What are Derivatives?

 A derivative is a financial instrument whose value is derived

the value of another asset, which is known as the underlying.

 When the price of the underlying changes, the value of the

derivative also changes.

 A Derivative is not a product. It is a contract that derives its

value from changes in the price of the underlying.

Example :
The value of a gold futures contract is derived from the
value of the underlying asset i.e. Gold.
 Traders in Derivatives Market
There are 3 types of traders in the Derivatives
Market
HEDGER
 A hedger is someone who faces risk associated
with price movement of an asset and who uses
derivatives as means of reducing risk.
 They provide economic balance to the market.
 SPECULATOR

SPECULATOR

• A trader who enters the futures market for

pursuit of profits, accepting risk in the
endeavor.
• They provide liquidity and depth to the
market.
 ARBITRAGEUR
• A person or a firm who simultaneously enters into
transactions in two or more markets to take
advantage of the discrepancies between prices in
these markets.
• Arbitrage involves making profits from relative
mispricing.
• They also help to make markets liquid, ensure
accurate and uniform pricing, and enhance price
stability
 Economic benefits of derivatives
i. Reduces risk
ii. Enhance liquidity of the underlying asset
iii. Lower transaction costs
iv. Enhances liquidity of the underlying asset
v. Enhances the price discovery process.
vi. Portfolio Management
vii. Provides signals of market movements
viii. Facilitates financial markets integration
 Types of Derivatives
Forwards-
A forward contract is a customized contract
between two entities, where settlement takes
place on a specific date in the future at today's
pre-agreed price.
Futures –
A futures contract is an agreement between two
parties to buy or sell an asset at a certain time in
the future at a certain price.
Options:
An option represents the right (but not the
obligation) to buy or sell a security or other asset
during a given time for a specified price (the
"strike price").
Swaps:
Swaps are private agreements between two
parties to exchange cash flows in the future
according to a prearranged formula.
 Hedging Currency Risk

Currency risk is the financial risk that arises

from potential changes in the exchange rate of
one currency in relation to another.

It is a financial instrument that involves the

exchange of interest in one currency for the
same in another currency.
 Forward Contract
A forward contract is an agreement between
two parties to buy or sell underlying assets at a
predetermined future date at a price agreed
when the contract is entered into. Forward
contracts are not standardized products. They
are over-the-counter (not traded in recognized
stock exchanges) derivatives that are tailored
to meet specific user needs.
The underlying assets of this contract include:

 Traditional agricultural or physical commodities

 Currencies (foreign exchange forwards)

 Interest rates (forward rate agreements or FRAs)

 Indian Derivative Market

Derivative markets in India have been in

existence in one form or the other for a long
time. In the area of commodities, the Bombay
Cotton Trade Association started future trading
way back in 1875.

In recent years government policy has shifted

in favour of an increased role at market based
pricing and less suspicious derivatives trading.
 The first step towards introduction of financial
derivatives trading in India was them
promulgation at the securities laws (Amendment)
ordinance 1995.