Derivatives--Meaning

“Something from something else”. Its value is entirely derived from the values of the underlying

asset.

Underlying asset can be securities, commodities, bullion, currency, livestock or anything else.

Derivative means Forward, Future, Option or any other contract of predetermined fixed duration.

Financial Derivatives--Meaning

Financial derivatives are financial instruments whose prices or values are derived from the prices of other underlying financial instruments or financial assets.

Underlying financial instrument can be equity share, stock, bond, debenture, treasury bill, foreign currency etc.

Financial derivatives are not revolutionary new instruments rather they are merely combination of older generation derivatives.

Derivatives--Features

Future contract between two parties. Based on underlying assets. Counter parties specifies obligation under derivative contract. Contract undertaken directly between two parties or particular

exchange. Financial derivatives are carried off-balance sheet.

No asset or liability underlying the contract was put on B/S.

It is treated as contingent asset or liability. Taking or making of delivery of underlying assets is not

involved.

It is known as deferred delivery or deferred payment.

Mostly it is a secondary market instrument and have little usefulness in mobilizing fresh capital by corporate.

Standardized, general and exchange-traded derivatives are being increasingly evolved.

Type of financial derivativesForward contract—Meaning:

A forward contract is a simple customized contract between two parties to buy or sell an assets at a certain time in the future for a certain price.

Not traded on an exchange , rather traded as a condition to the contract by the parties concerned.

Forward contract can be of cash settled or based on physical delivery.

Features of Forward contract Bilateral contract, they are exposed the counter party risk for

non-performance of obligation either of the parties. Each contract is custom designed, is unique in terms of

contract size, expiration date, the asset type, quality etc. A party with no obligation off setting the forward contract is

said to have an open position. A party with a closed position is called hedger.

The contract has to be settled by delivery of the assets on expiration date.

It is popular in foreign exchange market as well as interest rate bearing instruments.

Contd:

• Indian forward contract Act 1952: Hedge contract are freely transferable and do not specific, any

particular lot, consignment etc. Transferable specific delivery contracts– are freely

transferable from one party to another, but are concerned with a specific and predetermined consignment.

Non- transferable specific delivery contract– are contracts, are not transferable at all and as such, they are highly specific.

Specified price in a forward contract is referred to as the delivery price.

Forward price for a particular forward contract at a particular time. As time passes the forward price is likely to change whereas the delivery prices remains the same.

Contd:

Future contract--Meaning

A Future contract is an agreement between two parties to buy or sell a specified quantity of an asset at a specified price and at a specified time and place.

Traded on an exchange which sets certain standardized norms for trading in the future contract.

Features of future contract They are traded on an exchange. Standardized norms. Liquidity problem, which persists in the forward market, does

not exist in the future market. Credit risk of the transactions is eliminated by the exchange

through the clearing house.

Option--Meaning

A contract between two parties whereby one party obtains the rights, but not the obligation, to buy or sell a particular asset, at a specified price, on or before a specified date.

Person who acquires the right is know as the option buyer or option holder, while the other person is know as option seller or option writer.

The seller of the option for giving such option to the buyer charges an amount which is known as the option premium.

Type of option—Call option and Put option: Call option:----gives the holder the right to buy an asset at a

specified date for a specified price. Put option:---the holder gets the right to sell an asset at the

specified price and time. Specified price in a contract is known as the exercise price or

strike price. The date in the contract is known as expiration or exercise or

maturity date. Assets or security instruments or commodity covered under

the contract is called as the underlying assets. It includes shares, stock, foreign currencies, bonds,

commodities.

Option further divided into—European and American

option

European option:--can be exercised on the expiration date only.

American option:--can be exercised at any time before the maturity date.

Swap--Meaning

A Swap is an agreement between two counter parties to exchange cash flows in the future.

Terms like the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are determined and finalized by parties.

Calculation of cash flows involves the future values of one or more market variables.

Types of Swap—Interest rate and currency swap

Interest rate swap:

One party agrees to pay other party at a fixed rate on a principal amount, and in return, it receives interest at a floating on the same principal amount for a specified period. Currencies of the two sets of cash flow are the same.

Currency swap:

It involves in exchanging of interest flows in one currency for interest flows in other currency, it requires the exchange of cash flows in two currencies.

Use of Derivatives

Provides services to control, avoid, shift and manage efficiently different type of risk through hedging, arbitraging, spreading, etc.

Serve as barometer of the future trends in price, to discover the new prices both on the spot and future market.

No immediate full amount of the transaction is required for trading.

Trading enhance liquidity and reduce transaction costs in the markets for underlying assets.

Assist the investors, traders, managers of large pools of funds, to make proper asset allocation, increase their yields and achieve investment goals.

Contd: Helps in disseminating information regarding the future

markets trading of commodities and securities. Attract young investors, professionals, and experts who will

act as catalysts to the growth of financial markets. Observed that smoothen out price fluctuations, squeeze the

price spread, integrate price structure at different points time and remove shortages in the markets.

Encourage the competitive trading in the market, different risk taking by the market operators like speculators, hedgers, trader,

Assists the holders to shift or modify suitably the risk characteristics of their portfolios.

Critiques of derivatives

Speculative and gambling motives: Trading volumes have increase in multiples of the values of

the underlying assets and one to two percent are settled the actual delivery of the underlying assets.

Speculative buying and selling by professionals and amateurs affect the genuine producers and distributors.

Increase in risk: Observed –especially OTC markets, particularly customized,

privately managed and negotiated and they are highly risky. Powerful leveraged mechanism used to create risk.

Instability of the financial system: Argued that increased risk not only for the users but for the

whole financial system. Malpractices, desperate behavior and fraud by the users, have

threatened the stability of the financial markets and financial system.

Price instability: Helpful in price stabilization ,if exist a properly organized,

competitive and well-regulated market, trader behave and function in professional manner and standard code of conduct.

All these are not frequently practiced in the market, and cause to price instability rather than stability.

Displacement effect: Growth of derivative will reduce the volume of the business in

the primary or new issue market specifically for the new and small corporate units.

Most of investors will divert to the derivative market, raising fresh capital is difficult, and will create displacement effect in the financial market.

Increased regulatory burden: Instability in financial system, as a result more burden on the

government or regulatory to control the activities of the traders. Financial crisis and scams in the market from time to time and

regulatory authorities spent on to find out new regulatory, supervisory and monitoring tools, for to lead on fall of the financial system.

Risk in derivatives Derivatives trading has become a powerful segment of the

international financial market. Trading in equity derivatives have begun at different centers

of global financial markets. Derivatives are powerful tools for risk management, they turn

out to be disastrous weapons, if not used properly.

Nature of derivative trading: Handling the derivatives are just like handling dangerous

chemicals, or explosive device. Markets move at fast speed, market is highly liquid but too

risky. Used for different purpose like hedging the risk, speculation,

arbitraging, trading, etc.

Contd: Essential to implement as independent management function

to identity, monitor, control, and report all its aspects. High level of competent persons in his field.

Setting the risk vision: Setting policies Commercial objectives Risk tolerance Capital efficiency Financial capability Enhance competence Reviews

Increase in complexity of financial market: Business firm operates in dynamic business environment. Due to globalization and liberalization, the domestic financial

market are linked with the international financial market. Optimization of capital: Earning through derivatives is a very risky venture, because

derivative are used as powerful risk-management tools. Miscalculation of prices of derivative products has created

disaster for the creators. Optimum use of capital and financial resources, derivatives

should be used judiciously and carefully.

Reasons for managing derivatives risk:

Technology advances: Increased sophistication and new information technology have

created complications and insecurity in the business. Market events: Derivative products are in all spheres like agricultural product,

metals, commodities and financial product. Activities and development are increasing in different market

at fast rate all over, it will rise a market risk. Changes in accounting practices: To measure the value, there is need of sound techniques and

other statistical tools. Accounting standard and practice for the derivative are

relative new and in a process of evolution.

Types of risks in derivatives trading Credit risk: Also called as default risk. A counter party default its obligation is called credit risk. Exchange-traded future contract is likely to have significantly

less counter party risk in comparison to OTC contract. Market risk: Market risk exposes a firm to uncertainty, due to changes in

market factors, like foreign exchange rates, commodity prices, equity prices, etc.

To over come the market risk, the factor like risk strategy and policy, organization and culture, executive skill, procedure and control port folio characteristic, etc.

Liquidity risk: Refers to the fluctuation of derivative instruments prices for

not quickly sold or purchased in the market. Liquidity risk is higher in OTC market in comparison to the

exchange traded derivatives. A rise out of relative ability of an organization and mismatch

between the bank cash inflows and out flows arising out of derivative activity.

Legal risk: Risk relating to change in law or a regulatory rule, cause an

adverse financial impact on derivative. Global data base and the legal and regulatory compliance.

Operational risk: Risk relates to errors or frauds, which occurs in carrying out

operations, placing orders, making payment, taking deliveries, accounting for derivatives transactions.

Manual and automated control through out the organization, play in creating a secure operational environment.

Model risk(formal risk): Derivative instrument are priced or valued through specific

complicated mathematical formula, based on assumption. Observed that models, or formula fail to give accurate results

regarding price data. Due to changes in assumptions or other environment factors or

undetected flaws in the models.eg financial risk, interest rate risk, etc.