Derivatives

Dr. Kasamsetty SailathaHOD, PG Dept. of Commerce,

Vidya Vikas First Grade Collegel, Mysore.

• Introduction• Concept • History • Features • Functions of Derivative Market• Participants Derivative Market• Institutional and legal framework• Forward and Futures• Distinction between forward and Futures

Introduction: Risk is a characteristic feature of all commodity and capital markets. Over time, variations in the prices of agricultural and non-agricultural commodities occur as a result of interaction of demand and supply forces. The last two decades have witnessed a many-fold increase in the volume of international trade and business due to the ever growing wave of globalization and liberalization sweeping across the world. As a result, financial markets have experienced rapid variations in interest and exchange rates, stock market prices thus exposing the corporate world to a state of growing financial risk.

Increased financial risk causes losses to an otherwise profitable organization. This underlines the importance of risk management to hedge against uncertainty. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset. Derivatives are risk management tools that help an organization to effectively transfer risk. Derivatives are instruments which have no independent value. Their value depends upon the underlying asset. The underlying asset may be financial or non-financial.

For Ex. A farmer growing a crop in the month of January. His crop is likely to harvest in the month of April. If there is a demand for crop due to shortage in yield, after the harvest, farmer may get higher price. If the supply of crop is more, farmer may sell his crop for lower rate. Therefore there is a risk in the later situation. In such situation, farmer may enter into a contract and lock the price. If the prices or the crop go up, he may lose, but if there is a fall in prices of crop, he will stand to gain. The contract specifies the quantity, price and the date of delivery.This will enable you to minimize or reduce the risk, which otherwise will be face due to uncertain price fluctuations of the future price of the crop.

• Concept:The term ‘derivatives, refers to a broad class of financial instruments which mainly include forwards, futures, options and swaps. These instruments derive their value from the price and other related variables of the underlying asset. They do not have worth of their own and derive their value from the claim they give to their owners to own some other financial assets or security. A simple example of derivative is butter, which is derivative of milk. The price of butter depends upon price of milk, which in turn depends upon the demand and supply of milk. The general definition of derivatives means to derive something from something else.

• Definition of Financial DerivativesSection 2(ac) of Securities Contract Regulation

Act (SCRA) 1956 defines Derivative as:a) “a security derived from a debt instrument,

share, loan whether secured or unsecured, risk instrument or contract for differences or any other form of security;

b) “a contract which derives its value from the prices, or index of prices, of underlying securities”.

• Underlying Asset in a Derivatives ContractAs defined above, the value of a derivative instrument depends upon the underlying asset. The underlying asset may assume many forms:

i. Commodities including grain, coffee beans, orange juice;ii. Precious metals like gold and silver;iii. Foreign exchange rates or currencies;iv. Bonds of different types, including medium to long term

negotiable debt securities issued by governments, companies, etc.

v. Shares and share warrants of companies traded on recognized stock exchanges and Stock Index

vi. Short term securities such as T-bills; andvii. Over- the Counter (OTC) money market products such as loans

or deposits.

• History: The Derivatives markets can be traced back to the middle Ages.

They originally developed to meet the needs of farmers and merchants.

The Chicago Board of Trade (CBOT) was the first derivatives market established in 1848 to bring farmers and merchants together. Initially, its main task was to standardize the quantities and qualities of the grains that were traded. Within a few years, the first futures type contract was developed. It was known as to-arrive contract.

Speculators soon became interested in the contract and found trading the contract to be an attractive alternative to trading the gain itself. The Chicago Board of Trade now offers futures contracts on many different underlying assists, including corn, oats, soybeans, soybean oil wheat, silver, treasury bonds, and treasury notes.

• The Chicago Mercantile Exchange: In 1874, the Chicago Produced Exchange was established. This provided a

market for butter, eggs, poultry, and other perishable agricultural products. In 1898, the butter and egg dealers withdrew from this exchange to form the Chicago Butter and Egg Board. In 1919, this was renamed the Chicago Mercantile Exchange (CME) and was reorganized for futures trading. Since then, the exchange has provided a futures market for many commodities including pork bellies (1961), live cattle (1964) live hogs (1966) and feeder cattle (1971). In 1982, it introduced a futures contract, and a Eurodollar futures contract on the S&P 500 Stock Index.

The International Monetary Market (IMM) was formed as a division of the Chicago Mercantile Exchange in 1972 for futures trading in foreign currencies. The currency traded on the IMM now include the British Pound, the Canadian futures Dollar, the Japanese Yen, the (Swiss Franc, the German mark) European Euro and the Australian dollar. The IMM also trades a gold futures contract, a treasury bill futures contract, and a Eurodollar futures contract.

• Other Exchanges: Many other exchanges throughout the world now

trade futures contracts. Prominent among them are – Chicago Rice and Cotton Exchange (CRCE, the) – New York Futures Exchange (NYFE), – London International Financial Futures Exchange

(LIFFE), – Toronto Futures Exchange (TFE), – Singapore International Monetary Exchange (SIMEX)

and – National Commodity and Derivative Exchange

(NCDEX) of India.

• Features of Derivates Market:1. Derivatives are popular instruments traded

globally.2. Gain or loss depends on the underlying asset’s

value.3. Change in value of underlying asset will have

effect on values of derivatives.4. They are traded on exchange.5. They are liquid and transaction cost is lower.

• Functions of Derivatives Markets:– Risk management– Price Discovery– Transactional Efficiency– Financial Engineering

• Participants in the Derivatives market:1. Hedgers 2. Speculators3. Arbitrageurs4. Intermediary participants• Brokers• Jobbers

• Institutional and Legal Framework:1. Exchange 2. Clearing house3. Custodian/warehouse4. Regulatory framework

Forward Contracts.

• A one to one bipartite contract, which is to be performed in future at the terms decided today.

• Eg. A and B enter into a contract to trade in one stock on Infosys 3 months from today the date of the contract @ a price of Rs4675/-

• Note: Product ,Price ,Quantity & Time have been determined in advance by both the parties.

• Delivery and payments will take place as per the terms of this contract on the designated date and place. This is a simple example of forward contract.

• Features of Forwards:1. Forwards are transactions involving delivery of an

asset or a financial instrument at a future date.2. Both the buyer and seller are committed to the

contracts.3. Forward perform the function of ‘price-

discovery’ for commodities and financial assets. 4. As there is no performance guarantee in a

forward contract, there is always counterparty risk.

• Risks in a forward contract:– Liquidity risk: these contracts a biparty and not

traded on the exchange.– Default risk/credit risk/counter party risk.– Say Jay owned one share of Infosys and the price

went up to 4750/- three months hence, he profits by defaulting the contract and selling the stock at the market.

Futures • Future contracts are organized/standardized contracts in

terms of quantity, quality, delivery time and place for settlement on any date in future. These contracts are traded on exchanges.

• These markets are very liquid • In these markets, clearing corporation/house becomes

the counter-party to all the trades or provides the unconditional guarantee for the settlement of trades i.e. assumes the financial integrity of the whole system. In other words, we may say that the credit risk of the transactions is eliminated by the exchange through the clearing corporation/house.

• The key elements of a futures contract are:– Futures price– Settlement or Delivery Date– Underlying Asset.

• Features of futures:1. Futures are traded on organized exchanges with

clearing associations that act as intermediaries between the contracting parities.

2. Futures are highly standardized contracts that provide for the performance of the contract either through deferred delivery of an asset or a final cash settlement.

3. Both the parties pay a margin to the clearing association. This is used as a performance bond by contracting parties. The margin paid is generally marked to the market price every day.

4. Each futures contract has an association month which represents the month of contract delivery or final settlement.

• Distinction between forwards and futuresNature of difference

Forwards Futures

1. Size of contracts Decided by buyer and seller

Standardized in each contract

2. Price of contract Remains fixed till maturity

Changes every day

3. Market to market Not done Marked to market every day

4. Margin No margin required Margins are to be paid by both buyer and seller

5. No. of contracts in a year

There can be any number of contracts

No. of contracts in a year are fixed between 4 and 12

6. Hedging These are tailor-made for specific date and quantity, so perfect hedging is possible

Hedging is by nearest month and quantity contracts so perfect hedging not possible.

7. Market liquidity

Illiquid Liquid

8. Nature of market Over the counter Exchange traded9. Mode of delivery Specifically decided.

Most of the contracts result in deliver.

Standardized, most of contracts are cash settled.