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1. INTRODUCTION OF DERIVATIVE MARKET

What Does Derivative Mean?A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely acontract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most commonunderlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives arecharacterized by high leverage.

a.what is derivative market

The term `Derivative' indicates that it has no independent value, i.e. its value is entirely `derived' from the value

the underlying asset. The underlying asset can be securities, commodities, bullion, currency, livestock or anythelse. In other words, derivative means a forward, future, option or any other hybrid contract of pre-determined fix

duration, linked for the purpose of contract fulfillment to the value of a specified real or financial asset or to an indof securities.

B. Who are the operators in the derivatives market?

y Hedgers - Operators, who want to transfer a risk component of their portfolio.

y Speculators - Operators, who intentionally take the risk from hedgers in pursuit of profit.

y Arbitrageurs - Operators who operate in the different markets simultaneously, in pursuit of profit and eliminate m

pricing.

C. What is the importance of derivatives?

There are several risks inherent in financial transactions. Derivatives are used to separate risks from traditional instrumeand transfer these risks to parties willing to bear these risks.

1. The first is to eliminate uncertainty by exchanging market risks, commonly known as hedging. Corporates and finan

institutions, for example, use derivatives to protect themselves against changes in raw material prices, exchange rat

interest rates etc., as shown in the box below. They serve as insurance against unwanted price movements and reduce t

volatility of companies cash flows, which in turn results in more reliable forecasting, lower capital requirements, and hig

capital productivity. These benefits have led to the widespread use of derivatives: 92 percent of the worlds 500 larg

companies manage their price risks using derivatives.

2. The second use of derivatives is as an investment. Derivatives are an alternative to investing directly in assets with

buying and holding the asset itself. They also allow investments into underlying and risks that cannot be purchased direc

Examples include credit derivatives that provide compensation payments if a creditor defaults on its bonds, or weat

derivatives offering compensation if temperatures at a specified location exceed or fall below a predefined refere

temperature.

3. Derivatives also allow investors to take positions against the market if they expect the underlying asset to fall in val

Typically, investors would enter into a derivatives contract to sell an asset (such as a single stock) that they believe

overvalued, at a specified future point in time. This investment is successful provided the asset falls in value. Such strateg

are extremely important for an efficiently functioning price discovery in financial markets as they reduce the risk of ass

becoming excessively under- or overvalued.7)

D.Cash flow

The payments between the parties may be determined by:

y the price of some other, independently traded asset in the future (e.g., a common stock);

y the level of an independently determined index (e.g., a stock market index or heating-degree-days);

y the occurrence of some well-specified event (e.g., a company defaulting);

y an interest rate;

y an exchange rate;

y or some other factor.

Some derivatives are the right to buy or sell the underlying security or commodity at some point in the future fo

predetermined price. If the price of the underlying security or commodity moves into the right direction, the ow

of the derivative makes money; otherwise, they lose money or the derivative becomes worthless. Depending on terms of the contract, the potential gain or loss on a derivative can be much higher than if they had traded t

underlying security or commodity directly.

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2. HISTORY OF DERIVATIVE MARKET

The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forw

contracting, it was characterized by forward contracting on tulip bulbs around 1637. The first "futures" contracts

generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, wh

made them much like today's futures.

In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created

International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that w

not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one ba

on Ginnie Mae (GNMA) mortgages.

In the area of commodities, the Bombay Cotton Trade Association started futures trading in 1875 and, by the early 19India had one of the worlds largest futures industry. In 1952 the government banned cash settlement and options trad

and derivatives trading shifted to informal forwards markets.

Exchange-traded commodity derivatives have been trading only since 2000, and the growth in this market has been unev

The number of commodities eligible for futures trading has increased from 8 in 2000 to 80 in 2004.?

UsesDerivatives are used by investors to provide leverage or gearing, such that a small movement in the underlying value can cause a large difference in the valu

of the derivative speculate and to make a profit if the value of the underlying asset moves the way they expect (e.g., moves in a given

direction, stays in or out of a specified range, reaches a certain level) hedge or mitigate risk in the underlying, by entering into a derivative contract whose value moves in the opposite directio

to their underlying position and cancels part or all of it out obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather derivatives)create optionability where the value of the derivative is linked to a specific condition or event (e.g., the underlying reaching aspecific price levelDerivatives are usually broadly categorized by the: relationship between the underlying and the derivative (e.g., forward, option, swap) type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate derivatives, commodity derivatives

orcredit derivatives) market in which they trade (e.g., exchange-traded orover-the-counter) pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

Another arbitrary distinction is between:[2]

vanilla derivatives (simple and more common) and exotic derivatives (more complicated and specialized)

There is no definitive rule for distinguishing one from the other, so the distinction is mostly a matter of customCommon derivative contract typesThere are three major classes of derivatives:

1. Futures/Forwards are contracts to buy or sell an asset on or before a future date at a price specified today. A futurescontract differs from a forward contract in that the futures contract is a standardized contract written by a clearinghouse that operates an exchange where the contract can be bought and sold, whereas a forward contract is a non-standardized contract written by the parties themselves.

2. Options are contracts that give the owner the right, but not the obligation, to buy (in the case of a call option) or sell the case of a put option) an asset. The price at which the sale takes place is known as the strike price, and is specifat the time the parties enter into the option. The option contract also specifies a maturity date. In the case ofaEuropean option, the owner has the right to require the sale to take place on (but not before) the maturity date; in tcase of anAmerican option, the owner can require the sale to take place at any time up to the maturity date. If theowner of the contract exercises this right, the counter-party has the obligation to carry out the transaction.

3. Swaps are contracts to exchange cash (flows) on or before a specified future date based on the underlying value ofcurrencies/exchange rates, bonds/interest rates, commodities, stocks or other assets.