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425 views

Class 12 FMM Project

Uploaded by

dongrepruthviraj953
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What are derivatives

A derivative is a financial instrument whose value is derived from the


performance of an underlying asset, index, or rate. It essentially represents a
contract between two parties that derives its value from changes in the
underlying asset price. Derivatives prices are derived from fluctuations in the
underlying assets. The most common underlying assets for derivatives are
bonds, stocks, currencies, interest rates, commodities, and market indexes.
Traders use derivatives to access specific markets and trade different assets.
Contract values depend on changes in the prices of the underlying asset. When
the price of the underlying asset changes, the value of the derivative also
changes. Without an underlying asset, derivatives do not have any meaning. For
example, the value of a gold futures contract derives from the value of the
underlying asset i.e gold
History of derivatives
Derivatives are not new financial instruments. For example, the emergence of
the first futures contracts can be traced back to the second millennium BC in
Mesopotamia.
The sixth Babylonian king allowed sale of goods and assets at a pre-agreed
price. delivered at a future date.
Early forward contracts in the US addressed merchants' concerns about ensuring
that there were buyers and sellers for commodities. Credit risk remained a
serious problem. To deal with this problem, a group of Chicago businessmen
formed the Chicago Board of Trade (CBOT) in 1848, to provide a centralized
location (which would be known in advance) for buyers and sellers to negotiate
forward contracts. In 1919, Chicago Butter and Egg Board, a spin-off of CBOT,
was reorganized to allow futures trading. The CBOT and the CME remain the
two largest organized futures exchanges, indeed the two largest financial
exchanges of any kind in the world today.
However, the financial instrument was not widely used until the 1970s.
Currently the most popular stock index futures contract in the world is based on
S&P 500 index. traded on Chicago Mercantile Exchange. Index futures. futures
on T-bills and EuroDollar futures are the three most popular futures contracts
traded today.
Other popular international exchanges that trade derivatives are LIFFE in
England.
DTB in Germany, SGX in Singapore, TIFFE in Japan, MATIF in France, Eurex
etc.
The derivatives trading on the NSE commenced on June 12, 2000 with futures
trading on Nifty 50 Index. The introduction of new valuation techniques
sparked the rapid development of the derivatives market. Nowadays, we cannot
imagine modern finance without derivatives
Importance of derivatives
According to the Securities Contract Regulation Act. (1956) the term 'derivative
includes:
• 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:
• a contract which derives its value from the prices, or index of prices, of
underlying securities.

Derivatives are important financial instruments because

Derivatives are very similar to insurance. Insurance protects against specific


risks, such as fire, floods, theft and so on. Derivatives on the other hand. take
care of market risks - volatility in interest rates, currency rates.
commodity prices, and share prices.
• Derivatives offer a sound mechanism for insuring against various kinds of
risks arising in the world of finance.
• They offer a range of mechanisms to improve redistribution of risk, which can
be extended to every product existing, from coffee to cotton and live cattle to
debt instruments.

Advantages of derivatives are

They reduce financial risk involved in a transaction by making people commit


to prices in the present for future dates.
• They also allow a person to transfer the risk to another person who is willing
to take it.
• They are used to manage financial risk by allowing investors to take opposite
positions in a single transaction, also known as hedging.
• They are used to speculate on the price of different assets.
• They matter because when a person trades, the more risk he undertakes, the
more gains he will have.
• They can be used on both sides of the situation to either reduce risks or to take
risks.
• Derivatives can be used to hedge a position, speculate on the directional
movement of an underlying asset, or give leverage to holdings.
• These assets are commonly traded on exchanges or over-the-counter (OTC)
and are purchased through brokerages.

Disadvantages of derivatives
Financial derivatives can be very complex.
• What makes these derivatives so dangerous to the extent where Warren Buffett
called them "weapons of financial destruction", is because when you price a
derivative, there an assumption that the financial markets are frictionless (this is
a false and stupid assumption).
• Derivatives are seen as dangerous because they're mostly being used by hedge
funds and other investors to gain more leverage, increasing the risks of a
complete market collapse.
• Although derivatives traded on the exchanges generally go through a thorough
due diligence process, some of the contracts traded over-the-counter do not
include a benchmark for due diligence. Thus, there is a possibility of
counterpart default.

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