FINANCIAL DERVIATIVES

Dr. RAGHUVEER KATRAGADDA

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 What is a financial derivative?

• A financial instrument that has a value

derived from the value of something else.
• A derivative is a financial contract that
derives its value from an underlying asset
(U/A). The buyer/seller agrees to
purchase/sell the asset on a specific
future date at/for a specific price. 
• U/A  can be
Shares/Bonds/Commodities….
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 DERIVATIVE
• The term “Derivative”, indicates that it has no
independent value, i.e. its value is entirely
derived from the value of the underlying asset.
The underlying asset can be securities,
commodities, currency, livestock or anything
else.
• Derivative means forward, futures, options or
any other hybrid contract of predetermined fixed
duration, linked for the purpose of contract
fulfillment to the value of a specified real or
financial asset or to an index of securities.
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 KEY POINTS

• A derivative is a contract between two or

more parties whose value is based on an
agreed-upon underlying financial asset, index
or security.
• Futures contracts, forward contracts, options,
swaps, and warrants are commonly used
derivatives.
• Derivatives can be used to either mitigate risk
(hedging) or assume risk with the expectation
of commensurate reward (speculation).
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 Understanding Derivatives

• Derivatives are secondary securities whose value is

solely based (derived) on the value of the primary
security that they are linked to–called the underlying.
Typically, derivatives are considered advanced investing.
• There are two classes of derivative products–"lock" and
"option." Lock products (e.g. swaps, futures, or
forwards) bind the respective parties from the outset to
the agreed-upon terms over the life of the contract.
Option products (e.g. stock options), on the other hand,
offer the holder the right, but not the obligation, to buy
or sell the underlying asset or security at a specific price
on or before the option's expiration date. 

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 HISTORY

• The word derivatives originated in

mathematics and refers to a variable that has
been derived from another variable. For
example, a measure of distance in KM could
be derived from a measure of distance in
miles by dividing by 1.61, or Similarly a
measure of temperature in Celsius could be
derived from a measure of temperature in
Fahrenheit. 

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 HISTORY…2
• Derivative market can be traced back to the middle
ages. They were originally developed meet the needs
of farmers and merchants.
• The Chicago Board of Trade was the first derivatives
market established in 1848 to bring farmers and
merchants together. In 1874, the Chicago Produce
Exchange was established. In 1919, this was renamed
the Chicago Merchantile Exchange (CME) and was
reorganized for futures trading.
• In India it is trading on Multicommodity Exchange
(MCX), National Commodity and Derivatives Exchange
(NCDEX). 8
 CHARACTERSTICS
• It has one or more underlying assets
• Requires negligible initial investment
compared to other types of financial
contracts
• Should provide net settlement I.e.,
offsetting of initial contract position

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 FEATURES OF DERIVATIVES
• The instrument relates to the future contract and
settlement of terms between parties involved,
normally called maturity period in case of Forward
contract.
• The parties involved may be obliged to exercise their
contracts or offset them (Forwards, Futures) or may
have rights (like option buyers).
• The contracts are fulfilled or transacted through a
recognized exchange (Futures contracts) through the
clearing house or they may be private bi-lateral
contracts (Forwards, Swaps) or OTC contracts
(Options) 10
 FUNCTIONS OF DERIVATIVES MARKET

• Risk management- Stop loss

• Transfer of risk
•  Price discovery
• Transitional efficiency - low transaction cost
compare to rest like, brokerage, commission,
regulatory costs and margin requirements 
• Financial Engineering- as it is new field
creating calls, puts, futures and other
derivatives
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 USES OF DERIVATIVES
• Derivatives are used by companies and
individuals wanting to cover their risks. This is
facilitated by a counter party who has the
motivation to make profits out of the
Premium, or is holding a mirror-image
opposite position. Example for derivatives use;
An exporter to the US expects to get $50,000
in 3 months from now. She will be happy to
have this converted at around Rs. 75 per $.
• BUT??? At the end of 3months 1USD = Rs 70
or Rs 78. 12
 ADVANTAGES
• Since all transactions related to derivatives take place
in future it provides individuals with better
opportunities because an individual who want to short
some stock for long time can do it only in futures or
options.
• Hence the biggest benefit of this is that it gives
numerous options to an investor or trader to execute
all sorts of strategies.
• In derivatives market people can transact huge
transactions with small amounts and therefore it gives
the benefit of leverage and hence even people who
have less amount of money can enter into this market. 
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 ADVANTAGES…2
• Intraday traders get the benefit of liquidity as
these contracts are very liquid and also the
costs such as basis expense, brokerage are less
as compared to cash market.

• It is a great risk management tool and if

applied judiciously it can produce good results
and benefit its user.

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 DISADVANTAGES
• Leverage is a double edged sword and therefore if you
do not get it right chances are you wound end up
losing huge amount of money because these contracts
have specific maturities and on that date they get
expired unlike cash market where you can hold on to
stocks for long period of time.
• Since its inception many critics have been blaming
derivatives for huge fall which keeps happening
frequently after the introduction of derivatives and
many people say that it increases unnecessary
speculation in the market which is not good for the
small retail investors who are the backbone of stock
market. 15
 DISADVANTAGES
• It is quite complex and various strategies of
derivatives can be implemented only by an
expert and therefore for a layman it is difficult
to use this and therefore it limits its
usefulness.

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 PARTICIPANTS/ TRADERS IN DERIVATIVES
MARKET
• SPECULATORS
When a securities are brought with a sole object of selling
them in future at higher price or these are sold now with
the intension of buying at a lower price in future are called
Speculation transactions. The main objective of such
transactions is to take advantage of price differential at
different times.
For example; Ramu bought 200 shares of Tata Steel Limited
at Rs. 235 per share. He does not take and give delivery of
shares but settles the transactions by receiving the
difference in prices amounting to Rs. 5,000 plus brokerage . 
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 PARTICIPANTS/ TRADERS IN DERIVATIVES
MARKET…2
• ARBITRAGEURS
Arbitrage signifies the existence of a riskless profit.
‘Person actively engaged in seeking out minor price
discrepancies are called Arbitrageurs. Arbitrage is
simultaneous purchase and sale of equivalent assets at
prices which guarantee a fixed profit at the time of the
transactions, although the life of the assets and hence
the consumption of the profit may be delayed until some
future date.
Example: Arbitrageurs are in business to take advantage
of a discrepancy between prices in two different markets
(NSE and BSE)  19
 PARTICIPANTS/ TRADERS IN DERIVATIVES
MARKET…3
• HEDGER
Hedge is a strategy intended to protect an
investment or portfolio against loss. It usually
involves buying securities that move in the
opposite direction than the asset being
protected. Hedging is like buying insurance. It
is protection against unforeseen events. It is
usually involves balance any gains and losses
to the underlying assets.
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