THEME

An Understanding Of
Financial Derivatives
Gaurav Dhingra

< E X E C U T I V E S U M M A R Y >
◆ Derivative products initially emerged tives should be considered for inclusion
as hedging devices against fluctuations in any organisation’s risk-control arse-
in commodity prices. These offer organ- nal. The most common financial deriva-
isations the opportunity to break finan- tive products can be classified as for-
cial risks into smaller components to wards, futures, options and swaps.
best meet specific risk management Derivatives also have a darker side.
objectives. A derivative is an instrument Without a clearly defined risk manage-
where payoffs are derived from a more ment strategy, excessive use of financial
primitive or fundamental good. A finan- derivatives can cause serious losses and
cial derivative is a financial instrument, can threaten the firm’s long-term objec-
whose payoffs depend on another finan- tives. Derivatives being an important risk
cial instrument underlying the transac- management tool necessitate its users to
tion. Derivatives offer benefits such as understand the intended function and
risk management and efficiency in trad- the safety precautions before being put to
ing etc. to its users. Financial deriva- use for the benefit of the society at large.

erivatives remain a type of financial Emergence of financial derivative products

D instruments that few of us under-

stand and fewer still fully appreciate,
although many of us have invested
indirectly in derivatives by investing
in a Mutual Fund whose underlying assets may include
Derivative products initially emerged as hedging devices
against fluctuations in commodity prices, and commodity-
linked derivatives remained the sole form of such products for
almost three hundred years. Financial derivatives came into
spotlight in the post-1970 period due to growing instability in
derivative products. Even, the financial derivatives the financial markets. However, since their emergence, these
have changed the face of finance by creating new ways products have become very popular and by 1990s, they
to understand, measure and manage financial risks. accounted for about two-thirds of total transactions in deriva-
Derivatives offer tive products. In recent years, the market for financial deriva-
organisations the tives has grown tremendously in terms of variety of instru-
opportunity to ments available, their complexity and also turnover. In the class
break financial risks of equity derivatives the world over, futures and options on
into smaller com- stock indices have gained more popularity than on individual
ponents and then stocks, especially among institutional investors, who are major
to buy and sell users of index-linked derivatives. Even small investors find
those components to best meet specific risk manage- these useful due to high correlation of the popular indexes with
various portfolios and ease of use. The lower costs associated
The author is member of the Institute. The views expressed with index derivatives vis-a-vis derivative products based on
herein are the personal views of the author and do not individual securities is another reason for their growing use.
necessarily represent the views of the Institute. Source: www.nseindia.com

976
THE CHARTERED ACCOUNTANT MARCH 2004
 THEME

ment objectives. Using derivatives should be considered as a

part of any organisation’s risk management strategy to ensure Derivatives are securities under the SC(R)A and
that value enhancing investment opportunities can be pursued. hence the trading of derivatives is governed by the regu-
latory framework under the SC(R)A.
There is no definitive list of derivative products and
INTRODUCTION TO DERIVATIVES the types of derivative products that can be developed
A derivative is an instrument whose payoffs depend on a are limited by human imagination only. However the
more primitive or fundamental good. It is a contractual most common financial derivatives can be classified as
relationship between par- forwards, futures, options and swaps.
ties where payoffs are
derived from some agreed
upon benchmark. These APPLICATION OF FINANCIAL DERIVATIVES
do not have independent Some of the benefits that financial derivatives bring
existence without underly- to its users may be enumerated as:
ing product or commod-
ity. Even, derivatives do not have their own value and Risk Management
rather they derive their value from some underlying prod-
uct or commodity. Risk management is not about the elimination of
A financial derivative is a financial instrument, risk rather it is about the management of risk. Financial
whose payoffs depend on another financial instrument derivatives provide a powerful tool for limiting risks that
or we can say a financial derivative is a financial instru- individuals and organizations face in the ordinary con-
ment, whose value is linked in some way to the value of duct of their businesses.
another instrument, underlying the transaction. The Successful risk management with
underlying instrument could be securities, currencies or derivatives requires a thorough
indices. For example an option on a share of stock understanding of the principles
depends on the value of the underlying share. that govern the pricing of financial
derivatives. Used correctly, deriva-
To quote tives can save costs and increase
returns.
“A derivative can be defined as a financial instrument
whose value depends on (or derives from) the values of Trading Efficiency
other, more basic underlying variables.”
John C. Hull Derivatives allow for the free trading of individual
“A derivative is simply a financial instrument (or even risk components, thereby improving market efficiency.
more simply an agreement between two people) which Traders can use a position in one or more financial deriv-
has a value determined by the price of something else.” atives as a substitute for a position in the underlying
Robert L. McDonald instruments. In many instances
traders find financial derivatives to
Section 2 (aa) of the Securities Contracts (Regulation) be a more attractive instrument
Act [SC(R)A], 1956 defines derivatives as than the underlying security.
Reason being, the greater amount
of liquidity in the market offered by
“derivative” includes –
the financial derivatives and lower transaction costs
associated with trading a financial derivative as com-
(A) a security derived from a debt instrument, share,
pared to the costs of trading the underlying instrument.
loan, whether secured or unsecured, risk instru-
ment or contract for differences or any other
form of security;
Speculation
Serving as a speculative tool is not the only use, and
(B) a contract which derives its value from the prices,
probably not the most important use, of financial deriv-
or index of prices, of underlying securities

THE CHARTERED ACCOUNTANT 977 MARCH 2004

 THEME
atives. Financial derivatives are considered to be risky. The contract is settled at maturity date. The holder
However, these instruments act as a powerful instru- of the short position delivers the asset to the holder of
ment for knowledgeable traders to expose themselves to the long position in return for a cash amount equivalent
properly calculated and well understood risks in pursuit to the delivery price. Forwards contracts are traded over
of a reward i.e. profit. the counter and are not dealt with on an exchange. These
have certain flexibility and are self-regulatory. Forwards
markets afford privacy that is not there in the exchange
FORWARD CONTRACTS trading. Lack of liquidity and counter party default risks
These are the simplest form of derivative contracts. are the main drawbacks of a forward contract.
A forward contract is an agreement
between parties to buy/sell a spec-
ified quantity of an asset at a certain FUTURES CONTRACTS
future date for a certain price. One A futures contract is one by which one party agrees to
of the parties to a forward contract buy from / sell to the other party at a specified future
assumes a long position and agrees time, a specified asset at a price agreed at the time of the
to buy the underlying asset at a certain future date for a contract and payable on maturity date. The agreed price
certain price. The other party to the contract assumes a is known as the strike price. The
short position and agrees to sell the asset on the same underlying asset can be a commod-
date for the same price. The specified price is referred to ity, currency, debt or equity secu-
as the delivery price. The contract terms like delivery rity etc. Unlike forward contracts,
price and quantity are mutually agreed upon by the par- futures are usually performed by
ties to the contract. No margins are generally payable by the payment of difference between
any of the parties to the other. the strike price and the market price on the fixed future
date, and not by the physical delivery and the payment in
Features full on that date.
Salient features of forward contracts may be enumerated as:
● Each contract is custom designed, and hence is Features
unique in terms of contract size, maturity date and the Futures contracts can be characterised by:
asset type and quality, ● An organised exchange,
● On the expiration date, the contract is normally set- ● Standardised contract terms viz. the underlying asset,
tled by the delivery of the asset, the time of maturity and the manner of maturity etc.,
● Forward contracts being bilateral contracts are ● Associated clearinghouse to ensure smooth function-
exposed to counter party risk, and ing of the market,
● If the party wishes to cancel the contract or change ● Margin requirements and daily settlement to act as
any of its terms, it has necessarily to go to the same further safeguard, and
counter party. ● Existence of a regulatory authority.
Futures contracts being traded on organised
Illustration: On 1st April, Mr. ‘L’ enters into a for- exchanges impart liquidity to a transaction. The clearing-
ward contract with Mr. ‘S’ and agrees to purchase 1000 house, being the counter party to both sides of a transac-
shares of ‘X Ltd.’ for a pre-determined price of Rs. 10 tion, provides a mechanism that guarantees the honour-
three months forward. Here on the fixed future date, Mr. ing of the contract and ensuring very low level of default.
‘L’ will get the 1000 shares and will pay the price i.e. Rs.
10,000 and Mr. ‘S’ will deliver the shares and will receive Types of Futures
the money. Few types of financial futures are:
● Currency futures
● Interest futures
Specified Price ● Stock index futures

L S Illustration: On 1st September, Mr. ‘L’ enters into a

futures contract to purchase 100 equity shares of ‘X Ltd.’
Specified Asset at an agreed price of Rs. 100 in December. If on the

978
THE CHARTERED ACCOUNTANT MARCH 2004
 THEME
maturity date (as determined by the rules of the exchange products attractive; sometimes the products are
for the month of December) the price of the equity stock designed to reflect a corporate treasurer’s view on poten-
rises to Rs. 120 Mr. ‘L’ will receive Rs. 20 per share and tial future movements in particular market variables;
otherwise if the price of the share falls to Rs. 90 Mr. ‘L’ occasionally an exotic product is designed by an invest-
will pay Rs. 10 per share. ment bank to appear more attractive than it is to an
unwary corporate treasurer.”
If market price falls to Rs. 90 John C. Hull
Rs. 10 per share Illustration: Mr. ‘L’ pays $ 2,000 to buy a ‘December
103’ call option on a $ 100,000 US Treasury bond at an
L S exercise price of $ 103. If the price rises above $ 103, Mr.
‘L’ will gain from the difference and if the price falls
If market price rises to Rs. 120 below $ 103, the maximum amount which Mr. ‘L’ may
Rs. 20 per share lose is the amount of premium paid.
As compared to a forward contract the futures are
normally settled only by the difference between the
strike price and the market price as on maturity date. L Payments depending S
on the price at maturity date

OPTION CONTRACTS Premium $ 2,000

The literal meaning of the
word ‘option’ is ‘choice’ or we can
say ‘an alternative for choice’. In American Option and European Option
derivatives market also, the idea It is essential to be aware of the
remains the same. An option con- distinction between an American
tract gives the buyer of the option a Option and a European Option.
right (but not the obligation) to buy / sell the underlying An american option can be exer-
asset at a specified price on or before a specified future cised at any time upto the expira-
date. As compared to forwards and futures, the option tion date, a european option can be
holder is not under an obligation to exercise the right. exercised only on the expiration date itself. Most of the
Another distinguishing feature is that, while it does not option contracts traded on exchanges are of the type of
cost anything to enter into a forward contract or a futures american option.
contract, an investor must pay to the option writer to
purchase an option contract. The amount paid by the Call Option and Put Option
buyer of the option to the seller of the option is referred Basically there are two types of options viz. Call
to as the premium. For this reward i.e. the option pre- Option and Put Option. A call option gives the buyer of
mium, the option seller is under an obligation to sell / the option the right (but not the obligation) to buy the
buy the underlying asset at the specified price whenever underlying asset on or before a certain future date for a
the buyer of the option chooses to exercise the right. specified price whereas a put option gives the buyer of
Option contracts having simple standard features are the option the right (but not the obligation) to sell the
usually called plain vanilla contracts. Contracts having underlying asset on or before a certain future date for a
non-standard features are also available that have been specified price. As stated earlier, the option writer is
created by financial engineers. These are called exotic under an obligation to sell / buy the underlying asset at
derivative contracts. These are generally not traded on the specified price whenever the buyer of the option
exchanges and are structured between parties on their chooses to exercise the right. The specified price is
own. The relevance of exotic options can be understood known as the strike price or the exercise price and the
from these lines: specified date is known as the exercise date, maturity date
“ Exotic products come about for a number of rea- or the expiration date.
sons. Sometimes they meet a genuine hedging need in
the market; sometimes there are tax, accounting, legal, or Moneyness of an Option
regulatory reasons why corporate treasures find exotic Options can also be characterised in terms of their

THE CHARTERED ACCOUNTANT 979 MARCH 2004

 THEME
moneyness. Using notations, the loss that the buyer may suffer is the amount of the pre-
moneyness of an option for the mium paid and the gain depends on the difference
buyer of the option can be sum- between the strike price and the market price as on matu-
marised as: rity date. On the other hand, the gain to the seller of the
option is limited to the amount of the premium received
Call Option Put Option but the risk of loss is unlimited, depending upon the
In-the-money M>E M<E strike price and the market price as on maturity date.
At-the-money M=E M=E
Out-of-the-money M<E M>E
SWAPS
Where M is the prevalent market price for the option A swap can be defined as a
contract, and E is the exercise price of the option con- barter or exchange. A swap is a con-
tract. For a seller / writer of the option the >, < signs will tract whereby parties agree to
reverse. In words, the moneyness of the option for the exchange obligations that each of
buyer of the option can be stated as: them have under their respective underlying contracts or
● An in-the-money option is one that would lead to a we can say a swap is an agreement between two or more
positive cash flow to the buyer of the option if the parties to exchange sequences of cash flows over a period
buyer of the option exercises the option at the cur- in the future. The parties that agree to the swap are known
rent market price. as counter parties.

● An at-the-money option is one that would lead to a zero Types of Swaps

cash flow to the buyer of the option if the buyer of the There are two basic kinds of swaps:
option exercises the option at the current market price. ● Interest rate swaps
● Currency swaps
● An out-of-the-money option is one that would lead to
a negative cash flow to the buyer of the option if the
buyer of the option exercises the option at the current Today, interest rate swaps account for the majority of
market price. banks’ swap activity and the fixed-for-floating rate swap is
the most common interest rate swap. In such a swap, one
Cap, Floor and Collar party agrees to make fixed-rate interest payments in return
for floating-rate interest payments from the counterparty,
Limits can be set on the strike price for an option with the interest rate payment calculations based on a
contract. If an upper limit on the strike price is set, it is hypothetical amount of principal called the notional
called a ‘cap’. If a lower limit on the strike price is fixed, amount. Notional amount typically does not change hands
it is called a ‘floor’. If a combination of both i.e. ‘cap’ and and it is simply used to calculate payments. Currency
‘floor’ is used i.e. a range is fixed for the strike price, it is swaps involve exchange of currencies at specified
called a ‘collar’. If the market price as on maturity date is exchange rates and to make a series of interest payments
higher than the cap price, then the cap price will be the for the currency that is received at specified intervals.
strike price, otherwise the market price will be the strike Illustration: Mr. ‘A’ has borrowed from Mr. ‘X’ at
price. Similarly, if the market price as on maturity date is LIBOR (London Interbank Offered Rate) + 2%. Mr. ‘A’
lower than the floor price, then the floor price will be the to cover the transaction from unanticipated fluctuations
strike price otherwise the market price will be the strike in the interest rate, agrees to pay a fixed rate of 9% to Mr.
price. In other words we can conclude that in case of a ‘B’ and in return Mr. ‘B’ agrees to pay a floating rate i.e.
collar, the strike price can’t be higher than the cap price LIBOR + 2% to Mr. ‘A’. Although the actual payments
and lower than the floor price. between Mr. ‘A’ and Mr. ‘B’ will take place only on a net
Similar to a futures contract, the exercise of the basis. The net result of the transaction for each of the
option, normally, results in a contract to pay the differ- parties will be as follows:
ence between the strike price and the market price on the ● Mr. ‘X’ will receive the amount at LIBOR + 2%.
date of exercise of the option. As mentioned earlier, the ● Mr. ‘A’s liability is fixed at 9%.
buyer of the option has to pay a premium for purchasing ● Mr. ‘B’s liability depends on the fluctuating rate i.e.
the option. Hence on the maturity date the maximum LIBOR.

980
THE CHARTERED ACCOUNTANT MARCH 2004
 THEME
Let us take two cases: spective financial derivatives offer free trading of indi-
1) LIBOR = 10% vidual risk components.
In this case Mr. ‘A’ will pay to Mr. ‘X’ at the rate of As there is always an other side of the coin, deriva-
12%. Mr. ‘B’ will pay to Mr. ‘A’ at the rate of 3%. tives also have a darker side.
Hence the net liability of Mr. ‘A’ is 9% only. Organisations like Procter &
2) LIBOR = 5% Gamble, Long Term Capital
In this case Mr. ‘A’ will pay to Mr. ‘X’ at the rate of 7% Management, Barings Bank, etc.
and Mr. ‘A’ will pay to Mr. ‘B’ at the rate of 2%. Hence experienced huge losses from
the net liability of Mr. ‘A’ remains the same at 9%. derivatives trading in the early
1990’s. Barings Bank lost around
$1 billion just because one trader whose job was to carry
X out low risk arbitrage switched from being an arbitrageur
to a speculator. The hedge fund named Long Term
Capital Management lost about $4 billion in 1998. The
F L
treasury department of Procter & Gamble lost about $90
L I
million trading highly exotic interest rate derivatives con-
O B
tracts. These losses warn the users against excessive use
A O
of financial derivatives. Without a clearly defined risk
T R
management strategy, excessive use of financial deriva-
I +
tives can be risky. They can cause serious losses and can
N 2%
threaten the firm’s long-term objectives. Hence it is
G
important that users of derivatives fully understand the
FLOATING LIBOR + 2% complexity of financial derivative contracts and accom-
B panying risks. Derivatives being an important risk man-
A
agement tool necessitate its users to understand the
FIXED 9% intended function and the safety precautions before
being put to use. The use of derivatives should be inte-
Swaps are not traded on organized exchanges and grated into an organisation’s overall risk-management
have an informal market among the dealers. As distin- strategy and should be in harmony with its objectives.
guished from futures and options, swaps market affords Hence the users of derivatives can use these instruments
privacy that may not be there in exchange trading. The for their benefit and for the benefit of the society at large.
inherent limitations of a swaps market may be summa-
rized as follows; first, a party has to find a counter party
willing to take the opposite side of the transaction, sec-
ond, a swap agreement, being between two counter par- REFERENCES
ties cannot be altered or terminated early without the ● Options, Futures, and Other Derivatives – John C. Hull
agreement of both the parties, third, parties to the swap ● Derivatives Markets – Robert L. McDonald
must be certain of the creditworthiness of the counter
● Futures, Options, & Swaps – Robert W. Kolb
party as the risk of counter party default is always there.
● www.nseindia.com

CONCLUSION Note: The Council of the Institute of Chartered

Financial derivatives should be considered for inclu- accountants of India has recently issued a “Guidance
sion in any organisation’s risk-control arsenal. Using Note on Accounting for Equity Index and Equity Stock
derivatives allows risk to be broken into pieces that can Futures and Options” which is available at pages 245 to
be managed independently. The viability of financial 266 of the September 2003 issue of “The Chartered
derivatives rests on the principle of comparative advan- Accountant”. It is also available on the website of the
tage i.e. the relative cost of holding specific risks. Institute at http://www.icai.org/announ/GNon
Whenever comparative advantage exists, trade can ben- AcingforFuturesandOptions.doc. For accounting related
efit all parties involved. From a market-oriented per- aspects readers may kindly refer the Guidance Note. ■

THE CHARTERED ACCOUNTANT 981 MARCH 2004