Introduction to Derivatives

Module - I
 Risk Management

• Risk can be defined as deviation of the actual

result from the expected.
• Derivatives are used to manage risk that
emanate from normal operations of the
business
• Management of risk through derivatives is
commonly referred to as hedging.
 Overview of Derivative Contract
• Derivatives are contracts whose value is derived from the price of
the underlying asset.

• The most common underlying assets for derivatives are stocks,

bonds, commodities, currencies, interest rates, and market indexes. 

• Derivatives derive their names from their respective underlying

asset. Thus if a derivative’s underlying asset is equity, it is called
equity derivative and so on.
 Cont…
• The basic purpose of derivatives is to transfer the price risk
(inherent in fluctuations of the asset prices) from one party to
another; they facilitate the allocation of risk to those who are
willing to take it.
• In so doing, derivatives help mitigate the risk arising from the
future uncertainty of prices.
 Types of Derivatives

Equity Derivatives

Index derivatives

Commodity derivatives
Currency derivatives

Interest rate derivatives

Weather derivatives
 Derivative products

Forwards
Futures
Options
Swaps
 Forward Contract
• A forward is an agreement between two parties in which one party, the

buyer, enters into an agreement with the other party, the seller that he

would buy from the seller an underlying asset on the expiry date at the

forward price.

• The future date is referred to as expiry date and the pre-decided price is

referred to as Forward Price.

• Therefore, it is a commitment by both the parties to engage in a transaction

at a later date with the price set in advance. This is different from a spot

market contract, which involves immediate payment and immediate transfer

of asset.
 Cont..

• It may be noted that Forwards are private contracts and

their terms are determined by the parties involved.

• Forward contracts are traded only in Over the Counter

(OTC) market and not in stock exchanges. OTC market is

a private market where individuals/institutions can

trade through negotiations on a one to one basis.

 Example
• Currently tomatoes are selling at Rs.15 per kg in the
market.
• Assume that a farmer, will be harvesting 1000kgs of
tomatoes three months from now
• He is concerned about a potential decline in the price of
tomatoes
• He thus enters into a forward contract with a trader to sell
1000kgs of tomatoes at Rs. 10 per kg in 3 months, with
settlement on cash basis.
 Quiz
1. Based on the previous example, if the spot
price on expiry (maturity) is Rs. 13 per kg of
tomato, calculate the profit/loss incurred by
both the parties involved in the forward
contract.
2. What if the spot price on expiry is Rs. 8 Per
kg?
3. What if the spot price is Rs. 10 per kg?
• Scenario 1 - Spot Price > Forward Price.

• Spot price = Rs. 15, Forward Price = Rs.10

• That is 15 > 10 = Rs. 5

• Trader (buyer) makes a profit of Rs.5 per kg of

tomato (Rs.5 *1000 Kg = Rs.5,000)

• Trader (Buyer) makes a profit of Rs.5000

• Framer(Seller) incurs a loss of Rs.5000

• Scenario 2 – Spot Price < Forward Price

• Spot price = Rs. 6, Forward Price = Rs.10

• That is 6 < 10 = Rs. 4

• Farmer (Seller) makes a profit of Rs. 4 per kg of

tomato (Rs.4 *1000 Kg = Rs.4,000)

• Farmer (Seller) makes a profit of Rs.4,000

• Trader (Buyer) incurs a loss of Rs.4,000

 Scenario 3 – Spot Price = Forward Price

• Spot price = Rs. 10, Forward Price = Rs.10

• No profit, No Loss for both the parties

involved in the contract.
 Default risk in forward contracts
• A drawback of forward contracts is that they are subject to

default risk.

• The main reason behind such risk is the absence of any

mediator between the parties, who could have undertaken

the task of ensuring that both the parties fulfill their

obligations arising out of the contract.

• Default risk is also referred to as counter party risk or credit

risk.
 Futures
• Unlike a forward contract, a futures contract is not a
private transaction but gets traded on a recognized
stock exchange.
• In addition, a futures contract is standardized by the
exchange. All the terms of the contract are set by the
stock exchange.
• Also, both buyer and seller of the futures contracts
are protected against the counter party risk by an
entity called the Clearing Corporation.
 Options
• An option is a derivative contract between a buyer and a seller, where one

party gives to the other the right, but not the obligation, to fulfil the

contract.

• In return for granting the option, the party granting the option collects a

payment from the other party. This payment collected is called the

“premium” or price of the option.

• The right to buy or sell is held by the “option buyer” (also called the option

holder); the party granting the right is the “option seller” or “option writer”.

• Types – Call Option and Put Option

 Swaps
• A swap is a derivative contract through which two
parties exchange the cash flows from two different financial
instruments.
• The most common kind of swap is an interest rate and
currency swaps.
• Swaps do not trade on exchanges, and retail investors do not
generally engage in swaps. Rather, swaps are over-the-
counter contracts primarily between businesses or financial
institutions that are customized to the needs of both parties.
 Origin of Derivatives
• The earliest evidence of trading in derivatives is traced back to ancient

Greece.

• The advent of modern day derivatives contracts is attributed to farmers’

need to protect themselves against a decline in crop prices due to various

economic and environmental factors. Thus, derivatives contracts initially

developed in commodities.

• The first “futures” contracts can be traced to the Yodoya rice market in

Osaka, Japan around 1650.

• In 1848, the Chicago Board of Trade (CBOT) was established to facilitate

trading of forward contracts on various commodities.

• Organized commodity derivatives in India can be traced back to 1875
with the Cotton Trade Association’s future trading. Over time the
derivatives market developed in several other commodities in India.

• Following cotton, derivatives trading started in oilseeds in Bombay

(1900), raw jute and jute goods in Calcutta (1912) and in Bullion in
Bombay (1920).

• After Independence, the Parliament passed Forward Contracts

(Regulation) Act, 1952 which regulated forward contracts in
commodities all over India. The Act applies to goods, which are
defined as any movable property other than security, currency and
actionable claims.
• The commodity derivatives markets faced a
major crunch when the Act said that, only
those associations/exchanges, which are
granted recognition by the Government, are
allowed to organize forward trading in
regulated commodities.
• Derivatives, as exchange traded financial instruments was introduced
in India in June 2000. The National Stock Exchange (NSE) is the
largest exchange in India in derivatives, trading in various derivatives
contracts. The first contract to be launched on NSE was the Nifty 50
index futures contract.
• In a span of one and a half years after the introduction of index
futures, index options, stock options and stock futures were also
introduced in the derivatives segment for trading.
• NSE’s equity derivatives segment is called the Futures & Options
Segment or F&O Segment.
• NSE also trades in Currency and Interest Rate Futures contracts
under a separate segment.
 Participants in the Derivatives Market

• Based on the applications that derivatives are

put to, these investors can be broadly

classified into three groups:

– Hedgers

– Speculators

– Arbitrageurs
 Hedgers
• These investors have a position (i.e., have bought stocks) in the
underlying market but are worried about a potential loss arising out
of a change in the asset price in the future.
• Hedgers participate in the derivatives market to lock the prices at
which they will be able to transact in the future.
• A hedger normally takes an opposite position in the derivatives
market to what he has in the underlying market.
• The best way to understand hedging is to think of it as a form of
insurance. 
Long Hedge:
• A long hedge involves holding a long position in the futures market. A Long position

holder agrees to buy the underlying asset at the expiry date by paying the agreed

futures/ forward price.

• This strategy is used by those who will need to acquire the underlying asset in the

future.

• For example, a chocolate manufacturer who needs to acquire sugar in the future

will be worried about any loss that may arise if the price of sugar increases in the

future. To hedge against this risk, the chocolate manufacturer can hold a long

position in the sugar futures. If the price of sugar rises, the chocolate manufacture

may have to pay more to acquire sugar in the normal market, but he will be

compensated against this loss through a profit that will arise in the futures market.
• Short Hedge - A short hedge involves taking a short position in the futures
market.
• Short hedge position is taken by someone who already owns the underlying
asset or is expecting a future receipt of the underlying asset.
• For example, an investor holding Reliance shares may be worried about
adverse future price movements and may want to hedge the price risk.
• He can do so by holding a short position in the derivatives market. The
investor can go short in Reliance futures at the NSE.
• This protects him from price movements in Reliance stock.

• In case the price of Reliance shares falls, the investor will lose money in the
shares but will make up for this loss by the gain made in Reliance Futures.
 Speculators
• A Speculator is one who bets on the derivatives market based on his

views on the potential movement of the underlying stock price.

• Speculators take large, calculated risks as they trade based on

anticipated future price movements. They hope to make quick, large

gains; but may not always be successful.

• They normally have shorter holding time for their positions as compared

to hedgers. If the price of the underlying moves as per their expectation

they can make large profits. However, if the price moves in the opposite

direction of their assessment, the losses can also be enormous.

 Arbitrageurs

• Arbitrageurs attempt to profit from pricing

inefficiencies in the market by making
simultaneous trades that offset each other and
capture a risk-free profit.
• An arbitrageur may also seek to make profit in
case there is price discrepancy between the stock
price in the cash and the derivatives markets.
 Economic Benefits of Derivatives
• Risk Management - There are several risks inherent in financial transactions.

Derivatives are used to separate risks from traditional instruments and transfer these

risks to parties willing to bear these risks.

• Lower transaction cost

• Better portfolio management

• Catalyze entrepreneurial activity

• Enhance liquidity of the underlying asset

• Aids price discovery

• Improves Market Efficiency

• Provides signals of market movement

 Key points to Remember
• Buy (Long) Futures – Bullish (Increase)
• Sell (Short) Futures – Bearish (Decrease)
• Buy (Long) Call – Bullish (Increase)
• Sell (Short) Call – Not Increase

• Buy (Long) Put – Bearish (Decrease)

• Sell (Short) Put – Not Decrease