Most complex instruments


Derivatives are one of the most complex instruments. The word derivative comes from the word 'to derive'. It indicates that it has no independent value. A derivative is a contract whose value is derived from the value of another asset, known as the underlying asset, which could be a share, a stock market index, an interest rate, a commodity, or a currency. The underlying is the identification tag for a derivative contract. When the price of the underlying 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. The prices in the derivatives market are driven by the spot or cash market price of the underlying asset, which is gold in this example.

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.

In this era of globalisation, the world is a riskier place and exposure to risk is growing. Risk cannot be avoided or ignored. Man, however is risk averse. The risk averse characteristic of human beings has brought about growth in derivatives. Derivatives help the risk averse individuals by offering a mechanism for hedging risks.

Derivative products, several centuries ago, emerged as hedging devices against fluctuations in commodity prices. Commodity futures and options have had a lively existence for several centuries. Financial derivatives came into the limelight in the post-1970 period; today they account for 75 percent of the financial market activity in Europe, North America, and East Asia. The basic difference between commodity and financial derivatives lies in the nature of the underlying instrument. In commodity derivatives, the underlying asset is a commodity; it may be wheat, cotton, pepper, turmeric, corn, orange, oats, Soya beans, rice, crude oil, natural gas, gold, silver, and so on. In financial derivatives, the underlying includes treasuries, bonds, stocks, stock index, foreign exchange, and Euro dollar deposits. The market for financial derivatives has grown tremendously both in terms of variety of instruments and turnover.

Presently, most major institutional borrowers and investors use derivatives. Similarly, many act as intermediaries dealing in derivative transactions. Derivatives are responsible for not only increasing the range of financial products available but also fostering more precise ways of understanding, quantifying and managing financial risk.

Derivatives contracts are used to counter the price risks involved in assets and liabilities. Derivatives do not eliminate risks. They divert risks from investors who are risk averse to those who are risk neutral. The use of derivatives instruments is the part of the growing trend among financial intermediaries like banks to substitute off-balance sheet activity for traditional lines of business. The exposure to derivatives by banks have implications not only from the point of capital adequacy, but also from the point of view of establishing trading norms, business rules and settlement process. Trading in derivatives differ from that in equities as most of the derivatives are market to the market.


Derivative is a product whose value is derived from the value of one or more basic variables, called bases (underlying asset, index, or reference rate), in a contractual manner. The underlying asset can be equity, forex, commodity or any other asset.

According to Securities Contracts (Regulation) Act, 1956 {SC(R)A}, derivatives is

  • 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 securities under the Securities Contract (Regulation) Act and hence the trading of derivatives is governed by the regulatory framework under the Securities Contract (Regulation) Act.



The history of derivatives is quite colourful and surprisingly a lot longer than most people think. Forward delivery contracts, stating what is to be delivered for a fixed price at a specified place on a specified date, existed in ancient Greece and Rome. Roman emperors entered forward contracts to provide the masses with their supply of Egyptian grain. These contracts were also undertaken between farmers and merchants to eliminate risk arising out of uncertain future prices of grains. Thus, forward contracts have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence in the early 1700's in Japan. The first formal commodities exchange, the Chicago Board of Trade (CBOT), was formed in 1848 in the US to deal with the problem of 'credit risk' and to provide centralised location to negotiate forward contracts. From 'forward' trading in commodities emerged the commodity 'futures'. The first type of futures contract was called 'to arrive at'. Trading in futures began on the CBOT in the 1860's. In 1865, CBOT listed the first 'exchange traded' derivatives contract, known as the futures contracts. Futures trading grew out of the need for hedging the price risk involved in many commercial operations. The Chicago Mercantile Exchange (CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874 under the names of 'Chicago Produce Exchange' (CPE) and 'Chicago Egg and Butter Board' (CEBB). The first financial futures to emerge were the currency in 1972 in the US. The first foreign currency futures were traded on May 16, 1972, on International Monetary Market (IMM), a division of CME. The currency futures traded on the IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc, the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were followed soon by interest rate futures. Interest rate futures contracts were traded for the first time on the CBOT on October 20, 1975. Stock index futures and options emerged in 1982. The first stock index futures contracts were traded on Kansas City Board of Trade on February 24, 1982.

The first of the several networks, which offered a trading link between two exchanges, was formed between the Singapore International Monetary Exchange (SIMEX) and the CME on September 7, 1984.

Options are as old as futures. Their history also dates back to ancient Greece and Rome. Options are very popular with speculators in the tulip craze of seventeenth century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence; owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded in tulip bulb options. There was so much speculation that people even mortgaged their homes and businesses. These speculators were wiped out when the tulip craze collapsed in 1637 as there was no mechanism to guarantee the performance of the option terms.

The first call and put options were invented by an American financier, Russell Sage, in 1872. These options were traded over the counter. Agricultural commodities options were traded in the nineteenth century in England and the US. Options on shares were available in the US on the over the counter (OTC) market only until 1973 without much knowledge of valuation. A group of firms known as Put and Call brokers and Dealer's Association was set up in early 1900's to provide a mechanism for bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE) was set up at CBOT for the purpose of trading stock options. It was in 1973 again that black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This model helped in assessing the fair price of an option which led to an increased interest in trading of options. With the options markets becoming increasingly popular, the American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX) began trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties. The collapse of the Bretton Woods regime of fixed parties and the introduction of floating rates for currencies in the international financial markets paved the way for development of a number of financial derivatives which served as effective risk management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on which futures contracts are traded. The CBOT now offers 48 futures and option contracts (with the annual volume at more than 211 million in 2001).The CBOE is the largest exchange for trading stock options. The CBOE trades options on the S&P 100 and the S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225 trade almost round the clock. The N225 is also traded on the Chicago Mercantile Exchange.


India has started the innovations in financial markets very late. Some of the recent developments initiated by the regulatory authorities are very important in this respect. Futures trading have been permitted in certain commodity exchanges. Mumbai Stock Exchange has started futures trading in cottonseed and cotton under the BOOE and under the East India Cotton Association. Necessary infrastructure has been created by the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) for trading in stock index futures and the commencement of operations in selected scripts. Liberalised exchange rate management system has been introduced in the year 1992 for regulating the flow of foreign exchange. A committee headed by S.S.Tarapore was constituted to go into the merits of full convertibility on capital accounts. RBI has initiated measures for freeing the interest rate structure. It has also envisioned Mumbai Inter Bank Offer Rate (MIBOR) on the line of London Inter Bank Offer Rate (LIBOR) as a step towards introducing Futures trading in Interest Rates and Forex. Badla transactions have been banned in all 23 stock exchanges from July 2001. NSE has started trading in index options based on the NIFTY and certain Stocks.


In the decade of 1990's revolutionary changes took place in the institutional infrastructure in India's equity market. It has led to wholly new ideas in market design that has come to dominate the market. These new institutional arrangements, coupled with the widespread knowledge and orientation towards equity investment and speculation, have combined to provide an environment where the equity spot market is now India's most sophisticated financial market. One aspect of the sophistication of the equity market is seen in the levels of market liquidity that are now visible. The market impact cost of doing program trades of Rs.5 million at the NIFTY index is around 0.2%. This state of liquidity on the equity spot market does well for the market efficiency, which will be observed if the index futures market when trading commences. India's equity spot market is dominated by a new practice called 'Futures - Style settlement' or account period settlement. In its present scene, trades on the largest stock exchange (NSE) are netted from Wednesday morning till Tuesday evening, and only the net open position as of Tuesday evening is settled. The future style settlement has proved to be an ideal launching pad for the skills that are required for futures trading.

Stock trading is widely prevalent in India, hence it seems easy to think that derivatives based on individual securities could be very important. The index is the counter piece of portfolio analysis in modern financial economies. Index fluctuations affect all portfolios. The index is much harder to manipulate. This is particularly important given the weaknesses of Law Enforcement in India, which have made numerous manipulative episodes possible. The market capitalisation of the NSE-50 index is Rs.2.6 trillion. This is six times larger than the market capitalisation of the largest stock and 500 times larger than stocks such as Sterlite, BPL and Videocon. If market manipulation is used to artificially obtain 10% move in the price of a stock with a 10% weight in the NIFTY, this yields a 1% in the NIFTY. Cash settlements, which is universally used with index derivatives, also helps in terms of reducing the vulnerability to market manipulation, in so far as the 'short-squeeze' is not a problem. Thus, index derivatives are inherently less vulnerable to market manipulation.

A good index is a sound trade of between diversification and liquidity. In India the traditional index- the BSE - sensitive index was created by a committee of stockbrokers in 1986. It predates a modern understanding of issues in index construction and recognition of the pivotal role of the market index in modern finance. The flows of this index and the importance of the market index in modern finance, motivated the development of the NSE-50 index in late 1995. Many mutual funds have now adopted the NIFTY as the benchmark for their performance evaluation efforts. If the stock derivatives have to come about, the should restricted to the most liquid stocks. Membership in the NSE-50 index appeared to be a fair test of liquidity. The 50 stocks in the NIFTY are assuredly the most liquid stocks in India.

The choice of Futures vs. Options is often debated. The difference between these instruments is smaller than, commonly imagined, for a futures position is identical to an appropriately chosen long call and short put position. Hence, futures position can always be created once options exist. Individuals or firms can choose to employ positions where their downside and exposure is capped by using options. Risk management of the futures clearing is more complex when options are in the picture. When portfolios contain options, the calculation of initial price requires greater skill and more powerful computers. The skills required for pricing options are greater than those required in pricing futures.


In India, the futures market for commodities evolved by the setting up of the "Bombay Cotton Trade Association Ltd.", in 1875. A separate association by the name "Bombay Cotton Exchange Ltd" was established following widespread discontent amongst leading cotton mill owners and merchants over the functioning of the Bombay Cotton Trade Association. With the setting up of the 'Gujarati Vyapari Mandali" in 1900, the futures trading in oilseed began. Commodities like groundnut, castor seed and cotton etc began to be exchanged.

Raw jute and jute goods began to be traded in Calcutta with the establishment of the "Calcutta Hessian Exchange Ltd." in 1919. The most notable centres for existence of futures market for wheat were the Chamber of Commerce at Hapur, which was established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka, Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras, Gaziabad, Sikenderabad and Barielly in U.P. The Bullion Futures market began in Bombay in 1990. After the economic reforms in 1991 and the trade liberalization, the Govt. of India appointed in June 1993 one more committee on Forward Markets under Chairmanship of Prof. K.N. Kabra. The Committee recommended that futures trading be introduced in basmati rice, cotton, raw jute and jute goods, groundnut, rapeseed/mustard seed, cottonseed, sesame seed, sunflower seed, safflower seed, copra and soybean, and oils and oilcakes of all of them, rice bran oil, castor oil and its oilcake, linseed, silver and onions. All over the world commodity trade forms the major backbone of the economy. In India, trading volumes in the commodity market have also seen a steady rise - to Rs 5,71,000 crore in FY05 from Rs 1,29,000 crore in FY04. In the current fiscal year, trading volumes in the commodity market have already crossed Rs 3,50,000 crore in the first four months of trading. Some of the commodities traded in India include Agricultural Commodities like Rice Wheat, Soya, Groundnut, Tea, Coffee, Jute, Rubber, Spices, Cotton, Precious Metals like Gold & Silver, Base Metals like Iron Ore, Aluminium, Nickel, Lead, Zinc and Energy Commodities like crude oil, coal. Commodities form around 50% of the Indian GDP. Though there are no institutions or banks in commodity exchanges, as yet, the market for commodities is bigger than the market for securities. Commodities market is estimated to be around Rs 44,00,000 Crores in future. Assuming a future trading multiple is about 4 times the physical market, in many countries it is much higher at around 10 times.


The first step towards introduction of derivatives trading in India was the promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew the prohibition on options in securities. The market for derivatives, however, did not take off, as there was no regulatory framework to govern trading of derivatives. SEBI set up a 24-member committee under the Chairmanship of Dr.L.C.Gupta on November 18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee submitted its report on March 17, 1998 prescribing necessary pre-conditions for introduction of derivatives trading in India. The committee recommended that derivatives should be declared as 'securities' so that regulatory framework applicable to trading of 'securities' could also govern trading of securities. SEBI also set up a group in June 1998 under the Chairmanship of Prof.J.R.Varma, to recommend measures for risk containment in derivatives market in India. The report, which was submitted in October 1998, worked out the operational details of margining system, methodology for charging initial margins, broker net worth, deposit requirement and real-time monitoring requirements. The Securities Contract Regulation Act (SCRA) was amended in December 1999 to include derivatives within the ambit of 'securities' and the regulatory framework was developed for governing derivatives trading. The act also made it clear that derivatives shall be legal and valid only if such contracts are traded on a recognized stock exchange, thus precluding OTC derivatives. The government also rescinded in March 2000, the three decade old notification, which prohibited forward trading in securities. Derivatives trading commenced in India in June 2000 after SEBI granted the final approval to this effect in May 2001. SEBI permitted the derivative segments of two stock exchanges, NSE and BSE, and their clearing house/corporation to commence trading and settlement in approved derivatives contracts. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-30 (Sense) index. This was followed by approval for trading in options based on these two indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on individual securities commenced in July 2001. Futures contracts on individual stocks were launched in November 2001. The derivatives trading on NSE commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4, 2001 and trading in options on individual securities commenced on July 2, 2001. Single stock futures were launched on November 9, 2001. The index futures and options contract on NSE are based on S&P CNX Trading and settlement in derivative contracts is done in accordance with the rules, byelaws, and regulations of the respective exchanges and their clearing house/corporation duly approved by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative products.

The following are some observations based on the trading statistics provided in the NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the F&O segment. It constituted 70 per cent of the total turnover during June 2002. A primary reason attributed to this phenomenon is that traders are comfortable with single-stock futures than equity options, as the former closely resembles the erstwhile badla system.

On relative terms, volumes in the index options segment continues to remain poor. This may be due to the low volatility of the spot index. Typically, options are considered more valuable when the volatility of the underlying (in this case, the index) is high. A related issue is that brokers do not earn high commissions by recommending index options to their clients, because low volatility leads to higher waiting time for round-trips.

Put volumes in the index options and equity options segment have increased since January 2002. The call-put volumes in index options have decreased from 2.86 in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the traders are increasingly becoming pessimistic on the market.

Farther month futures contracts are still not actively traded. Trading in equity options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a less risky alternative (read substitute) to generate profits from the stock price movements. The fact that the option premiums tail intra-day stock prices is evidence to this. If calls and puts are not looked as just substitutes for spot trading, the intra-day stock price variations should not have a one-to-one impact on the option premiums.


Factors contributing to the explosive growth of derivatives are price volatility, globalisation of the markets, technological developments and advances in the financial theories.


A price is what one pays to acquire or use something of value. The objects having value maybe commodities, local currency or foreign currencies. The concept of price is clear to almost everybody when we discuss commodities. There is a price to be paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of a unit of another persons money is called interest rate. And the price one pays in one's own currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have 'demand' and producers or suppliers have 'supply', and the collective interaction of demand and supply in the market determines the price. These factors are constantly interacting in the market causing changes in the price over a short period of time. Such changes in the price is known as 'price volatility'. This has three factors : the speed of price changes, the frequency of price changes and the magnitude of price changes.

The changes in demand and supply influencing factors culminate in market adjustments through price changes. These price changes expose individuals, producing firms and governments to significant risks. The break down of the BRETTON WOODS agreement brought and end to the stabilising role of fixed exchange rates and the gold convertibility of the dollars. The globalisation of the markets and rapid industrialisation of many underdeveloped countries brought a new scale and dimension to the markets. Nations that were poor suddenly became a major source of supply of goods. The Mexican crisis in the south east-Asian currency crisis of 1990's have also brought the price volatility factor on the surface. The advent of telecommunication and data processing bought information very quickly to the markets. Information which would have taken months to impact the market earlier can now be obtained in matter of moments. Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

These price volatility risk pushed the use of derivatives like futures and options increasingly as these instruments can be used as hedge to protect against adverse price changes in commodity, foreign exchange, equity shares and bonds.


Earlier, managers had to deal with domestic economic concerns ; what happened in other part of the world was mostly irrelevant. Now globalisation has increased the size of markets and as greatly enhanced competition .it has benefited consumers who cannot obtain better quality goods at a lower cost. It has also exposed the modern business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the competitiveness of our products vis--vis depreciated currencies. Export of certain goods from India declined because of this crisis. Steel industry in 1998 suffered its worst set back due to cheap import of steel from south east asian countries. Suddenly blue chip companies had turned in to red. The fear of china devaluing its currency created instability in Indian exports. Thus, it is evident that globalisation of industrial and financial activities necessitiates use of derivatives to guard against future losses. This factor alone has contributed to the growth of derivatives to a significant extent.


A significant growth of derivative instruments has been driven by technological break through. Advances in this area include the development of high speed processors, network systems and enhanced method of data entry. Closely related to advances in computer technology are advances in telecommunications. Improvement in communications allow for instantaneous world wide conferencing, Data transmission by satellite. At the same time there were significant advances in software programmes without which computer and telecommunication advances would be meaningless. These facilitated the more rapid movement of information and consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole resources are rapidly relocated to more productive use and better rationed overtime the greater price volatility exposes producers and consumers to greater price risk. The effect of this risk can easily destroy a business which is otherwise well managed. Derivatives can help a firm manage the price risk inherent in a market economy. To the extent the technological developments increase volatility, derivatives and risk management products become that much more important.


Advances in financial theories gave birth to derivatives. Initially forward contracts in its traditional form, was the only hedging tool available. Option pricing models developed by Black and Scholes in 1973 were used to determine prices of call and put options. In late 1970's, work of Lewis Edeington extended the early work of Johnson and started the hedging of financial price risks with financial futures. The work of economic theorists gave rise to new products for risk management which led to the growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives instruments.



A contract that obligates one counter party to buy and the other to sell a specific underlying asset at a specific price, amount and date in the future is known as a forward contract. Forward contracts are the important type of forward-based derivatives. They are the simplest derivatives. There is a separate forward market for multitude of underlyings, including the traditional agricultural or physical commodities, as well as currencies and interest rates. The change in the value of a forward contract is roughly proportional to the change in the value of its underlying asset. These contracts create credit exposures. As the value of the contract is conveyed only at the maturity, the parties are exposed to the risk of default during the life of the contract. Forward contracts are customised with the terms and conditions tailored to fit the particular business, financial or risk management objectives of the counter parties. Negotiations often take place with respect to contract size, delivery grade, delivery locations, delivery dates and credit terms.


A future contract is an agreement between two parties to buy or sell an asset at a certain time the future at the certain price. Futures contracts are the special types of forward contracts in the sense that are standardized exchange-traded contracts.

Equities, bonds, hybrid securities and currencies are the commodities of the investment business. They are traded on organised exchanges in which a clearing house interposes itself between buyer and seller and guarantees all transactions, so that the identity of the buyer or the seller is a matter of indifference to the opposite party. Futures contract protect those who use these commodities in their business.

Futures trading are to enter into contracts to buy or sell financial instruments, dealing in commodities or other financial instruments for forward delivery or settlement on standardised terms. The futures market facilitates stock holding and shifting of risk. They act as a mechanism for collection and distribution of information and then perform a forward pricing function. The futures trading can be performed when there is variation in the price of the actual commodity and there exists economic agents with commitments in the actual market. There must be a possibility to specify a standard grade of the commodity and to measure deviations from this grade. A futures market is established specifically to meet purely speculative demands is possible but is not known. Conditions which are thought of necessary for the establishment of futures trading are the presence of speculative capital and financial facilities for payment of margins and contract settlement. In addition, a strong infrastructure is required, including financial, legal and communication systems.


A derivative transaction that gives the option holder the right but not the obligation to buy or sell the underlying asset at a price, called the strike price, during a period or on a specific date in exchange for payment of a premium is known as 'option'. Underlying asset refers to any asset that is traded. The price at which the underlying is traded is called the 'strike price'.

There are two types of options i.e., CALL OPTION AND PUT OPTION.


A contract that gives its owner the right but not the obligation to buy an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a 'Call option'. The owner makes a profit provided he sells at a higher current price and buys at a lower future price.


A contract that gives its owner the right but not the obligation to sell an underlying asset-stock or any financial asset, at a specified price on or before a specified date is known as a 'Put option'. The owner makes a profit provided he buys at a lower current price and sells at a higher future price. Hence, no option will be exercised if the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference shares, bonds and warrants become the subject of options.


Swaps are transactions which obligates the two parties to the contract to exchange a series of cash flows at specified intervals known as payment or settlement dates. They can be regarded as portfolios of forward's contracts. A contract whereby two parties agree to exchange (swap) payments, based on some notional principle amount is called as a 'SWAP'. In case of swap, only the payment flows are exchanged and not the principle amount. The two commonly used swaps are:


Interest rate swaps is an arrangement by which one party agrees to exchange his series of fixed rate interest payments to a party in exchange for his variable rate interest payments. The fixed rate payer takes a short position in the forward contract whereas, the floating rate payer takes a long position in the forward contract.


Currency swaps is an arrangement in which both the principle amount and the interest on loan in one currency are swapped for the principle and the interest payments on loan in another currency. The parties to the swap contract of currency generally hail from two different countries. This arrangement allows the counter parties to borrow easily and cheaply in their home currencies. Under a currency swap, cash flows to be exchanged are determined at the spot rate at a time when swap is done. Such cash flows are supposed to remain unaffected by subsequent changes in the exchange rates.


Financial swaps constitute a funding technique which permit a borrower to access one market and then exchange the liability for another type of liability. It also allows the investors to exchange one type of asset for another type of asset with a preferred income stream.

The other kind of derivatives, which are not, much popular are as follows :


Baskets options are option on portfolio of underlying asset. Equity Index Options are most popular form of baskets.


Normally option contracts are for a period of 1 to 12 months. However, exchange may introduce option contracts with a maturity period of 2-3 years. These long-term option contracts are popularly known as Leaps or Long term Equity Anticipation Securities.


Options generally have lives of up to one year, the majority of options traded on options exchanges having a maximum maturity of nine months. Longer-dated options are called warrants and are generally traded over-the-counter.


Swaptions are options to buy or sell a swap that will become operative at the expiry of the options. Thus a swaption is an option on a forward swap. Rather than have calls and puts, the swaptions market has receiver swaptions and payer swaptions. A receiver swaption is an option to receive fixed and pay floating. A payer swaption is an option to pay fixed and receive floating.



The process of managing the risk or risk management is called as hedging. Hedgers are those individuals or firms who manage their risk with the help of derivative products. Hedging does not mean maximising of return. The main purpose for hedging is to reduce the volatility of a portfolio by reducing the risk.


Speculators do not have any position on which they enter into futures and options Market i.e., they take the positions in the futures market without having position in the underlying cash market. They only have a particular view about future price of a commodity, shares, stock index, interest rates or currency. They consider various factors like demand and supply, market positions, open interests, economic fundamentals, international events, etc. to make predictions. They take risk in turn from high returns. Speculators are essential in all markets - commodities, equity, interest rates and currency. They help in providing the market the much desired volume and liquidity.


Arbitrage is the simultaneous purchase and sale of the same underlying in two different markets in an attempt to make profit from price discrepancies between the two markets. Arbitrage involves activity on several different instruments or assets simultaneously to take advantage of price distortions judged to be only temporary.

Arbitrage occupies a prominent position in the futures world. It is the mechanism that keeps prices of futures contracts aligned properly with prices of underlying assets. The objective is simply to make profits without risk, but the complexity of arbitrage activity is such that it is reserved to particularly well-informed and experienced professional traders, equipped with powerful calculating and data processing tools. Arbitrage may not be as easy and costless as presumed.



For any purchase and sale, brokers perform an important function of bringing buyers and sellers together. As a member in any futures exchanges, may be any commodity or finance, one need not be a speculator, arbitrageur or hedger. By virtue of a member of a commodity or financial futures exchange one get a right to transact with other members of the same exchange. This transaction can be in the pit of the trading hall or on online computer terminal. All persons hedging their transaction exposures or speculating on price movement, need not be and for that matter cannot be members of futures or options exchange. A non-member has to deal in futures exchange through member only. This provides a member the role of a broker. His existence as a broker takes the benefits of the futures and options exchange to the entire economy all transactions are done in the name of the member who is also responsible for final settlement and delivery. This activity of a member is price risk free because he is not taking any position in his account, but his other risk is clients default risk. He cannot default in his obligation to the clearing house, even if client defaults. So, this risk premium is also inbuilt in brokerage recharges. More and more involvement of non-members in hedging and speculation in futures and options market will increase brokerage business for member and more volume in turn reduces the brokerage. Thus more and more participation of traders other than members gives liquidity and depth to the futures and options market. Members can attract involvement of other by providing efficient services at a reasonable cost. In the absence of well functioning broking houses, the futures exchange can only function as a club.


Even in organised futures exchange, every deal cannot get the counter party immediately. It is here the jobber or market maker plays his role. They are the members of the exchange who takes the purchase or sale by other members in their books and then square off on the same day or the next day. They quote their bid-ask rate regularly. The difference between bid and ask is known as bid-ask spread. When volatility in price is more, the spread increases since jobbers price risk increases. In less volatile market, it is less. Generally, jobbers carry limited risk. Even by incurring loss, they square off their position as early as possible. Since they decide the market price considering the demand and supply of the commodity or asset, they are also known as market makers. Their role is more important in the exchange where outcry system of trading is present. A buyer or seller of a particular futures or option contract can approach that particular jobbing counter and quotes for executing deals. In automated screen based trading best buy and sell rates are displayed on screen, so the role of jobber to some extent. In any case, jobbers provide liquidity and volume to any futures and option market.



Exchange provides buyers and sellers of futures and option contract necessary infrastructure to trade. In outcry system, exchange has trading pit where members and their representatives assemble during a fixed trading period and execute transactions. In online trading system, exchange provide access to members and make available real time information online and also allow them to execute their orders. For derivative market to be successful exchange plays a very important role, there may be separate exchange for financial instruments and commodities or common exchange for both commodities and financial assets.


A clearing house performs clearing of transactions executed in futures and option exchanges. Clearing house may be a separate company or it can be a division of exchange. It guarantees the performance of the contracts and for this purpose clearing house becomes counter party to each contract. Transactions are between members and clearing house. Clearing house ensures solvency of the members by putting various limits on him. Further, clearing house devises a good managing system to ensure performance of contract even in volatile market. This provides confidence of people in futures and option exchange. Therefore, it is an important institution for futures and option market.


Futures and options contracts do not generally result into delivery but there has to be smooth and standard delivery mechanism to ensure proper functioning of market. In stock index futures and options which are cash settled contracts, the issue of delivery may not arise, but it would be there in stock futures or options, commodity futures and options and interest rates futures. In the absence of proper custodian or warehouse mechanism, delivery of financial assets and commodities will be a cumbersome task and futures prices will not reflect the equilibrium price for convergence of cash price and futures price on maturity, custodian and warehouse are very relevant.


Futures and options contracts are daily settled for which large fund movement from members to clearing house and back is necessary. This can be smoothly handled if a bank works in association with a clearing house. Bank can make daily accounting entries in the accounts of members and facilitate daily settlement a routine affair. This also reduces a possibility of any fraud or misappropriation of fund by any market intermediary.


A regulator creates confidence in the market besides providing Level playing field to all concerned, for foreign exchange and money market, RBI is the regulatory authority so it can take initiative in starting futures and options trade in currency and interest rates. For capital market, SEBI is playing a lead role, along with physical market in stocks, it will also regulate the stock index futures to be started very soon in India. The approach and outlook of regulator directly affects the strength and volume in the market. For commodities, Forward Market Commission is working for settling up national National Commodity Exchange.


Derivative markets help investors in many different ways:


Futures and options contract can be used for altering the risk of investing in spot market. For instance, consider an investor who owns an asset. He will always be worried that the price may fall before he can sell the asset. He can protect himself by selling a futures contract, or by buying a Put option. If the spot price falls, the short hedgers will gain in the futures market, as you will see later. This will help offset their losses in the spot market. Similarly, if the spot price falls below the exercise price, the put option can always be exercised.

Derivatives markets help to reallocate risk among investors. A person who wants to reduce risk, can transfer some of that risk to a person who wants to take more risk. Consider a risk-averse individual. He can obviously reduce risk by hedging. When he does so, the opposite position in the market may be taken by a speculator who wishes to take more risk. Since people can alter their risk exposure using futures and options, derivatives markets help in the raising of capital. As an investor, you can always invest in an asset and then change its risk to a level that is more acceptable to you by using derivatives.


Price discovery refers to the markets ability to determine true equilibrium prices. Futures prices are believed to contain information about future spot prices and help in disseminating such information. As we have seen, futures markets provide a low cost trading mechanism. Thus information pertaining to supply and demand easily percolates into such markets. Accurate prices are essential for ensuring the correct allocation of resources in a free market economy. Options markets provide information about the volatility or risk of the underlying asset.


As opposed to spot markets, derivatives markets involve lower transaction costs. Secondly, they offer greater liquidity. Large spot transactions can often lead to significant price changes. However, futures markets tend to be more liquid than spot markets, because herein you can take large positions by depositing relatively small margins. Consequently, a large position in derivatives markets is relatively easier to take and has less of a price impact as opposed to a transaction of the same magnitude in the spot market. Finally, it is easier to take a short position in derivatives markets than it is to sell short in spot markets.


The availability of derivatives makes markets more efficient; spot, futures and options markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it is possible to exploit arbitrage opportunities quickly and to keep prices in alignment. Hence these markets help to ensure that prices reflect true values.


Derivative markets provide speculators with a cheaper alternative to engaging in spot transactions. Also, the amount of capital required to take a comparable position is less in this case. This is important because facilitation of speculation is critical for ensuring free and fair markets. Speculators always take calculated risks. A speculator will accept a level of risk only if he is convinced that the associated expected return, is commensurate with the risk that he is taking.



Banks have traditionally taken deposits from their customers and put those deposits to work as loans. Because the deposits and the loans are dominated in the same currency, this activity has no associated foreign exchange risk. But it does limit banks to lending to customers which need to borrow in the currencies which the banks have available on deposits.

If a bank is asked to lend to a customer in a currency other than one of those it has on deposits it creates a currency exposure for the bank. Suppose a customer wants to borrow EUROS from a US Bank for 5 years and that the US bank has no natural source of EUROS. It is possible for the banks to cover this exposure in the forward market by selling EUROS forwards and buying US dollars. The transaction costs associated with this, in particular the bid / offer spread in the medium term foreign exchange forward market, would make the resultant cost of the loan prohibitively expensive for the borrower.

Currency swaps provide an economic alternative to this problem for banks. In order to cover the exposure created by a loan to a customer in EUROS funded by a bank's deposit in US dollar, a bank could receive fixed rate US dollars in a currency swap and pay fixed rate EUROS.

One of the consequences of the development of the currency swap market is that banks now often make much more competitive medium term forward foreign exchange prices than they used to. Most banks quote forward foreign exchange and currency swap prices from the same desk and increases liquidity in the latter has improved liquidity in the former. Banks therefore, need no longer restrict their lending activities to the currencies in which they have natural deposits. They are free to fund themselves in the most competitively priced currency and to lend to their customers in the currency of the customer's preference, using a currency swap as an asset and liability matching tool

The "Normal yield curve", reflects that it is much easier for banks to borrow at the short end of the curve than the long end. This means that banks can fund themselves much more effectively in the inter bank market in maturities such as the overnight, tom / next (overnight from tomorrow, or tomorrow to the next day), spot / next, one week, one month, three months and six months than they can in maturities such as five years or 20 years.

With the development of the swaps market it is possible for banks to satisfy their customers demands for fixed rate funding while ensuring that the banks assets and liabilities are matched. Suppose a bank has a customer who needs 5 years fixed rate funds. Let us say that the bank finances in this loan in the interbank market at 3 month LIBOR. The bank now has a 3 month liability and a 5 year asset (Figure 1).

The bank is short floating rate interest at 3 month LIBOR and long fixed rate interest at the rate at which it lends to its customer. This is called the asset liability mismatch. So in order to hedge its position the banks needs to match its exposure to 3 month LIBOR by receiving on a floating rate basis in an interest rate swap, and match its exposure on a fixed rate basis by paying a fixed rate in a interest rate swap. This is a hedge which is ideally suited to an interest rate swap which the bank receives a floating rare of interest and pays a fixed rare (Figure 2).

This structure has the benefit for the bank that it eliminates the bank's exposure to interest rate risk. The bank can no longer profit from a fall in interest rates but it cannot lose money on its asset and liability mismatch as a result of an increase in rates. The bank will make or lose money based on its pricing of the credit risk in the transaction and its overall loan exposure rather than on its ability to forecast interest rates. Hence the interest rate swaps provide banks with an opportunity to change their risks from interest rate to credit.


  • hedging interest rate risk
  • Hedging foreign exchange risk


A major aircraft manufacturer has decided to replace his mainframe computer. The cost after trade in is $ 10 million, payable on delivery.


The treasurer buys the December Put Option with a strike price of 91.25 (implied rate of 8.75%), which allows the manufacturer to enter into a Euro - Dollar futures contract for a premium price of .25. the notional principal, that is the size of the contract is $ 1 million, so ten contracts are taken to cover the full short-term borrowing cost. The put will make money only if the underlying future falls below the strike price less the price paid for the option. Remember, the Euro-Dollar future is quoted as an index on a base of 100, a lower price means a higher rate of interest


In Mid-December, depending upon how the LIBOR rate has changed, the treasurer will use or not use the put option on the future which was purchased. If the cost of short-term borrowing has remained the same or declined, the put option will expire worthless. The money expended upon the premium, of 0.25 % per $ 1 million contract, will have been lost. If, however, interest rates were to rise, the put option contract on the Euro-Dollar future will be exercised. If, for example, Euro - Dollar Rates rise to 10.76% (89.10 on the index) which would have given the treasurer a borrowing cost of 11.26% (LIBOR + 50 bases points), the Put would be utilised, exercising the right to sell the option on the future at the strike price of 91.25, for an intrinsic value of 2.1 (Or 2% in interest terms).

The gain in value on the Put options contract compensates for the increased cost of borrowing on the LIBOR Rate. The risk of funding the new mainframe computer has been managed.


Hedging foreign exchange rate risk


An American manufacturer of clothing imports fabric from the United Kingdom. In 6 months time, in anticipation of the 2005-06 winter season, he will need to purchase 1 million Pounds Sterling, in order to pay for the desired imports, in order for his finished goods to be competitive and ensure adequate margins, the exchange rate must not fluctuate significantly. A weakening of the US dollar by more than 5% may create problems in terms of price competitiveness and profit margins.


In Mid June, 2005, the manufacturer is scheduled to receive and pay for the imports.


The manufacturer has no funding exposure as the imports will be paid from working capital.

Exchange Rate

The present rate is STG/ USD = 1.50, which is satisfactory with respect to commercial objectives, but a weakening of more than 5% will result in diminished margins or a non competitive position.


The manufacturer is worried that because of declining rates of interests and the current account deficits, the US dollar may waken against the Pound Sterling, from its current rate of 1.50.


The manufacturer buys one call option contract with a Strike or Exercise price of 1.51. If the US dollar weakens the call contract will be used to buy the Pounds - Sterling at the set price. If, the US dollar stays the same or strengthens, the contract will expire worthless and the premium paid for the option will have been lost.


In June 2005, the Us dollar does weaken and the new spot exchange rate is STG/USD = 1.60. Hence, the call option at 1.51 has intrinsic value of 9 US cents. Instead of the 1 million Pound Sterling required by the manufacturer costing 1.6 million US dollars, the exercise of the call contract will net $ 90000 US ( $ 1.6 million - $ 1.51 million).

After subtracting the price of the premium of 2.5%, the net gain will be $ 50000 US ( $ 1.6 million - $ 1.55 million), which partially off-sets the depreciation in the US Dollar exchange Rate, and is within the manufacturer's target range of 5% to remain competitive on pricing.

Through this hedging technique the underlying commercial objective will be ensured. If the US Dollar exchange rate had not weakened, the expenditure on the premium would still have kept his net cost of the imports within the self imposed 5% competitive range.


  • RBI should play a greater role in supporting derivatives.
  • Derivatives market should be developed in order to keep it at par with other derivative markets in the world.
  • Speculation should be discouraged.
  • There must be more derivative instruments aimed at individual investors.
  • SEBI should conduct seminars regarding the use of derivatives to educate individual investors.



  • Futures markets - Sunil. K. Parameswaran
  • Understanding futures market - Robert. W. Klob
  • Derivatives Market in India - Susan Thomas
  • Financial Derivatives - V. K. Bhalla
  • Financial Services and Markets - Dr. S. Guruswamy
  • Futures and Options - D. C. Gardner



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