Ragumoorthy Nehrumoorthy

Presentation by,

Indian History of Derivatives

The Bombay Cotton trade association started future Trading in 1875

In 1952 the government banned cash settlement and Option Trading

In 1995 a Prohibition of trading options was lifted

In 1999, the Securities Contract (Regulation) Actof 1956 was amended and derivatives could beDeclared “securities”

NSE Started trade in future and option by 2005

A Derivative is a Financial Instrument whose value depends on – is derived from – the value of some other financial instrument, called the underlying asset.

Derivative is . . . .

The value of derivative is linked to risk or volatility inEither financial asset, transaction, market rate, orcontingency, and creates a product

Underlying AssetsStocks

Interest Rates

Precious Metals

Agricultural Commodities

Crude Oil

Bonds

Foreign Exchange Rate

T-Bill

Features of Derivatives

Traded on Exchange

All Transaction in derivatives take place in futurespecific date

Hedging Device-Reduces Risk

Derivatives are often leveraged, such that a small movement in the underlying value can cause a Large difference in the value of the derivative

Basic Purpose of Derivatives

In Derivative Transactions, one party’s loss is always another party’s gain

The main purpose of derivatives is to transfer risk from one person or firm to another, that is, to provide insurance

If a farmer before planting can guarantee a certain price he will receive, he is more likely to plant

Derivatives improve overall performance of the economy

Types of Derivatives Contract

Forwards Swaps

Options

Futures

Futures

A Financial contract obligating the buyer to purchase anasset, (or the seller to sell an Asset), such as a physicalcommodity or a financial instrument, at a predeterminedFuture date and price.

Some of the most popular assets on which futuresContracts are available are equity stocks, indices,Commodities and Currency

Margin accounts andmarking to market

Clearing Corporation requires initial deposits in amargin account

Tracks daily gains and losses and posts these to margin accounts

The contract is settled daily basis which is known as “Marking to Market”

Practical View on Futures & Clearing Corporation

Forwards

A forward contract is a customized contract between two entities, where settlement takes place as a specific date in the future at Predetermined price

Normally traded outside exchange

Forwards are also known as Private Contracts

Options

The owner of the option has option to sell or buy assetsat a given price on or before given date

American Option European Option

An option that may beexercised on any tradingDay on or before expiry

An option that may only beexercised on expiry date

Important Concepts of Option

Options

Call Option – a right to buy an asset at a predeterminedprice (strike price) on or Before a specific date

If asset price is higher than the strike price - Option is in the moneyIf asset price is exactly at the strike price - Option is at the moneyIf asset price is below the strike price

- Option is out of the money

Obviously would not exercise an option that is out of the money

Options

Put Option – a right to sell and asset at a predeterminedPrice on or before a specific date

If asset price is lower than the strike price - Option is in the moneyIf asset price is exactly at the strike price - Option is at the moneyIf asset price is higher than the strike price

- Option is out of the money

SwapsSwaps are private agreement between two parties toexchange cash flows in the future according to apre-arranged formula

They can be regarded as portfolio of forward contracts

The two commonly used Swaps are:

(i)Interest Rate Swaps : A interest rate swap entails swapping only the interest related cash flows between the parties in the same currency.

(ii) Currency Swaps : A currency swap is a foreign exchange Agreement between two parties to exchange a given amount of one currency for Another and after a specified period of time, to give back the original Amount swapped.

Practical View on SWAPS

Types of Derivatives Markets

Over-the-Counter derivatives :

Contracts that are traded between two parties directlywithout going through an exchange

Forward and Swap Contracts are OTC derivatives

Exchange-traded derivatives :

Contracts that are traded in derivatives exchanges

Market PlayersHedgers – Transfer of Risk component of their portfolio

Speculators – Intentionally taking the risk from the Hedgers in pursuit of profit

Arbitrageurs – Operating in different markets Simultaneously, in pursuit of profit and eliminatemis-pricing

Any Questions ?