
date. Unlike forwards, futures are regulated, have fixed terms, and involve daily settlements.

Key Features of Futures Contracts

SED RELI HERE

1. Standardized Contracts: Terms like quantity, quality, and delivery date are fixed by the
exchange.

2. Exchange-Traded: Futures are traded on organized exchanges (e.g., NSE, CME), which
guarantee contract performance.

3. Daily Mark-to-Market: Gains and losses are settled daily through a clearinghouse, reducing
credit risk.

4. Margin Requirements: Traders must deposit an initial margin and maintain it throughout the
contract.

5. High Liquidity: Futures contracts are highly liquid and easy to buy or sell before expiry.

6. Used for Hedging and Speculation: Widely used by businesses and investors to manage price
risk or speculate on price movements.

7. Regulated Market: Subject to strict regulations by market authorities to ensure fairness and
transparency.

Example

A farmer agrees to sell 1,000 bushels of wheat at $5 per bushel in 3 months through a futures
contract on a commodity exchange. The contract can be sold before maturity if the farmer wants to
exit.
Types of Futures Contracts:
COFI CIS
Commodity Futures

These contracts are based on physical commodities like agricultural products, metals, or energy
resources. Commodity futures allow producers, consumers, and investors to hedge against price
fluctuations in the physical goods market.

• Example: A farmer growing wheat can sell wheat futures contracts to lock in a price before
harvest, protecting against the risk of falling prices.

• Use: Helps producers and buyers manage risks due to price volatility of raw materials.
Investors may also trade these futures to profit from price changes.

2. Financial Futures

Financial futures are contracts based on financial instruments such as currencies, interest rates, and
stock indices. These are widely used by businesses and investors for hedging or speculation.

• Example: An Indian company expecting payment in USD may buy USD futures to lock in the
exchange rate and avoid currency risk.

• Use: Helps manage risks related to foreign exchange rate fluctuations, interest rate changes,
or stock market movements.

3. Currency Futures

Currency futures are a subset of financial futures, specifically focused on foreign exchange rates.
These contracts allow parties to fix the price at which one currency will be exchanged for another at
a future date.

• Example: An importer in India expects to pay $1 million in three months. To avoid the risk of
the rupee depreciating against the dollar, they buy USD futures at the current rate.

• Use: Used by importers, exporters, and investors to hedge foreign exchange risk.

4. Interest Rate Futures

These futures are based on debt securities such as government bonds, treasury bills, or other fixed-
income instruments. They allow market participants to hedge or speculate on future interest rate
changes.

• Example: A bank expecting to lend money in the future may sell interest rate futures to
hedge against the risk of rising interest rates (which would make borrowing more expensive).

• Use: Helps financial institutions and investors manage exposure to interest rate fluctuations.

5. Stock Index Futures

Stock index futures are contracts based on a stock market index (like the S&P 500 or Nifty 50). They
allow investors to speculate on or hedge against the overall movement of the stock market.

• Example: An investor expecting the market to fall can sell Nifty 50 futures to profit from the
decline or hedge existing stock holdings.
Functions of Futures Contracts - heplisas

1. Hedging Risk
Futures allow businesses and investors to lock in prices for assets they plan to buy or sell in
the future, protecting them from unfavorable price changes. For example, a farmer can
hedge against falling crop prices.

2. Price Discovery
Futures markets help discover the future price expectations of an asset based on supply and
demand. This provides useful information to producers, consumers, and investors about
likely price trends.

3. Liquidity
Futures markets are highly liquid, allowing traders to buy and sell contracts easily. This
liquidity ensures that participants can enter or exit positions quickly without major price
changes.

4. Speculation
Traders and investors use futures contracts to speculate on price movements without
owning the actual asset. This helps add liquidity and can contribute to more efficient
markets.

5. Standardization and Regulation

Futures contracts are standardized and traded on regulated exchanges, providing
transparency, reduced counterparty risk, and market fairness.

6. Facilitates Arbitrage
Futures markets allow arbitrageurs to take advantage of price differences between the
futures and spot markets, helping align prices and improving market efficiency.
distinction between Futures and Forward Contracts:

SST COLI MARE PUR PRICE SIZE

Feature Forward Contract Futures Contract

Over-the-counter (OTC), privately Traded on organized exchanges (e.g.,

Trading Venue
negotiated NSE, CME)

Customized terms (price, quantity, Standardized contract terms set by the

Standardization
delivery date) exchange

Settled at maturity (usually physical Marked-to-market daily with cash

Settlement
delivery) settlements

Low risk due to clearinghouse

Counterparty Risk High risk (no clearinghouse guarantee)
guarantee

Low liquidity, contracts are not easily Highly liquid, contracts can be
Liquidity
transferable bought/sold anytime

Margin Initial and maintenance margins

Usually, no margin required upfront
Requirement required

Highly regulated by exchanges and

Regulation Less regulated, OTC market
authorities

Purpose Mainly hedging customized risk Hedging and speculation

Transparent pricing with public order

Price Transparency Less transparent, negotiated privately
books

Contract Size Flexible Fixed and standardized

Detailed Explanation of Futures Contract Pricing
The price of a futures contract is not arbitrary; it is closely linked to the current market (spot) price
of the underlying asset and the costs and benefits associated with holding (or carrying) that asset
until the contract’s delivery date.

1. Spot Price (S) SCOTI PIS

The spot price is the current price at which the asset (commodity, currency, or financial instrument)
can be bought or sold in the market today. This is the starting point for pricing futures.

2. Cost of Carry (C)

Cost of carry refers to the total cost of holding the asset until the future date, including:

• Financing Cost: Interest paid to borrow money to buy the asset (usually approximated by the
risk-free interest rate).

• Storage Cost: For physical goods like commodities, costs for warehousing, insurance, and
transportation.

• Other Costs: Any additional costs such as spoilage, insurance, or handling fees.

If the asset generates income during the holding period, such as dividends for stocks or rental
income for property, this income reduces the cost of carry.

3. Time to Maturity (T)

This is the duration from the present until the futures contract expires, usually expressed in years or
fractions of years.

4. Income from the Asset (Y)

If the asset produces income (like dividends or coupons), the present value of that income reduces
the futures price because the buyer of the futures does not receive that income directly.

5. Pricing Formula

The theoretical price FFF of a futures contract is given by:

F=S×e(r+c−y)×TF = S \times e^{(r + c - y) \times T}F=S×e(r+c−y)×T

Where:

• FFF = Futures price

 • SSS = Spot price

• rrr = Risk-free interest rate (annualized)

• ccc = Storage and other carrying costs (annualized)

• yyy = Income yield from the asset (annualized)

• TTT = Time to maturity (in years)

• eee = The base of natural logarithms (~2.71828), used for continuous compounding

6. Interpretation of Pricing

• Contango: When the futures price FFF is above the spot price SSS, usually because carrying
costs exceed income yields. Common in commodities with storage costs.

• Backwardation: When the futures price FFF is below the spot price SSS, often because the
asset pays income or there is high demand for immediate delivery.

7. Example

Imagine you want to price a futures contract on gold:

• Spot price of gold: ₹50,000 per 10 grams

• Annual risk-free interest rate: 6% (0.06)

• Annual storage cost: 1% (0.01)

• Income from gold: 0% (no dividends)

• Time to maturity: 3 months = 0.25 years

Using the formula:

F=50,000×e(0.06+0.01−0)×0.25=50,000×e0.0175≈50,000×1.0176=₹50,880F = 50,000 \times e^{(0.06

+ 0.01 - 0) \times 0.25} = 50,000 \times e^{0.0175} \approx 50,000 \times 1.0176 =
₹50,880F=50,000×e(0.06+0.01−0)×0.25=50,000×e0.0175≈50,000×1.0176=₹50,880

So, the futures price would be about ₹50,880, slightly higher than the current spot price due to the
cost of carrying gold.

8. Special Cases

• Currency Futures:
The formula is adapted to account for interest rates in both currencies:

F=S×e(rd−rf)×TF = S \times e^{(r_d - r_f) \times T}F=S×e(rd−rf)×T

where rdr_drd = domestic interest rate, rfr_frf = foreign interest rate.

Currency Futures – Definition
A currency futures contract is a standardized agreement traded on an exchange to buy or sell a
specific amount of one currency for another at a fixed price (exchange rate) on a specified future
date.

Key Features of Currency Futures SEDMA HE CA

1. Standardized Contracts: Fixed contract sizes, maturity dates, and currency pairs set by the
exchange.

2. Exchange-Traded: Traded on regulated exchanges like the NSE, CME, or ICE, providing
transparency and security.

3. Daily Settlement: Marked-to-market daily, so profits and losses are settled every trading day.

4. Margin Requirements: Traders must deposit initial and maintenance margins to trade.

5. Used for Hedging and Speculation: Helps importers, exporters, investors, and speculators
manage or profit from currency fluctuations.

6. No Counterparty Risk: Clearinghouse guarantees the contract, reducing default risk.

How Currency Futures Work

Suppose an Indian company expects to pay $1 million in 3 months. To avoid the risk of the Indian
Rupee (INR) depreciating against the US Dollar (USD), it can buy USD/INR currency futures at today’s
rate. If the INR weakens, the futures contract gains value, offsetting the higher cost of dollars in the
spot market.

Example

• Spot rate: 1 USD = ₹75

• The company buys currency futures for $1 million at ₹75.50 per USD, expiring in 3 months.

• If after 3 months, the spot rate rises to ₹77 (rupee weakens), the company gains on the
futures contract, offsetting the higher dollar cost.
Market Index

A Market Index is a numerical representation that tracks and measures the performance of a specific
group of securities, typically stocks, within a particular market or sector. It reflects the overall
movement and trends of that segment, serving as a benchmark to gauge market health, investor
sentiment, and economic conditions.

Types of Market Indexes PEM

1. Price-Weighted Index:
The index value depends on the price of each stock. Higher-priced stocks have more
influence.
Example: Dow Jones Industrial Average (DJIA).

2. Market Capitalization-Weighted Index:

Stocks are weighted according to their market capitalization (stock price × number of shares).
Larger companies have a bigger impact.
Examples: S&P 500, Nasdaq Composite, Nifty 50, Sensex.

3. Equal-Weighted Index:
Each stock contributes equally regardless of size or price.

Functions of a Market Index BIM RE MAMA

1. Benchmark for Performance

Acts as a standard against which investors and fund managers compare the performance of
their portfolios.

2. Market Indicator
Reflects the overall health and direction of the stock market or specific sectors, indicating
bullish or bearish trends.

3. Investment Tool
Serves as the basis for index funds, exchange-traded funds (ETFs), and other passive
investment products.
 4. Risk Management
Provides a reference for derivative instruments like futures and options, enabling investors to
hedge against market risks.

5. Economic Barometer
Offers insights into the broader economy’s condition by tracking key companies that
influence economic activity.

6. Facilitates Market Analysis

Helps analysts and researchers study market trends, volatility, and investor sentiment.

7. Promotes Market Transparency

By aggregating prices of multiple stocks, it makes market movements easier to understand
for investors.

Functions of Index Futures

1. Hedging:
Protects investors and portfolio managers against adverse market movements by allowing
them to offset potential losses in their stock holdings.

2. Speculation:
Enables traders to profit from expected rises or falls in the overall market index without
owning the underlying stocks.

3. Price Discovery:
Helps in determining the future expected value of the stock market index based on current
market information and investor sentiment.

4. Arbitrage:
Facilitates risk-free profit opportunities by exploiting price differences between the futures
market and the underlying index.

5. Liquidity:
Provides a highly liquid platform for investors to enter or exit market positions quickly.

6. Market Efficiency:
Enhances overall market efficiency by integrating spot and futures markets, leading to better
price alignment.

7. Portfolio Management:
Assists fund managers in managing market risk and adjusting portfolio exposure quickly and
cost-effectively.
Cost of Carry Model is a financial theory that determines the fair price of a futures contract by
adjusting the current spot price of the underlying asset for the costs and benefits of holding
(carrying) the asset until the contract’s expiration. These costs include interest, storage, insurance,
and other expenses, while benefits may include income like dividends or interest earned on the
asset. For currency futures, the model mainly considers the interest rate difference between two
currencies. This ensures futures prices reflect the true economic cost of holding the asset and
prevent arbitrage opportunities.

key components of the Cost of Carry Model:

1. Spot Price (S):

The current market price of the underlying asset.

2. Carrying Costs:
Expenses incurred to hold the asset until the futures contract expires, including:

o Financing or interest cost (cost of capital)

o Storage costs (for physical commodities)

o Insurance and maintenance expenses

3. Income or Benefits (y):

Returns earned by holding the asset, such as:

o Dividends (for stocks)

o Interest income (for bonds)

o Convenience yield (non-monetary benefits of physical possession)

4. Time to Maturity (t):

The length of time from the current date to the futures contract’s expiration, usually
expressed in years.

5. Risk-Free Interest Rate (r):

The theoretical return on a riskless investment, used to calculate financing costs.

6. Futures Price (F):

The price of the futures contract, which equals the spot price adjusted for the net cost of
carry over the period ttt.
The futures price FFF is calculated as:

F=S×e(r+u−y)×tF = S \times e^{(r + u - y) \times t}F=S×e(r+u−y)×t

Where:

• rrr = risk-free interest rate

• uuu = storage cost rate

• yyy = income or yield from the asset

• ttt = time to maturity (in years)

In Currency Futures

Since currencies do not have storage costs or dividends, the formula simplifies to:

F=S×e(rd−rf)×tF = S \times e^{(r_d - r_f) \times t}F=S×e(rd−rf)×t

 Options

Options are derivative contracts that give the holder the right, but not the obligation, to buy or
sell an underlying asset (such as stocks, indices, currencies, or commodities) at a predetermined
price (called the strike price) within a specified time frame or on a specific expiry date.

Two Main Types of Options

1. Call Option:

o Gives the buyer the right to buy the underlying asset at the strike price.

o Buyers expect the price to go up in the future.

o Example: If you buy a call option on a stock at ₹100, and the price rises to ₹120, you
can buy it at ₹100 and sell at ₹120 for a profit.

2. Put Option:

o Gives the buyer the right to sell the underlying asset at the strike price.

o Buyers expect the price to go down in the future.

o Example: If you buy a put option at ₹100, and the price drops to ₹80, you can sell it
at ₹100 and buy at ₹80 to gain the difference.

Key Features of Options OTS PULE HES LUS

1. Right, Not Obligation:

The buyer has the right to buy (call) or sell (put) the asset, but is not required to do so.

2. Types – Call and Put Options:

o Call Option: Right to buy.

o Put Option: Right to sell.

3. Strike Price:
The fixed price at which the buyer can buy or sell the underlying asset.

4. Premium:
The cost paid by the buyer to the seller (option writer) to own the option.

5. Expiry Date:
The option must be exercised before or on this date, after which it becomes invalid.
 6. Underlying Asset:
Options derive their value from an asset like stocks, indices, currencies, or commodities.

7. Leverage:
Small investment (premium) can control a large value of the underlying asset.

8. Hedging Tool:
Used to protect against losses in stock or asset prices.

9. Speculation Opportunity:
Traders can profit from expected price movements without owning the actual asset.

10. Limited Risk for Buyer:

The maximum loss for an option buyer is limited to the premium paid.

11. Unlimited Profit Potential (for Calls):

A call option buyer can benefit from rising asset prices with unlimited upside.

12. Standardized Contracts:

Traded on exchanges like NSE, BSE (in India), with fixed contract terms.

Common Option Strategies to Mitigate Risk

Strategy Description Use Case

1. Protective Buying a put option to protect against a An investor holding stocks buys a put to
Put decline in asset price. hedge against a fall in prices.

Holding an asset and selling a call option on Generates income and protects slightly
2. Covered Call
the same asset. against downside risk.

3. Collar Buying a protective put and selling a covered Limits both upside and downside, used by
Strategy call simultaneously. risk-averse investors.

4. Long Buying both a call and a put at the same strike Profits from high volatility (both up or down
Straddle price. movement).
Strategy Description Use Case

5. Long Buying a call and a put at different strike Cheaper than a straddle, still used to profit
Strangle prices. from large movements.

6. Bear Put Buying a put at a higher strike and selling a Hedging against moderate price decline at a
Spread put at a lower strike. lower cost.

7. Bull Call Buying a call at a lower strike and selling

Spread another call at a higher strike.

Derivatives vs. Swaps

Basis of
Derivatives Swaps
Comparison

A derivative is a financial instrument whose A swap is a type of derivative in

value is derived from an underlying asset which two parties exchange cash
Definition
such as stocks, bonds, commodities, flows or liabilities from different
currencies, interest rates, etc. financial instruments.

Interest Rate Swaps, Currency

Types Forwards, Futures, Options, Swaps Swaps, Commodity Swaps, Credit
Default Swaps
Basis of
Derivatives Swaps
Comparison

Mainly used for hedging or

Purpose Hedging, speculation, arbitrage
managing risk

Swaps are customized contracts and

Some derivatives like futures and options
Standardization usually traded over-the-counter
are standardized and traded on exchanges
(OTC)

Market Traded on both exchanges and OTC markets Traded only in OTC markets

Generally more complex and

Can range from simple (options) to complex
Complexity requires negotiation between
(exotic derivatives)
parties

Can be cash-settled or involve physical Usually involves exchange of cash

Settlement
delivery flows over a period of time

- Interest Rate Swap: Fixed to

- Stock options
floating interest rate exchange
Examples - Currency futures
- Currency Swap: INR to USD debt
- Commodity forwards
servicing

Commodity Markets — Definition

A Commodity Market is a regulated marketplace where raw materials and primary products (called
commodities) are bought and sold, either for immediate delivery (spot market) or for future
delivery (futures market) through standardized contracts.

These markets facilitate price discovery, risk management (hedging), and investment in physical
goods such as agricultural products, metals, energy resources, and livestock.
Key Features of Commodity Markets DES PR HIR MALI GP

Feature Explanation

1. Physical or Derivative Commodities are traded either as physical goods (spot market) or
Trading through contracts like futures and options (derivatives market).

Futures and options contracts have standardized terms — quality,

2. Standardized Contracts
quantity, delivery date, and location.

Market prices reflect supply and demand dynamics, helping

3. Price Discovery
stakeholders decide on buying/selling.

Producers and consumers use the market to protect against adverse

4. Hedging Mechanism
price movements.

5. Speculation and Traders and investors participate to profit from price fluctuations,
Investment adding liquidity to the market.

Commodity exchanges are regulated by authorities (e.g., SEBI in India)

6. Regulated Marketplaces
to ensure fairness and transparency.

7. Margin and Settlement Trades require margin deposits to manage risk; settlement can be cash
System or physical delivery.

8. High Liquidity for Commodities like gold, crude oil, and agricultural staples have active
Popular Commodities trading and easy entry/exit.

Commodity prices are influenced by global factors like geopolitical

9. Global Market Influence
events, weather, and economic policies.

Includes farmers, miners, manufacturers, traders, hedgers, speculators,

10. Diverse Participation
and institutional investors.

Types of Commodities — Detailed Explanation MEA LI

1. Energy Commodities

• Description: These include fuels and power sources essential for industrial activity,
transportation, and electricity generation.
 • Examples:

o Crude Oil: The most traded energy commodity; used to produce gasoline, diesel,
plastics, and other products.

o Natural Gas: Used for heating, electricity generation, and as an industrial feedstock.

o Coal: Primarily used in power plants and steel production.

• Characteristics:

o Highly sensitive to geopolitical events, supply disruptions, and global demand.

o Prices are volatile due to weather, political tensions, and OPEC decisions.

2. Metals

• Description: These are either precious or industrial metals used in manufacturing, jewelry,
electronics, and construction.

• Examples:

o Gold: Precious metal used as a store of value, jewelry, and in electronics.

o Silver: Used in jewelry, electronics, solar panels, and photography.

o Copper: Key industrial metal for electrical wiring, plumbing, and construction.

o Aluminum: Lightweight metal used in transportation, packaging, and construction.

• Characteristics:

o Precious metals often act as safe havens during economic uncertainty.

o Industrial metals closely tied to economic growth and infrastructure development.

3. Agricultural Commodities

• Description: These are raw or minimally processed farm products used as food, feed, or raw
materials for other industries.

• Examples:

o Wheat: Staple food grain used worldwide for bread and food products.
 o Corn: Used as food, livestock feed, and increasingly for biofuel (ethanol) production.

o Coffee: Popular beverage commodity, sensitive to weather and geopolitical factors in

growing regions.

o Sugar: Used in food and beverage industries, also affected by weather and trade
policies.

• Characteristics:

o Highly seasonal and weather-dependent.

o Prices influenced by crop yields, government policies, and global consumption

patterns.

4. Livestock

• Description: Commodities related to live animals and animal products used primarily for
meat and dairy.

• Examples:

o Cattle: Includes live cattle for beef production.

o Hogs: Pigs raised for pork production.

• Characteristics:

o Prices depend on feed costs, disease outbreaks, consumer demand, and export
policies.

o Influenced by seasonal demand (holidays, festivals) and farming cycles.

History of Commodity Trading

1. Ancient Beginnings

• Commodity trading dates back thousands of years to ancient civilizations like Mesopotamia,
Egypt, and the Indus Valley, where basic goods such as grains, livestock, and metals were
bartered or exchanged.
 • Early markets were local and informal, often based on barter systems without standardized
currency.

2. Emergence of Formal Markets

• Around 2000 BC, the first recorded commodity exchanges appeared in places like the Middle
East and ancient Greece, where merchants began trading contracts and promissory notes.

• The Roman Empire facilitated trade of commodities like olive oil, wine, and metals across its
vast territories.

3. Medieval Period

• Commodity markets developed further in medieval Europe, particularly in trading hubs like
Venice and Bruges.

• Fairs and guilds provided organized venues for trading commodities and standardizing
measures.

4. Birth of Futures Trading — The Dojima Rice Exchange

• The first formal futures exchange was established in Japan in the early 1700s — the Dojima
Rice Exchange in Osaka.

• Farmers and merchants traded contracts to buy and sell rice at future dates to hedge against
price fluctuations.

5. Modern Commodity Exchanges in the West

• The Chicago Board of Trade (CBOT) was founded in 1848, becoming one of the world’s first
organized futures exchanges.

• Standardized contracts for agricultural commodities like corn, wheat, and soybeans helped
farmers hedge risks and facilitated price discovery.

• The New York Mercantile Exchange (NYMEX) and London Metal Exchange (LME) later
became major hubs for energy and metals trading.

6. 20th Century to Present

• Introduction of electronic trading platforms revolutionized commodity markets by increasing

speed and accessibility.

• Expansion of commodity derivatives markets to include options and other complex contracts.

• Increased participation by institutional investors and speculators transformed commodity

markets into global, highly liquid financial markets.
 • In India, commodity futures trading formally began in the early 20th century and was later
regulated by SEBI from 2015, with major exchanges like MCX and NCDEX playing a central
role.

Summary Timeline

Period Key Development

Ancient Times Barter and local commodity trade

1700s (Japan) Dojima Rice Exchange — first futures market

1800s (USA) Chicago Board of Trade founded; standardized futures contracts

1900s Growth of energy and metals exchanges (NYMEX, LME)

Late 20th Century Electronic trading and global expansion

21st Century (India) SEBI regulates commodity markets; MCX, NCDEX growth

Major Commodities Traded in Indian Derivatives Exchanges

India has a vibrant commodity derivatives market, with the Multi Commodity Exchange (MCX) and
the National Commodity and Derivatives Exchange (NCDEX) being the two primary dedicated
exchanges. The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) also offer
commodity derivatives trading.
Here are the major categories and specific commodities commonly traded on derivatives
exchanges in India

1. Bullion (Precious Metals) • These are among the most popular and actively traded
commodities, often considered safe-haven assets.
2. Gold: Traded in various forms (e.g., Gold, Gold Mini, Gold Petal). • Silver: Traded in
various forms (e.g., Silver, Silver Mini, Silvermicro

• 2. Energy • These commodities are crucial for industrial and domestic consumption, and their
prices are influenced by global supply, demand, and geopolitical factors.

• Crude Oil: A highly liquid and volatile commodity

• Natural Gas: Increasingly important as India transitions towards cleaner energy.

Base Metals (Industrial Metals)

• These metals are essential for manufacturing, construction, and other industries,
reflecting the overall health of the economy.
• Copper, Aluminium, Zinc, Lead • Nickel

4. Agricultural Commodities •

NCDEX primarily focuses on agricultural commodities, playing a crucial role in

price discovery and risk management for farmers and agri-businesses
. • Cereals and Pulses:
Wheat, Maize, Chana (Chickpea), Moong, Tur.
• Oilseeds and Oils: Soybean, Mustard Seed, Castor Seed, Refined Soy Oil, Crude
Palm Oil.
• Spices: Jeera (Cumin), Turmeric, Coriander, Pepper.
• Fibres: Cotton.
• Other agricultural products: Mentha Oil, Cardamom.

• Major Exchanges and their Focus:

• Multi Commodity Exchange (MCX):

The largest commodity derivatives exchange in India. It primarily deals in bullion (gold, silver),
energy (crude oil, natural gas), and base metals. It also offers trading in select agricultural
commodities like Cotton and Mentha Oil.

• National Commodity and Derivatives Exchange (NCDEX): This exchange is exclusively dedicated
to agricultural commodities. It provides a platform for trading in a wide range of cereals, pulses,
oilseeds, spices, and other agri-products.

• National Stock Exchange (NSE) & Bombay Stock Exchange (BSE): While primarily equity
exchanges, they have also ventured into commodity derivatives, offering contracts in bullion and
base metals
Participants in Commodity Derivative Markets

1. Hedgers

• Who: Producers, farmers, manufacturers, processors, and consumers of commodities.

• Role: Use commodity derivatives (futures and options) to protect themselves from price
risk.

• Example: A farmer selling wheat futures to lock in a price before harvest; a jeweler buying
gold futures to hedge against price rise.

• Goal: Reduce uncertainty about future prices, ensuring business stability.

2. Speculators

• Who: Traders, investors, and financial institutions who do not have a direct interest in the
physical commodity.

• Role: Take positions in commodity derivatives to profit from price movements.

• Example: Buying crude oil futures anticipating prices will rise.

• Goal: Earn profits by predicting price changes; provide liquidity to the market.

3. Arbitrageurs

• Who: Traders who exploit price differences of the same commodity in different markets or
forms.

• Role: Buy low in one market and sell high in another to lock in riskless profits.

• Example: Simultaneously buying gold in spot market and selling gold futures if futures price
is higher than spot plus carrying cost.

• Goal: Ensure price efficiency across markets.

4. Brokers and Traders

• Who: Intermediaries licensed to execute trades on behalf of clients.

• Role: Facilitate buying and selling of commodity contracts on exchanges.

• Goal: Provide access to markets and earn commission/fees.

5. Clearing Members

• Who: Entities authorized by the exchange to clear and settle trades.

• Role: Guarantee trade settlement, manage margin collections, and ensure financial integrity.

• Goal: Reduce counterparty risk and maintain smooth functioning of markets.

6. Regulators

• Who: Government bodies like SEBI (Securities and Exchange Board of India) in India.

• Role: Regulate and supervise commodity derivatives markets to ensure transparency, protect
investors, and prevent market manipulation.

• Goal: Promote fair and orderly markets.

Summary Table

Participant Role Objective

Hedgers Manage price risk Protect from adverse price moves

Speculators Take risk for profit Profit from price volatility

Arbitrageurs Exploit price differences Ensure price efficiency

Brokers/Traders Execute trades for clients Facilitate market access

Clearing Members Clear and settle trades Guarantee settlement

Regulators Monitor and regulate markets Ensure transparency & fairness

Commodity Market Indices

What is a Commodity Market Index?

A Commodity Market Index is a benchmark or a composite measure that tracks the overall price
movements of a selected basket of commodities. It reflects the performance of the commodities
market or specific segments of it.

These indices serve as a reference point for investors, traders, and fund managers to gauge market
trends, compare returns, or create investment products like commodity index funds and ETFs.

Key Features of Commodity Indices: BUB PR WEIGHT

• Basket of Commodities: Includes multiple commodities like energy, metals, and agriculture.
 • Weighted Composition: Each commodity is assigned a weight based on factors like market
size or production volume.

• Price Tracking: The index reflects changes in commodity prices over time.

• Benchmarking Tool: Helps measure the performance of commodity investments or market

segments.

• Used in Derivatives: Many commodity futures and options contracts are based on index
values.

Popular Global Commodity Indices:

Index Name Description

S&P GSCI (Goldman Sachs Broad-based, includes energy, metals, agriculture; widely
Commodity Index) used globally.

Bloomberg Commodity Index Tracks a diversified basket of 23 commodities, focusing on

(BCOM) liquidity and production data.

CRB Index (Commodity Research One of the oldest indices, covering energy, metals,
Bureau Index) agriculture.

Reuters/Jefferies Commodity Index

Updated version of the CRB, tracks 19 commodities.
(RJ/CRB)

Commodity Indices in India:

• MCX Commodity Index: Tracks major commodities traded on Multi Commodity Exchange.

• NCDEX Commodity Index: Tracks agricultural commodities on the National Commodity &
Derivatives Exchange.

Commodity Futures

What are Commodity Futures?

A commodity futures contract is a standardized legal agreement to buy or sell a specific quantity
and quality of a commodity at a predetermined price on a specified future date.

These contracts are traded on commodity exchanges and are used by producers, consumers, and
investors to manage price risk or speculate on price movements.

Key Features of Commodity Futures

Feature Explanation

Standardization Contracts specify quantity, quality, delivery time & place.

Could be agricultural (wheat, coffee), metals (gold, copper), energy

Underlying Commodity
(crude oil), etc.

Future Delivery Date Settlement occurs on a set date in the future.

Trading Venue Traded on regulated exchanges like MCX, NCDEX in India.

Margin Requirement Traders must deposit margin to cover potential losses.

Mark-to-Market Daily settlement of gains and losses to reflect market prices.

Physical Delivery or Cash Some contracts result in delivery of the commodity; others are
Settlement cash-settled.

Purpose of Commodity Futures

• Hedging: Producers and consumers lock in prices to reduce risk.

• Speculation: Traders seek to profit from price changes.

• Price Discovery: Futures prices signal market expectations of future commodity prices.

• Liquidity: Futures markets provide a platform for buyers and sellers to transact efficiently.

Example

• A wheat farmer expects to harvest 1000 quintals in 3 months.

• To avoid price risk, the farmer sells 10 wheat futures contracts now at ₹2000 per quintal.

• Regardless of market price at harvest, the farmer is assured ₹2000 per quintal through the
futures contract.

Commodity

• Definition:
A commodity is a basic good or raw material that is interchangeable with other goods of the
same type.

• Types:

o Agricultural: Wheat, coffee, sugar, cotton

o Energy: Crude oil, natural gas, coal

 o Metals: Gold, silver, copper, aluminum

o Livestock: Cattle, hogs

• Characteristics:
Commodities are typically standardized and traded on markets, and their prices fluctuate
based on supply and demand.

2. Commodity Futures

• Definition:
A commodity futures contract is a standardized agreement to buy or sell a specific quantity
and quality of a commodity at a predetermined price on a specific future date.

• Purpose:
Used primarily to hedge price risk or to speculate on price movements without physically
handling the commodity immediately.

• Key Points:

o Traded on regulated commodity exchanges (e.g., MCX, NCDEX in India)

o Requires margin deposits and involves daily settlement (mark-to-market)

o Can result in physical delivery or cash settlement

General principles of pricing refer to the fundamental guidelines or rules that businesses follow to
determine the most appropriate price for their products or services. These principles help ensure
that prices are set in a way that covers costs, meets customer expectations, remains competitive in
the market, and contributes to the company’s overall profitability and strategic goals.

General Principles of Pricing

1. Cost-Based Pricing:

o Set price by adding a profit margin to the total cost (fixed + variable).

o Ensures the business covers costs and earns a return.

2. Value-Based Pricing:

o Price is based on the perceived value to the customer, not just cost.

o Common in luxury, brand-driven, or tech products.

3. Demand and Supply:

o Prices adjust based on market demand and supply.

o High demand with low supply = higher price, and vice versa.

4. Competitive Pricing:

o Set price in line with competitors’ prices.

o Helps to attract customers in a competitive market.

5. Market Conditions:

o Economic trends, inflation, interest rates, and customer purchasing power all
influence pricing decisions.

6. Customer Behavior:

o Pricing considers how sensitive customers are to price changes (price elasticity).

o If demand is inelastic, firms can charge more.

7. Profit Maximization:

o Pricing aims to generate the highest possible profit, balancing volume and margin.

8. Legal and Ethical Considerations:

o Prices must comply with laws (no price fixing, predatory pricing, etc.) and ethical
norms.

1. What is the Black-Scholes Model?

The Black-Scholes Model is a mathematical model for pricing European-style options, which are
contracts giving the holder the right (but not the obligation) to buy or sell an asset at a specified
price (strike price) on a specific future date (expiry).

It helps determine the fair market value of a call option (right to buy) or put option (right to sell)
based on:

Key Elements of the Black-Scholes Model

Element Symbol Explanation

1. Current Stock The current market price of the underlying stock.

S0S_0S0
Price Higher stock price → higher call option value.

The agreed price at which the option can be

2. Strike Price KKK exercised. Higher strike price → lower call option
value.

Time remaining until the option expires, in years.

3. Time to
TTT More time → higher option value due to increased
Expiration
uncertainty.

The theoretical return on a risk-free investment

4. Risk-Free Interest
rrr (e.g., government bonds). Affects the present value
Rate
of the strike price.

The expected fluctuation in the stock price. Higher

5. Volatility of the
σ\sigmaσ volatility → higher option value (greater potential
Stock
profit).

The probability values derived from the standard

6. Cumulative N(d1),N(d2)N(d_1),
normal distribution, used to assess the likelihood of
Normal Distribution N(d_2)N(d1),N(d2)
profitable outcomes.

Used to bring the strike price value to present

7. Discount Factor e−rTe^{-rT}e−rT
terms. Helps adjust future payoffs to today’s value.

• the stock’s current price,

• the strike price,

• time to expiration,

• risk-free interest rate,

• and volatility.

3. Key Assumptions of the Model

The model relies on several idealistic assumptions:

Assumption Explanation

1. European Options Can only be exercised on the expiration date.

2. No Dividends The underlying stock pays no dividends during the option’s life.

3. Efficient Markets Prices reflect all available information.

4. No Transaction
No brokerage or tax involved in buying/selling.
Costs

5. Constant Risk-Free
The risk-free interest rate is known and remains constant.
Rate

6. Lognormal Stock prices are log-normally distributed and continuously follow a

Distribution geometric Brownian motion.

7. Constant Volatility The volatility of the underlying asset is constant over time.

3. The Core Formula

Call Option Price:

C=S0⋅N(d1)−K⋅e−rT⋅N(d2)C = S_0 \cdot N(d_1) – K \cdot e^{-rT} \cdot N(d_2)C=S0⋅N(d1)−K⋅e−rT⋅N(d2

)

Put Option Price:

P=K⋅e−rT⋅N(−d2)−S0⋅N(−d1)P = K \cdot e^{-rT} \cdot N(-d_2) – S_0 \cdot N(-d_1)P=K⋅e−rT⋅N(−d2)−S0

⋅N(−d1)

Where:

• S0S_0S0: Current stock price

• KKK: Strike price

• TTT: Time to expiration (in years)

• rrr: Risk-free interest rate

• σ\sigmaσ: Volatility (standard deviation of the asset’s return)

• N(x)N(x)N(x): Cumulative standard normal distribution function

• eee: Euler’s number (~2.718)

What is a Swap?

A swap is a derivative contract in which two parties agree to exchange (or “swap”) cash flows or
financial instruments over a specified period according to predetermined rules.
 Unlike futures or options, swaps are typically over-the-counter (OTC) contracts, customized to
suit the needs of the parties involved.

Key Features of Swaps

1. Customized Contracts

o Swaps are tailor-made agreements between two parties, with terms (notional
amount, payment dates, rates) negotiated to meet specific needs.

2. No Upfront Premium

o Unlike options, swaps usually require no initial payment when the contract is
initiated.

3. Exchange of Cash Flows

o Parties agree to exchange periodic cash flows (e.g., interest payments, commodity
prices) based on the contract terms.

4. Over-the-Counter (OTC) Market

o Swaps are traded OTC, meaning directly between counterparties, not on formal
exchanges, allowing for flexibility but also increasing counterparty risk.

5. Notional Principal

o The underlying principal amount is usually not exchanged; it serves as a basis for
calculating the cash flows.

6. Counterparty Risk

o Since swaps are OTC, there is a risk that one party may default on payment
obligations.

7. Settlement Periods

o Payments are exchanged at regular intervals (monthly, quarterly, annually) as

agreed.

8. Purpose

o Mainly used for hedging risks (interest rate, currency, commodity price) or for
speculative purposes.

9. Variety of Types

o Swaps can be based on interest rates, currencies, commodities, credit risks, or

other financial metrics.

10. Flexibility

o Terms and conditions can be highly customized to fit the needs of both parties,
unlike standardized futures or options.
 Common Types of Swaps

Swap Type Description Purpose

Interest Rate Exchange fixed interest payments for Manage interest rate
Swap floating-rate payments (or vice versa). risk.

Exchange principal and interest payments in Hedge or speculate on

Currency Swap
different currencies. currency risk.

Commodity Exchange fixed commodity price payments Hedge commodity price

Swap for floating price payments. risk.

Credit Default Insurance-like contract protecting against Manage credit risk

Swap default risk of a borrower. exposure.

Types of Swaps

1. Interest Rate Swap

• Exchange of cash flows based on fixed interest rate for floating interest rate, or vice versa.

• Used by companies to manage interest rate exposure.

• Example: A company pays fixed rate and receives floating rate to benefit if interest rates
drop.

2. Currency Swap

• Exchange of principal and interest payments in different currencies.

• Helps firms hedge foreign exchange risk on international loans or investments.

• Example: A company borrows USD but needs INR; swaps currency cash flows with another
firm.

3. Commodity Swap

• Exchange of fixed price payments for floating commodity price payments (or vice versa).

• Used to hedge commodity price risk.

• Example: An airline pays fixed jet fuel price; the supplier receives floating market price.

4. Credit Default Swap (CDS)

• A contract that provides insurance against default by a borrower.

 • The buyer pays a premium, and the seller compensates if the borrower defaults.

• Used to manage credit risk.

5. Equity Swap

• Exchange of returns on equity assets for returns based on a fixed rate or other asset class.

• Used to gain exposure to equity markets without owning the underlying stock.

6. Total Return Swap

• One party pays the total return of an asset (income plus capital gains), while the other pays a
fixed or floating rate.

• Used for transferring both risk and return of an asset without transferring ownership.

Derivatives vs. Swaps

Aspect Derivatives Swaps

Financial contracts whose value depends A specific type of derivative where

Definition on an underlying asset (stocks, two parties exchange cash flows
commodities, currencies, interest rates). based on agreed terms.

Includes futures, options, forwards, and A subset of derivatives focused on

Types
swaps. exchanging cash flows.

Can be traded on exchanges (futures, Mostly traded OTC (over-the-counter),

Trading Venue
options) or OTC (forwards, swaps). customized contracts.

Futures and options are standardized; Highly customized contracts tailored

Standardization
forwards and swaps are customized. to counterparties.

Usually based on interest rates,

Underlying Can be stocks, bonds, commodities,
currencies, commodities, credit, or
Asset currencies, interest rates, indexes, etc.
equities.

Can involve physical delivery or cash Generally cash settlements; currency

Settlement
settlement. swaps may involve principal exchange.

Hedging, speculation, arbitrage, price Mainly hedging and managing

Purpose
discovery. financial risks, also speculation.
Aspect Derivatives Swaps

Varies; options have complex payoffs, Generally complex due to customized

Complexity
futures straightforward. terms and periodic cash flows.

Counterparty Lower on exchange-traded derivatives; Higher, as swaps are OTC and depend
Risk higher on OTC derivatives. on counterparty creditworthiness.

What is Interest Rate Exposure?

Interest rate exposure is the risk that changes in market interest rates will negatively affect a
company’s or investor’s financial position. This exposure arises mainly because of:

• Variable/floating rate borrowings: Interest costs fluctuate as market rates change.

• Fixed income investments: Their market values are inversely related to interest rates.

• Interest-sensitive assets and liabilities: Such as bonds, loans, leases, and pension
obligations.

2. Types of Interest Rate Exposure

a. Borrowing Exposure

• When debt has floating interest rates (e.g., linked to benchmark rates like LIBOR, RBI repo),
the borrower faces the risk of rising interest expenses if rates increase.

• Example: A company with ₹100 crore loan at floating rate repo + 1% will pay more if repo
rates rise.

b. Investment Exposure

• Fixed-rate bondholders face the risk of falling bond prices if interest rates increase, as newer
bonds offer higher yields.

• This can cause unrealized losses if the bonds are sold before maturity.

c. Reinvestment Risk

• When interest or principal payments from fixed income investments mature, the investor
might only be able to reinvest at lower prevailing rates.

d. Price Risk

• The market price of fixed income securities moves inversely with interest rates, creating
volatility in portfolio valuations.
Managing Interest Rate Exposure

A. Interest Rate Swaps

• Exchange floating-rate payments for fixed-rate payments (or vice versa).

• Stabilizes interest payments.

• Example: Company with floating loan swaps into fixed payments to hedge rising rates.

B. Interest Rate Futures

• Standardized contracts traded on exchanges to hedge against interest rate movements.

• Less flexible but lower counterparty risk.

C. Interest Rate Options (Caps, Floors, Collars)

• Caps limit maximum interest payable.

• Floors guarantee minimum interest receivable.

• Collars create a band between cap and floor rates.

D. Debt Restructuring

• Refinancing floating-rate debt into fixed-rate debt or changing debt maturities.

E. Diversification

• Mix of fixed and floating rate instruments to balance exposure.

6. Example

A company has ₹50 crore floating rate loan at RBI repo + 1.5%. It fears rising interest rates will
increase its borrowing costs. To manage this, it enters into an interest rate swap to pay fixed 8% and
receive floating payments. Regardless of repo rate changes, the company’s effective interest payment
is fixed at 8%, stabilizing its cash flows.

7. Risks in Managing Interest Rate Exposure

• Basis Risk: Hedge may not perfectly offset exposure.

• Counterparty Risk: Risk of default in OTC swaps.

• Opportunity Cost: If rates fall, fixed payments may be higher than market.

• Liquidity Risk: Difficulty in unwinding derivative contracts.

Summary Table

Aspect Description

Exposure Types Borrowing, investment, reinvestment, price risk

Measurement Tools Gap analysis, duration, stress testing

Management Instruments Swaps, futures, options, restructuring, diversification

Risks Basis risk, counterparty risk, opportunity cost, liquidity risk

What is an Interest Rate Swap?

An Interest Rate Swap is a financial contract between two parties who agree to exchange interest
payment obligations on a specified notional principal amount for a set period. Typically, one party
pays a fixed interest rate while the other pays a floating interest rate.

Key Features

• Notional Principal: The principal amount on which interest payments are calculated but not
exchanged.

• Swap Tenor: Duration of the swap contract (e.g., 2 years, 5 years).

 • Payment Frequency: Usually quarterly, semi-annual, or annual.

• Two Legs:

o Fixed leg: One party pays a predetermined fixed interest rate.

o Floating leg: The other party pays a floating rate, often linked to benchmarks like
LIBOR, EURIBOR, or RBI repo rate.

What is a Currency Swap?

A Currency Swap is a financial agreement between two parties to exchange principal and interest
payments in different currencies over a specified period. It involves swapping both the notional
principal amounts and interest payments, usually to manage currency risk or obtain better financing
terms.

Key Features of Currency Swaps

1. Exchange of Principal Amounts

o At the start and maturity of the swap, the notional principal amounts in two different
currencies are exchanged between parties, usually at the initial agreed exchange
rate.

2. Exchange of Interest Payments

o During the life of the swap, parties exchange interest payments calculated on the
swapped principal amounts. These payments can be fixed or floating rates.

3. Tenor / Maturity

o Currency swaps usually have longer maturities, often ranging from 1 year up to 10 or
more years, depending on the needs of the parties.

4. Hedging Both Interest Rate and Currency Risk

o The swap simultaneously manages exposure to both fluctuations in currency

exchange rates and interest rates.

5. Customization

o Terms such as currencies involved, notional amounts, interest rates, payment

frequency, and tenor can be customized to meet the specific requirements of the
parties.

6. No Upfront Cash Flow (Usually)

o Except for the initial principal exchange, currency swaps generally do not require
upfront premiums like options.

7. Counterparty Risk

o Since these are typically over-the-counter (OTC) contracts, there is a risk that the
other party may default.

8. Non-Transferable
 o Usually, currency swaps are not transferable contracts and involve bilateral
agreements.

Functions of Forward Rate Agreements (FRAs)

1. Interest Rate Risk Hedging

o The primary function of an FRA is to hedge against adverse movements in interest

rates.

o Borrowers use FRAs to lock in borrowing costs, while lenders use them to secure
investment returns.

2. Speculation on Interest Rates

o Traders and investors can use FRAs to speculate on future interest rate movements
without borrowing or lending actual funds.

o Profit is made based on the difference between the agreed rate and the actual
market rate.

3. Cash Flow Management

o Helps in budgeting and managing future interest-related cash flows with certainty,
especially for corporate treasuries.

4. Customizable Financial Contracts

o FRAs can be tailored to specific needs, including term, notional amount, and rate
index, making them flexible for a wide range of users.

5. Useful for Banks and Financial Institutions

o Used to align asset-liability mismatches on their balance sheets due to different

interest rate exposures.

6. Locking in Future Interest Rates

o Ensures a known interest rate for a future loan or investment, protecting against
interest rate volatility.

7. Benchmark Management

o FRAs are often based on benchmarks like LIBOR, SOFR, MIBOR, helping institutions
manage exposures to these rates.
Hedging is a risk management strategy used by businesses and investors to protect themselves
from losses caused by unfavorable price or currency fluctuations. In currency markets, hedging
involves using financial contracts like futures, forwards, or options to lock in exchange rates for
future transactions. This helps reduce uncertainty in cash flows and shields profit margins from
volatile currency movements. The primary aim of hedging is to minimize risk, not to generate
profit. Although it may involve some costs, hedging provides financial stability and allows
companies to plan and operate confidently in global markets.

Key Features of Hedging

1. Risk Reduction:
Hedging primarily aims to minimize or eliminate risk from price or currency fluctuations.

2. Use of Financial Instruments:

It involves derivatives like futures, forwards, options, and swaps to create offsetting
positions.

3. Protective Strategy:
Hedging acts like insurance, protecting businesses from adverse market movements.

4. Not for Profit:

The goal is risk management, not making a profit, though gains can occur if markets move
favorably.

5. Cost Involved:
Hedging may require payment of premiums, margins, or transaction fees.

6. Locks in Prices or Rates:

It fixes exchange rates or prices in advance to provide financial certainty.

7. Standardized or Customized Contracts:

Hedging instruments can be standardized (like futures) or customized (like forwards).

8. Reduces Uncertainty:
Helps businesses in budgeting, forecasting, and financial planning by stabilizing cash flows.
 9. Partial or Full Hedging:
Companies can hedge the entire exposure or only a part depending on their risk appetite.

Speculation: Definition

Speculation is the practice of buying and selling financial assets, such as currency futures, with the
aim of making profits from anticipated price movements. Unlike hedgers who seek to reduce risk,
speculators willingly take on risk hoping to benefit from changes in market prices.

Features of Speculation

1. Profit Motive:
Speculators aim to earn profits from price or currency fluctuations.

2. High Risk:
Unlike hedging, speculation involves taking significant market risk based on price predictions.

3. No Underlying Exposure:
Speculators do not have a direct business need for the asset; they trade purely for profit.

4. Short-Term Focus:
Speculative trades are usually short-term to capitalize on market volatility.

5. Market Liquidity Provider:

Speculators increase market activity and liquidity, benefiting all participants.

6. Leverage Usage:
They often use borrowed funds or margin to increase potential returns (and risks).

7. Long and Short Positions:

Speculators can profit from both rising and falling markets by taking appropriate positions.

8. Based on Market Analysis:

Speculation relies on technical, fundamental, or sentiment analysis to predict price
movements.

9. Potential for Large Gains and Losses:

The risk-return profile is high; profits can be large, but so can losses.
Arbitrage: Definition

Arbitrage is the practice of simultaneously buying and selling an asset or equivalent financial
instrument in two or more different markets to take advantage of price differences. The goal of
arbitrage is to make a risk-free profit from these discrepancies without exposure to market risk. It
exploits inefficiencies where the same asset trades at different prices in different places or forms.

Key Features of Arbitrage

1. Risk-Free Profit:
The fundamental feature of arbitrage is that it yields a profit without taking any market
risk. Since the buy and sell transactions are simultaneous, the arbitrageur locks in a
guaranteed profit regardless of price movements.

2. Simultaneous Transactions:
Arbitrage involves buying an asset in one market while simultaneously selling it in another.
This simultaneity is essential to avoid exposure to price changes during the transaction
period.

3. Exploiting Price Differences:

Arbitrage arises from price differentials for the same or equivalent assets—such as stocks,
currencies, or futures—in different markets or trading platforms. The arbitrageur profits
from these temporary inconsistencies.

4. No or Low Investment of Own Capital:

Many arbitrage strategies use borrowed funds or offsetting positions, requiring little initial
capital. The positions offset each other, minimizing exposure.

5. Promotes Market Efficiency:

Arbitrage helps in correcting price inefficiencies by forcing prices in different markets to
converge. This activity ensures that markets remain fair and prices reflect true value.

6. Short-Lived Opportunities:
Because many traders constantly scan for arbitrage opportunities, price differences tend to
vanish quickly once identified and acted upon. Hence, arbitrage opportunities are often
brief.
 7. Requires Speed and Volume:
Since profits per arbitrage transaction are usually small, arbitrageurs often engage in high-
volume or high-frequency trades to accumulate significant gains.

8. Examples in Currency Futures:

In currency futures markets, arbitrageurs exploit differences between the futures price and
the theoretical price derived from spot rates and interest rates (interest rate parity). They
simultaneously trade in spot and futures markets to earn a riskless profit.

Detailed Explanation of Futures Contract Pricing

The price of a futures contract is not arbitrary; it is closely linked to the current market (spot) price
of the underlying asset and the costs and benefits associated with holding (or carrying) that asset
until the contract’s delivery date.

1. Spot Price (S)

The spot price is the current price at which the asset (commodity, currency, or financial instrument)
can be bought or sold in the market today. This is the starting point for pricing futures.

2. Cost of Carry (C)

Cost of carry refers to the total cost of holding the asset until the future date, including:

• Financing Cost: Interest paid to borrow money to buy the asset (usually approximated by the
risk-free interest rate).

• Storage Cost: For physical goods like commodities, costs for warehousing, insurance, and
transportation.

• Other Costs: Any additional costs such as spoilage, insurance, or handling fees.

If the asset generates income during the holding period, such as dividends for stocks or rental
income for property, this income reduces the cost of carry.

3. Time to Maturity (T)

This is the duration from the present until the futures contract expires, usually expressed in years or
fractions of years.

4. Income from the Asset (Y)

If the asset produces income (like dividends or coupons), the present value of that income reduces
the futures price because the buyer of the futures does not receive that income directly.

5. Pricing Formula

The theoretical price FFF of a futures contract is given by:

F=S×e(r+c−y)×TF = S \times e^{(r + c - y) \times T}F=S×e(r+c−y)×T

Where:

• FFF = Futures price

• SSS = Spot price

• rrr = Risk-free interest rate (annualized)

• ccc = Storage and other carrying costs (annualized)

• yyy = Income yield from the asset (annualized)

• TTT = Time to maturity (in years)

• eee = The base of natural logarithms (~2.71828), used for continuous compounding

6. Interpretation of Pricing

• Contango: When the futures price FFF is above the spot price SSS, usually because carrying
costs exceed income yields. Common in commodities with storage costs.

• Backwardation: When the futures price FFF is below the spot price SSS, often because the
asset pays income or there is high demand for immediate delivery.

7. Example

Imagine you want to price a futures contract on gold:

• Spot price of gold: ₹50,000 per 10 grams

• Annual risk-free interest rate: 6% (0.06)

• Annual storage cost: 1% (0.01)

• Income from gold: 0% (no dividends)

• Time to maturity: 3 months = 0.25 years

Using the formula:

F=50,000×e(0.06+0.01−0)×0.25=50,000×e0.0175≈50,000×1.0176=₹50,880F = 50,000 \times e^{(0.06

+ 0.01 - 0) \times 0.25} = 50,000 \times e^{0.0175} \approx 50,000 \times 1.0176 =
₹50,880F=50,000×e(0.06+0.01−0)×0.25=50,000×e0.0175≈50,000×1.0176=₹50,880
So, the futures price would be about ₹50,880, slightly higher than the current spot price due to the
cost of carrying gold.

8. Special Cases

• Currency Futures:
The formula is adapted to account for interest rates in both currencies:

F=S×e(rd−rf)×TF = S \times e^{(r_d - r_f) \times T}F=S×e(rd−rf)×T

where rdr_drd = domestic interest rate, rfr_frf = foreign interest rate.

5 Application Of Market Index

Babe cre depa media

A market index, like the Nifty 50 or Sensex in India, is far more than just a number you see on the
news. It's a powerful tool with a wide range of practical applications for investors, analysts, fund
managers, and even the general public.

• Here are the major applications of a market index:

• Barometer of Market Performance/Economic Health:

• "Pulse of the Economy": This is arguably the most common and intuitive application. A rising
index generally indicates a growing economy and positive investor sentiment, while a falling index
suggests economic slowdown or pessimism.

• Quick Snapshot: It provides a quick and easy way to understand how the overall stock market (or
a specific segment of it) is performing over a period.

• Benchmark for Fund Managers and Investors:

• Performance Measurement: Fund managers (of mutual funds, ETFs, etc.) often use a relevant
market index as a benchmark to assess their own performance. If a fund aims to outperform the
large-cap segment, its returns will be compared against the Nifty 50 or Sensex.

• "Beat the Index": Many active fund managers strive to "beat the index" (generate higher returns
than the benchmark), while passive funds (like index funds and ETFs) aim to replicate the index's
performance.

• Creation of Index Funds and Exchange Traded Funds (ETFs):

• Passive Investing: Indices are the foundation for passive investment vehicles. • Index Funds:
These mutual funds invest in all the stocks that make up a particular index, in the same proportion,
aiming to track its performance.
• ETFs (Exchange Traded Funds): Similar to index funds but traded like stocks on an exchange
throughout the day. They provide investors with a simple, cost-effective way to get diversified
exposure to an entire market segment.

• Derivatives Trading (Futures and Options):

• Risk Management and Speculation: Indices are underlying assets for a huge volume of
derivatives trading.

• Index Futures: Allow investors to take a position on the future direction of the entire market or a
segment without buying individual stocks. Used for hedging portfolio risk or speculating on market
movements.

• Index Options: Provide the right, but not the obligation, to buy or sell the value of the index at a
specific price. Used for more sophisticated hedging or speculative strategies.

• Economic Indicator and Forecasting:

• Leading Indicator: Stock market indices are often considered leading economic indicators,
meaning their movements can sometimes predict future economic activity. A consistent rise in the
index might signal future economic growth, while a sustained fall could precede a recession.

• Sentiment Gauge: They reflect investor confidence and overall market sentiment, which can
influence consumer spending and business investment.

• Portfolio Diversification and Asset Allocation:

• Broad Exposure: Investors can use index-linked products (like ETFs) to get diversified exposure to
a broad market or a specific sector without having to research and buy individual stocks.

• Strategic Allocation: Understanding different indices (e.g., large-cap, mid-cap, smallcap, sectoral
indices) helps inve

• Academic Research and Analysis:

• Studying Market Behavior: Researchers use historical index data to study market efficiency,
correlations between different asset classes, the impact of economic events, and long-term
investment trends.

• Developing Models: Indices are crucial inputs for developing and testing financial models related
to risk, return, and portfolio optimization.

• Media and Public Information:

• Simplifying Complexity: Indices simplify complex market movements into a single,

understandable number, making it easier for the public and media to grasp general market trends.
• News Reporting: They are a staple of financial news reporting, providing context for daily market
activities. 6 Futures Contract
Definition of Forward Market (India):

The forward market in India refers to an over-the-counter (OTC) financial market where
participants enter into customized contracts to buy or sell an asset (such as a commodity, currency,
or financial instrument) at a predetermined price on a specified future date. These contracts are
known as forward contracts.

Simple Definition:

A forward market is a financial market where contracts are made to buy or sell assets at a future
date for a price agreed upon today.

Example:

An Indian importer expecting to pay $100,000 in 3 months may enter into a currency forward
contract to fix the exchange rate now, protecting against rupee depreciation.

Key Features of the Forward Market in India

Here are the main characteristics that define the forward market in India:

Feature Description

1. Customized Forward contracts are tailor-made agreements between two parties,

Contracts unlike standardized futures.

2. Over-the-Counter
These contracts are traded privately and not on formal exchanges.
(OTC)

3. Asset Types Commonly used for currencies, commodities, and interest rates.

4. Future Settlement Contracts are settled at a specified future date, as agreed in the contract.

5. Fixed Price The buying/selling price is fixed at the time of entering the contract.

6. Hedging Tool Helps businesses and investors hedge against future price risks.

7. No Margin Unlike futures markets, forward markets typically don’t require margin
Requirement deposits.

Since there’s no central clearinghouse, there’s a risk of default by either

8. Counterparty Risk
party.

9. No Daily Mark-to-
Profits and losses are realized only at maturity, not adjusted daily.
Market

- Currency forwards are regulated by the RBI

10. Regulation
- Commodity forwards are overseen by SEBI
Key Segments of the Forward Market in India

The forward market in India is broadly divided into the following major segments, based on the
type of underlying asset being traded:

1. Currency Forward Market

• Purpose: To hedge against exchange rate fluctuations.

• Users: Importers, exporters, banks, multinational companies.

• Regulator: Reserve Bank of India (RBI)

• Example: An Indian importer books a USD-INR forward rate to lock in the cost of future
payments.

2. Commodity Forward Market

• Purpose: To hedge against price volatility in agricultural and industrial commodities.

• Common Commodities: Wheat, rice, cotton, crude oil, gold, silver, etc.

• Regulator: Securities and Exchange Board of India (SEBI) (after merger with FMC)

• Key Exchanges:

o MCX (Multi Commodity Exchange of India)

o NCDEX (National Commodity & Derivatives Exchange)

3. Interest Rate Forward Market

• Purpose: To manage interest rate risk on loans or investments.

• Instruments: Forward Rate Agreements (FRAs)

• Users: Banks, financial institutions, corporate treasuries.

• Regulator: RBI

4. Equity Forward Market (Limited in India)

• While India focuses more on futures for equity instruments, some OTC forward deals may
happen between large institutions.

• Not widely used due to availability of exchange-traded futures.