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Derivatives

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8 views

Derivatives

Uploaded by

Sanjib Das
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Derivatives

A Derivative is a contract between two or more parties whose value is based on an


underlying Variable. These Variables can be Bonds, Commodities, Currencies,
Interest Rates, Equities etc. Derivatives can be used Both for Hedging & also for
Speculation.
MAJOR TYPES OF DERIVATIVES
 Forwards/futures
 Options
 Swaps
 Others

Understanding Derivatives through an example of Forwards


With an objective to provide readers flavour of derivatives, an example of a forward
transaction is given below.
An exporter A in India who manufactures pens secures an order for manufacturing
and exporting one pen to B in the United States on 1 January 2010. A's cost of
production is IN 42 per pen and his target profit is IN 3. Considering that A needs to
invoice in USD such that he receives INR 45, he raises an invoice for USD 1
(prevailing conversion rate USDI = INR 45). It took six months for *A' to manufacture
and export pens. On 1 July 2010, A receives USD 1 as invoiced. However since
USD/INR does not remains constant, there can be potentially three different
scenarios on 1 Jul 2010.
Scenario USD/INR Market Rate Outcome if unhedged
1 40 A is unhappy
2 45 A is Neutral
3 50 A is happy

The ideal situation for A would have been to convert USD proceeds into INR 45
which he had used while invoicing the pen at USD 1. However, as can be seen from
above table due to exchange rate volatility, A can either have windfall gain at 50 or
loss at 40. Instead of this, if A had entered into foreign exchange forward agreement
with the bank on 1 January, wherby he would under all scenarios receive INR 45 for
selling USD 1 to the bank (assuming forward rate for 6 months delivery is 45), then
his scenario analysis would be as follows –
Scenario USD/INR Market Forward Rate @ Outcome if hedged
Rate 45
1 40 45 A is happy
2 45 45 A is Neutral
3 50 45 A is unhappy due to
opportunity loss
So entering to a forward contract had made A happy in the first scenario with neutral
position in the second scenario and sad in third scenario (opportunity loss of INR 5
or more). This is known as entering into a hedging contract (insurance against future
market volatility), and such a form of hedging is known as forward contract.

Participants in the Derivatives Market:


The three broad categories of participants who trade in the derivatives market are as
follows:
1. Hedgers: They face the risk associated with the price of an underlying asset.
Hence, they use forward/futures or options markets to minimize or eliminate the risk.
2. Speculators: They wish to bet on future movements in the price of an asset.
Hence, they use forward, futures and options contracts to bet in the market which
can either be profitable or a loss-making proposition.
3. Arbitrageurs: They are in business to take advantage of a discrepancy between
prices in two different markets. For example, if they see the futures price of an asset
getting out of line with the cash price, they will take offsetting positions in the two
markets to lock in a profit. This is especially true for equity and commodity markets in
India.

Some Facts About Derivatives Market


Derivatives market is a contract based notional market which is approximately fifteen
times the world’s GDP. Derivatives market impacts the actual economy or say the
GDP as the prices of commodities needed to manufacture goods are speculated
over derivatives market. Derivatives were originally invented as a tool for hedging so
that we can fix a price today so that later on we should bear no loss. If this contract is
done with a bank it is known as forward contract and if it is done on an exchange it is
known as a futures contract. Also foreign currency movements and equity prices are
also caused due the derivatives. If the derivative contract is done with a broker it is
called an exchange traded counter derivatives and if it is with the bank it is called
over the counter derivatives. More than 90% derivatives are done with the banks and
also 90 % Derivatives market is currency and interest rate derivatives.

Difference Between ETC and OTC

Future (ETC) Forwards (OTC)

Standardized product (in terms of Product designed by banks as per client


maturity, amount) available through requirement.
recognized exchanges.
A futures contract is a contractual A forward contract is a contractual
agreement between two parties to buy or agreement between two parties to buy or
sell a standardized quantity and quality of sell an asset at a future date for a
asset on a specific future date on a predetermined mutually agreed price
futures exchange. while entering into the contract. A
forward contract is not traded on an
exchange.
A futures contract is traded on the A forward contract is traded in an OTC
centralized trading platform of an market.
exchange.
The contract price of a futures contract is The contract price of a forward contract
transparent as it is available on the is not transparent, as it is not publicly
centralized trading screen of the disclosed. It is with bank.
exchange.
In futures contracts, the exchange In forward contracts, counter-party risk is
clearing house provides trade guarantee. high due to the customized nature of the
Therefore, counterparty risk is almost transaction.
eliminated.
A regulatory authority and the exchange A forward contract is not regulated by
regulate a futures contract. any exchange. It is regulated by RBI.

Options
Options is a form of financial derivative that gives buyers the right but not the
obligation to buy or sell an underlying asset at an agreed upon price and date.

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