MODULE 1

History, meaning, features, types, economic benefits of derivatives, factors contributing to the
growth of derivatives, functions of derivative markets, exchange traded versus OTC
derivatives, Players in derivatives markets, Indian Derivatives Market.
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INTRODUCTION:
Risk is a characteristic feature of all commodity and capital markets. Prices of all commodities—be
they agricultural like wheat, cotton, rice, coffee or tea, or non-agricultural like silver, gold etc.—are
subject to fluctuation over time in keeping with prevailing demand and supply conditions. Producers
or possessors of these commodities obviously cannot be sure of the prices that their produce or
possession may fetch when they have to sell them, in the same way as the buyers and the processors
are not sure what they would have to pay for their buy. Similarly, prices of shares and debentures or
bonds and other securities are also subject to continuous change. Those who are charged with the
responsibility of managing money, their own or of others, are therefore constantly exposed to the
threat of risk. In the same way, the foreign exchange rates are also subject to continuous change.
Thus, an importer of a certain piece of machinery is not sure of the amount he would have to pay in
rupee terms when the payment becomes due.

One of the significant features of both the financial and capital markets is huge fluctuations. The
market prices of stock and shares, commodities, currencies, gold, petroleum etc. fluctuate constantly
and pose a threat to those who are engaged in the business of these products. Modern finance has
provided innovative tools to hedge such a risk. The emergence of the market for derivative products,
most notably forwards, futures and options, can be traced back to the willingness of risk-averse
economic agents to guard themselves against uncertainties arising out of fluctuations in asset prices.
By their very nature, the financial markets are marked by a very high degree of volatility. Through
the use of derivative products, it is possible to transfer price risks partially or fully by locking–in asset
prices. As instruments of risk management, these generally do not influence the fluctuations in the
underlying asset prices. However, by locking-in asset prices, derivative products minimize the impact
of fluctuations in asset prices on the profitability and cash flow situation of risk-averse investors.

The primary objectives of any investor are to bring an element of certainty to returns and minimise
risks. Derivatives are contracts that originated from the need to limit risk. Financial derivatives are
widely used for hedging the prices of one's assets. They enable traders to transfer price risk either
partially or fully by locking the asset price. Though some people use financial derivatives for
speculation, they have been created with the basic objective of limiting price risk. Thus, the financial
derivatives are basically used as risk management tool.

WHAT ARE DERIVATIVES?

Derivatives are financial contracts whose value is dependent on an underlying asset or group of
assets. The commonly used assets are stocks, bonds, currencies, commodities and market indices. The
value of the underlying assets keeps changing according to market conditions. The basic principle
behind entering into derivative contracts is to earn profits by speculating on the value of the
underlying asset in future.
 Derivatives are financial contract whose value is linked to the value of an
underlying asset. They are complex financial instruments that are used for various purposes,
including hedging and getting access to assets or markets. A derivative instrument by itself does not
constitute ownership. It is, instead, a promise to convey ownership.
For example: Wheat farmers may wish to sell their harvest at a future date to eliminate the risk of a
change in prices by that date. Such a transaction is an example of a derivative. The price of this
derivative is driven by the spot price of wheat which is the “underlying.”
Derivatives were originally designed to help investors eliminate exchange rate risks, but their utility
has grown over the years to help investors not only mitigate various types of risks but also to access
more market opportunities. Derivatives are now attractive to many types of investors because they
help them to remain exposed to price changes of different financial assets without actually owning
them.
CLASSIFICATION OF DERIVATIVES

One form of classification of derivative instruments is between commodity derivatives and financial
derivatives. The basic difference between these is the nature of the underlying instrument or asset.
In a commodity derivatives, the underlying instrument is a commodity which may be wheat, cotton,
pepper, sugar, jute, turmeric, corn, soya beans, crude oil, natural gas, gold, silver, copper and so on.
In a financial derivative, the underlying instrument may be treasury bills, stocks, bonds, foreign
exchange, stock index, gilt-edged securities, cost of living index, etc. It is to be noted that financial
derivative is fairly standard and there are no quality issues whereas in commodity derivative, the
quality may be the underlying matters. However, the distinction between these two from structure
and functioning point of view, both are almost similar in nature.

Another way of classifying the financial derivatives is into basic and complex derivatives. In this,
forward contracts, futures contracts and option contracts have been included in the basic derivatives
whereas swaps and other complex derivatives are taken into complex category because they are
 built up from either forwards/futures or options contracts, or both. In fact, such derivatives are
effectively derivatives of derivatives.

FINANCIAL DERIVATIVES:
A financial derivative is a tradable product or contract that ‘derives’ its value from an underlying
asset. The underlying asset can be stocks, currencies, commodities, indices, and even interest rates.
The value of the underlying asset changes with the market movements. The key motives of a
derivative contract are to speculate on the underlying asset prices in the future and to guard against
the price volatility of an underlying asset or commodity.
Derivatives provide investors and traders with opportunities to manage risk, speculate on
future price movements, and gain exposure to different markets without owning the underlying
asset.

TYPES OF FINANCIAL DERIVATIVES:

On the basis of type of asset underlying, the financial derivatives, as shown in the below Figure, are
classified into four broad categories, viz., Commodity derivatives, Equity derivatives, Debt
derivatives and Currency derivatives.

(i) Commodity Derivatives

The asset underlying the commodity derivatives could be any commodities such as Chilli, maize,
cardamom, gram etc. (agriculture) and gold, silver etc. (non-agriculture).
The commodity derivatives include commodity forwards, commodity futures and options and are
traded with an objective of eliminating the losses arising from the price fluctuations
(ii) Equity Derivatives
The asset underlying the equity derivatives could be any shares, securities or index. These are
further classified into equity forwards, futures and options, index futures and options and equity
swaps and derivatives are traded with an objective of eliminating the losses arising from the
fluctuations in the share prices.
(iii) Debt Derivatives
The derivative in which the underlying asset is interest rate is known as debt derivative or interest
rate derivative. These are further classified into Interest Rate Forwards and Futures (i.e.,
abbreviated as IRF) and interest rate swap and are traded with an objective of reducing the
excessive borrowing cost arising from the interest rate fluctuations.
(iv) Currency Derivatives
The asset underlying the currency derivatives is currency of any country (i.e., exchange rate).
These are further classified into currency forwards, currency futures and options and currency
swap and are traded with an objective of eliminating the losses arising from the currency
fluctuations.

The financial derivatives, on the basis of with or without trading pit, can be divided into two
categories, viz., Exchange traded and OTC traded financial derivatives. The derivative instruments
which are generally standardized and traded in the stock exchanges and commodity exchanges are
called as exchange traded derivatives. For instance, futures, options, swaps, etc. are the exchange
traded derivatives. However, some of the derivatives such as forwards, equity swap, swaption, FRAs,
CDS, etc., are customized as per requirements of the parties to the derivative contract which are
called as OTC-traded derivatives.

TYPES OF FINANCIAL DERIVATIVE INSTRUMENTS:

The most common types are forwards, futures, options and swap.

Forward Contracts
A forward contract is a customized contract between two parties to buy or sell an asset at a specified
price at a fixed date in the future.

In a forward contract, the buyer and seller agree to buy or sell an underlying asset at a price they
both agree on at an established future date. This price is called the forward price. This price is
calculated using the spot price and the risk-free rate. The former refers to an asset’s current market
price. The risk-free rate is the hypothetical rate of return on an investment, assuming there is zero
risk.

In a forward contract, the buyer takes a long position while the seller takes a short position. The idea
behind forward contracts is that the parties involved can use them to manage volatility by locking in
pricing for the underlying assets. In that sense, a forward contract is a way to hedge against market
uncertainty. This investing strategy is a bit more complex and may not be used by the everyday
investor.
 The main features of forward contracts are
 They are bilateral contracts and hence exposed to counter-party risk such as non-payment
due to defaults.
 Each contract is custom designed, and hence is unique in terms of contract size, expiration
date and the asset type and quality.
 The contract price is generally not available in public domain.
 The contract has to be settled by delivery of the asset on expiration date.
 Either of the parties can cancel the contract. The canceling party has to pay the difference
between the contract rate and the spot rate of the commodity.
 Forward contracts are neither regulated nor standardized. They are customized contracts
between two parties and considered over the counter (OTC) deals.
 In case the party wishes to reverse the contract, it has to compulsorily go to the same
counter party, which being in a monopoly situation can command the price it wants.

Let us understand how a forward contract works with the help of an example.
A leading beverage company enters into a contract with a coffee estate for exporting 10,000 Kg
Coffee Beans three months from now. The current price of coffee beans is Rs. 500/Kg. However,
the estate is concerned about the declining coffee prices and wants to ensure that they make sizable
profits from the deal. Hence, the estate enters into a forward contract with the beverage company to
sell the 10,000 Kg Coffee Beans after three months at a rate of Rs. 480 per kg, irrespective of the
market price at that point.
After three months, the beverage company will procure the same amount of Coffee Beans from the
estate at an agreed price as per the forward contract.
There are three possibilities:
 If the current market price is less than the contract price, the beverage company makes a potential
loss, in that had it not entered into a forward contract, it could have procured the same amount at
the market price. In this case, the estate saves itself from the eroding costs.
 If the market price is greater than the contract price, it’s the estate that makes a potential loss
since they could have sold the beans at an increased rate had they not entered into the hedge
contract.
 The market price is the same as the contract price. In that case, there is zero potential profit or loss
to both parties.
 SETTLEMENT
There are two ways for a settlement to occur in a forward contract: delivery or cash basis. If the
contract is on a delivery basis, the seller must transfer the underlying asset or assets to the buyer.
The buyer then pays the seller the agreed-upon price in cash. When a contract is settled on a cash
basis, the buyer still makes the payment on the settlement date but no assets change hands. This
payment amount is determined by the difference between the current spot price and the forward
price.

This assumes that there is a difference between the two prices at settlement. If there is no change
and they are the same, then the contract is settled without an exchange of cash.

ADVANTAGES OF FORWARD CONTRACTS:

 High degree of customisation: Forward contracts can be customised to suit the requirements
of the parties involved.
 No margin requirement: While trading in forward contracts, no prerequisite margin is
required.
RISKS INVOLVED IN FORWARD CONTRACTS:
 Counterparty risk: If either of the parties involved decline to honour the contract, the deal
will not be completed. This is known as the counterparty risk.
 No regulator: This is an over-the-counter (OTC) agreement, and there is no third-party
regulator involved. Simply put, there is no one to hold both the parties accountable.
 In a highly volatile market, forward contracts may hurt a company that miscalculated the
movement of the prices.
In order to overcome the risk associated with forward contracts, future contracts were introduced.

Future Contracts
A futures contract is a standardized contract between two parties where both parties agree to buy and
sell a particular asset of specific quantity and at a predetermined price, at a specified date in future.
The parties to the future contract are under an obligation to perform the contract. These contracts are
traded on the stock exchange. The underlying asset can be stocks, bonds, precious metals, currencies,
and interest rates. The values of future contracts are marked-to-market every day. It means that the
contract value is adjusted according to market movements till the expiration date. The settlement of
futures contracts primarily allows cash settlement instead of physical delivery.
The features of futures contracts:
 Organised Exchanges: Unlike forward contracts which are traded in an over-the-counter market,
futures are traded on organised exchanges with a designated physical location where trading takes
place. This provides a ready, liquid market in which futures can be bought and sold at any time like in
a stock market.
 Standardisation: In the case of forward currency contracts, the amount of commodity to be delivered
and the maturity date are negotiated between the buyer and seller and can be tailor- made to buyer's
requirements. In a futures contract, both these are standardised by the exchange on which the contract
is traded.
 Clearing House: The exchange acts as a clearing house to all contracts struck on the trading floor. For
instance, a contract is struck between A and B. Upon entering into the records of the exchange, this is
immediately replaced by two contracts, one between A and the clearing house and another between B
and the clearing house.
 Margins: Like all exchanges, only members are allowed to trade in futures contracts on the exchange.
Others can use the services of the members as brokers to use this instrument. Thus, an exchange
member can trade on his own account as well as on behalf of a client. A subset of the members is the
"clearing members" or members of the clearing house and non- clearing members must clear all their
transactions through a clearing member.
 Marking to Market: The exchange uses a system called marking to market where, at the end of each
trading session, all outstanding contracts are reprised at the settlement price of that trading session.
This would mean that some participants would make a loss while others would stand to gain. The
exchange adjusts this by debiting the margin accounts of those members who made a loss and crediting
the accounts of those members who have gained
 Actual Delivery is Rare: In most futures contracts, the commodity is actually delivered by the seller
and is accepted by the buyer. Futures contracts are entered into for acquiring or disposing off a
commodity in the future for a gain at a price known today.

Example of a Futures Contract

Suppose you expect the stock prices of Britannia Industries to increase in the coming months. And you
want to make money from this opportunity. You have two options -
 Buy shares of Britannia industries from the spot market.

 Buy futures with Britannia limited as the underlying.

Let us explore the first option.

Suppose the market price of one share of Britannia Industries is Rs 3,000. You want to buy 100 shares.
The cost of 100 shares will be Rs 3 Lakhs!
But you only have Rs 1.5 Lakh. So, you end up buying 50 shares. As expected, the price of Britannia rises
to Rs 4,500 after 3 weeks. You sell your 50 shares and book a profit of Rs 25,000. You made 50%
returns in just 3 weeks! You are on top of the world! But could you have made more profit?
The answer is Yes. You could have made much higher profits if you had explored option two Investing
in Britannia's Futures.

Let us see how scenario two would play out.

You have Rs 1 lakh for investment. Let us assume that one Britannia futures contract is available at Rs
3100. One Britannia futures contract contains 200 shares. So, the total value of the contract is Rs
6,20,000. The good news is that you do not have to pay the entire Rs 6,20,000 to buy a Britannia futures
contract. You simply need to pay an initial margin.

For now, assume that the initial margin required to carry one Britannia futures contract is Rs 62000
(assume margin is 10% of contract size)

So, you buy one Britannia futures contract for Rs 62000. As expected, the share price of Britannia
Industries rises from Rs 3,000 to Rs 4,500 in the spot market. Remember if the price of underlying
asset increases, even the price of the derivative will increase.

So, the price of your futures contract increases from Rs 3100 to Rs 4600 after 3 weeks. Now you decide
to sell your contract before expiry. Your buying price is Rs 3100 and your selling price is Rs 4600. So,
you made Rs 1400 per share. Since, one lot of Britannia industries contains 200 shares, your total profit is
Rs 2,80,000!
This is a gain of 451% in less than 1 month!
Now you do not have to be a financial genius to know that 483% gain is better than 50% gain! So, here's
what you got by trading Britannia futures instead of buying from the spot market:
 Superior returns - 451% vs 50%
 Access to better volumes - In the spot market you could buy only 100 shares. But in the
futures contract, you bought 200 shares!
 Lower Capital - In spot market you invested Rs 3 Lakh, whereas in the futures market you
invested only Rs 6200

DIFFERENCES:
 ADVANTAGES OF FUTURES CONTRACTS:
1. Opens the Markets to Investors - Futures contracts are useful for risk-tolerant investors.
Investors get to participate in markets they would otherwise not have access to.
2. Stable Margin Requirements - Margin requirements for most of the commodities and currencies
are well- established in the futures market. Thus, a trader knows how much margin he should put
up in a contract
3. No Time Decay Involved - In options, the value of assets declines over time and severely reduces
the profitability for the trader. This is known as time decay. A futures trader does not have to
worry about time decay.
4. High Liquidity - Most of the futures markets offer high liquidity, especially in case of currencies,
indexes, and commonly traded commodities. This allows traders to enter and exit the market when
they wish to.
5. Simple Pricing - Unlike the extremely difficult Black-Scholes Model-based options pricing,
futures pricing is quite easy to understand. It is usually based on the cost-of-carry model, under
which the futures price is determined by adding the cost of carrying to the spot price of the asset.
6. Protection Against Price Fluctuations - Forward contracts are used as a hedging tool in
industries with high level of price fluctuations. For example, farmers use these contracts to protect
themselves against the risk of drop in crop prices.
7. Hedging Against Future Risks - Many people enter into forward contracts for better risk
management. Companies often use these contracts to limit risk that may arise from foreign
currency exchange.

DISADVANTAGES OF FUTURES CONTRACTS:

 No Control Over Future Events - One common drawback of investing in futures trading is that
you do not have any control over future events. Natural disasters, unexpected weather conditions,
political issues, etc. can completely disrupt the estimated demand-supply equilibrium.
 Leverage Issues - High leverage can result in rapid fluctuations of futures prices. The prices can
go up and down daily or even within minutes.
 Expiration Dates - Future contracts involve a certain expiration date. The contracted prices for
the given assets can become less attractive as the expiration date comes nearer. Due to this,
sometimes, a futures contract may even expire as a worthless investment.
 Interest rate risk: The risk that an investment's value will change due to a change in the absolute
level of interest rates. Normally, rise in interest rates during the investment period may result in
reduced prices of the held securities.
 Liquidity Risk: Liquidity risk is an important factor in trading. Level of liquidity in a contract
can impact the decision to trade or not. Even if a trader arrives at a strong trading view, he may
not be able to execute the strategy due to lack of liquidity. There may not be enough opposite
interest in the market at the right price to initiate a trade. Even if a trade is executed, there is
always a risk that it can become difficult or costly to exit from positions in illiquid contracts.
 Settlement and Delivery Risk: All executed trades need to be settled and closed at some point.
Daily settlement takes the form of automatic debits and credits between accounts with any
shortfalls being recovered through margin calls. Brokers are obligated to fulfill all margin calls.
Use of electronic systems with online banking has reduced the risks of failed daily settlements.
However, non-payment of margin calls by clients poses a serious risk for brokers.
 In cases where clients fail to pay margin calls, brokers need to be proactive and take steps to close
out positions. Managing risks of client non-payment is an internal broker function that should be
done in real-time. Delayed response to client delinquency can result in the creating losses for
brokers if not default.
Similarly, the risk of non-delivery is substantial for physically delivered contracts. Brokers need to
ensure that they allow only those clients access to trade deliverable contracts till maturity who
have the capacity and ability to make good on delivery obligations.
 Operational Risk: Operational risk is a major source of losses for brokers as well as investor
complaints. Errors due to manual mistakes by staff are a major area of risk for all brokers.
Measures like adequate staff training, supervision, internal controls, and documentation of
standard operating procedures and segregation of tasks are essential for running a brokerage house
as well as for reducing instances and impact of operational risks.

SETTLEMENT
When a futures trader takes a position (long or short) in a futures contract, he can settle the contract in
three different ways.
 Closeout: In this method, the futures trader closes out the futures contract even before the expiry.
If he is long a futures contract, he can take a short position in the same contract. The long and the
short position will be off-set and his margin account will be marked to market and adjusted for
P&L. Similarly, if he is in a short futures contract, he will take a long position in the same contract
to close out the position.
 Physical Delivery: If the futures trader does not closeout the position before expiry, and
keeps the position open and allows it to expire, then the futures contract will be settled by
physical delivery or cash settlement (discussed below). This will depend on the contract
specifications. In case of the physical delivery, the clearinghouse will select a counterparty for
physical settlement (accept delivery) of the futures contract. Typically, the counterpart
selected will be the one with the oldest long position. So, at the expiry of the futures contract,
the short position holder will deliver the underlying asset to the long position holder.
 Cash Settlement: In case of cash settlement (in case the contract has expired), there is no
need for physical delivery of the contract. Instead, the contract can be cash-settled. This can
be done only if the contract specifies so. If a contract can be cash settled, the trader need not
closeout the position before expiry, He can just leave the position open. When the contract
expires, his margin account will be marked-to market for P&L on the final day of the contract.
Cash settlement is a preferred option for most traders because of the savings in transaction
costs.

Options Contracts
Option is the most important part of derivatives contract. An Option contract gives
the right but not an obligation to buy/sell the underlying assets. The buyer of the
options pays the premium to buy the right from the seller, who receives the
premium with an obligation to sell the underlying assets if the buyer exercises his
right. Options can be traded in both OTC market and exchange traded markets.

Options can be divided into two types - call and put.

Calls give the buyer the right but not the obligation to buy a given quantity of the
underlying asset, at a given price on or before a given future date. Puts give the
buyer the right, but not the obligation to sell a given quantity of the underlying
asset at a given price on or before a given date.

Swaps
Swaps are derivative contracts wherein two parties exchange their financial
obligations. The cash flows are based on a notional principal amount agreed
between both the parties without exchange of principal. The amount of cash flows is
based on a rate of interest. One cash flow is generally fixed and the other changes
on the basis of a benchmark interest rate. Interest rate swaps are the most
commonly used category. Swaps are not traded on stock exchanges and are over-
the-counter contracts between businesses or financial institutions.
1. Interest rate swaps: These involve swapping only the interest related cash
flows between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than
those in the opposite direction.

FEATURES OF DERIVATIVES MARKET

Derivative can be defined as a contract or an agreement for exchange of payments, whose value is
derived from the value of an underlying asset. In simple words the price of derivative depends on
the price of other assets.
Some of the features of derivative markets –
1. Derivative are of three kinds future or forward contract, options and swaps and underlying assets
can be foreign exchange, equity, commodities markets or financial bearing assets.
2. As all transactions in derivatives takes place in future specific dates it is easier to short sell then
doing the same in cash markets because an individual can take of markets and take the position
accordingly because one has more time in derivatives.
3. Since derivatives have standardized terms due to which it has low counterparty risk, also
transactions costs are low in derivative market and hence they tend to be more liquid and one can
take large positions in derivative markets quite easily.
4. Derivatives have a maturity or expiration date after which they become worthless or
automatically terminate. For example, options have a specified life during which the holder
can exercise some sort of right. At the end of that life, the contract expires whether that right
has been exercised or not.
5. When value of underlying assets changes then value of derivatives also changes and hence one
can construct portfolio which is needed by one and that too without having the underlying asset.
So for example if one want to buy some stock and short the market then he can buy the future of a
stock and at the same time short sell the market without having to buy or sell the underlying
assets.
6. 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.
7. 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.
8. Intraday traders get the benefit of liquidity as these contracts are very liquid and also the costs
such as basis expense, brokerage is less as compared to cash market.
9. It is a great risk management tool and if applied judiciously it can produce good results and
benefit its user.
10. 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.
11. 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.
12. 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.
Hence from the above one can see that derivatives have some important features which make them
quite attractive to all category institutions, investors and traders.

FUNCTIONS OF DERIVATIVE MARKETS

The derivatives market performs a number of functions.
1. Price Discovery
Futures market prices depend on a continuous flow of information from around the world and
require a high degree of transparency. A broad range of factors (climatic conditions, political
situations, debt default, refugee displacement, land reclamation and environmental health, for
example) impact supply and demand of assets (commodities in particular) - and thus the current
and future prices of the underlying asset on which the derivative contract is based. This kind of
information and the way people absorb it constantly changes the price of a commodity. This
process is known as price discovery.
Prices in an organized derivatives market reflect the perception of
market participants about the future and lead the prices of underlying to the perceived future
level. The prices of derivatives converge with the prices of the underlying at the expiration of the
derivative contract. Thus, derivatives help in discovery of future as well as current prices.
2. Risk Management
This could be the most important purpose of the derivatives market. Risk management is the
process of identifying the desired level of risk, identifying the actual level of risk and altering the
latter to equal the former. This process can fall into the categories of hedging and speculation.
The derivatives market helps to transfer risks from those who have them but
may not like them to those who have an appetite for them.
3. They Improve Market Efficiency for the Underlying Asset
For example, investors who want exposure to the Nifty 50 can buy a Nifty 50 stock index fund or
replicate the fund by buying Nifty 50 futures and investing in risk-free bonds. Either of these
methods will give them exposure to the index without the expense of purchasing all the
underlying assets in the Nifty 50.
4. Derivatives Also Help Reduce Market Transaction Costs
 Because derivatives are a form of insurance or risk management, the cost of trading in them has to
be low or investors will not find it economically sound to purchase such "insurance" for their
positions
5. Derivatives, due to their inherent nature, are linked to the underlying cash markets. With the
introduction of derivatives, the underlying market witnesses higher trading volumes because of
participation by more players who would not otherwise participate for lack of an arrangement to
transfer risk.
6. Speculative trades shift to a more controlled environment of derivatives market. In the absence of
an organized derivatives market, speculators trade in the underlying cash markets. Margining,
monitoring and surveillance of the activities of various participants become extremely difficult in
these kinds of mixed markets.
7. An important incidental benefit that flows from derivatives trading is that it acts as a catalyst for
new entrepreneurial activity. The derivatives have a history of attracting many bright, creative,
well-educated people with an entrepreneurial attitude. They often energize others to create new
businesses, new products and new employment opportunities, the benefit of which are immense.

Finally, derivatives markets help increase savings and investment in the long run. Transfer of risk
enables market participants to expand their volume of activity.

NEED FOR DERIVATIVES MARKET

Purpose #1: To Transfer risk
Derivative is best used as risk management tool by which you can transfer the risk associated with
the underlying asset to the party who is willing to take that risk.
To simplify the risk term, it has been divided into three parts:
 Credit Risk: Credit risk arises when any of the parties fail to fulfill the obligation under the
agreement. Such an event is called a default. It is also known as 'default risk'.
 Liquidity Risk: Liquidity risk is financial risk that arises due to uncertain cash crunch. An
institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash
outflows, or some other event causes counter-parties to avoid trading with or lending to the
institution.
 Market Risk: Fluctuation in the prices of the underlying asset contributes to market risk.
Market risk comprises of four risk factors: Equity risk, Interest rate risk, Currency risk and
Commodity risk. In general, risk varies from sector to sector.
For example, Banks use derivatives to hedge against risks that may affect their operations
and earnings including interest rate risk, market risk, foreign exchange risk and counter-party risk.
Farmers use derivatives to lock the price of their crops in order to protect their harvest, so they are
exposed to price risk. The importance of derivatives is increasing day by days because of high
volatility in the market.
Purpose #2: To Hedge
Derivatives were originally created as tools for hedging. Businesses face a lot of risks related to
commodity prices in their day-to-day operations.
 For instance, the operations of an airline firm are largely affected by the prices of jet fuel. The
prices of jet fuel fluctuate on a daily basis. Hence, businesses cannot earn a stable income.
Organizations usually prefer stability and hence there is a need for a financial instrument which
can ensure stable prices regardless of the rise and fall in commodity prices
 Exporters face a lot of risk related to foreign exchange. Their goods are invoiced in foreign
currency. However, they have to pay their expenses in local currency. The exchange rates
between the foreign and local currency change every second. Hence, the profitability of such an
export-oriented firm is hit by these changes in the commodity prices. They too feel that there is a
need for a financial instrument which can provide them a stable exchange rate regardless of the
ups and downs in the market so that they can plan their operations based on this stable platform.
 Lastly, a farmer faces the risk of the variability in the price of his produce. If there is excess
produce in a given year, then the prices are low or else the prices are high. The farmer wants to
get rid of this price variability and hence feels that there is a need for a financial instrument that
can help him fix the prices.
Hedging is the legitimate reason for the existence of derivatives. Hedging happens when the people
buying or selling derivatives contract use the underlying asset in the day-to-day operations of their
firm.

Purpose # 3: To Speculate
The third most common reason behind the usage of derivatives is speculation. Now, this may not
seem like a legitimate reason. However, speculators are necessary participants in any market as they
provide liquidity.
Hedging happens when the parties to a contract have genuine business interests in the
underlying asset. Speculation is the exact opposite. Speculators have no interest in the underlying
asset and take part in the contract because they believe that they can make a gain out of the price
movements.
For instance, if you believe that the US dollar will depreciate significantly against
the Euro in the next month, derivatives contracts enable you to take a position on this in the market.
Since derivative contracts are extremely leveraged, speculation in the derivative market is a highly
risky business. However, there are people who specialize in doing so.
Purpose # 4: Circumventing Regulations
The fourth reason why derivatives are used in the marketplace is to circumvent (avoiding) regulation.
Certain institutions like pension funds are prohibited from making investments in any kind of risky
securities. Hence, derivatives help in superficially de-risking the securities and making it legal for the
pension funds to purchase them.
Consider the case of mortgage-backed securities. In USA, Pension funds were
not allowed to invest money in real estate since it was considered a risky bet. However, investment
bankers created de-risked mortgage-backed securities which were backed by agencies like Freddie
Mac and Fannie Mae. These securities appeared to be risk free and hence pension funds could legally
trade in them.
There are many such instances wherein derivatives have been used to circumvent regulations and
change the very nature of the investment being made.
Purpose # 5: Minimizing Trade Costs
Investors all over the world do not like transaction costs. Derivatives provide a great way to avoid
and evade them. This can be best explained with the help of an example.
Consider the case of a company that has taken a fixed rate loan from a
bank. However, now they believe that the interest rates will go down. Hence, they feel like they
should take a floating rate loan. However, closing the loan before its due date would attract
prepayment penalty. Also, taking a new loan would generally attract processing charges. Hence to
avoid these transaction costs on both sides, a firm can simply structure a swap wherein they can
switch over to floating interest rates without bearing any of the above-mentioned transaction charges.

Hence, derivatives are extremely useful financial instruments. This usefulness adds tremendously to
their popularity and explains why ever Multinational Corporation, major bank or investment bank in
the world is highly involved in derivative trading.

ADVANTAGES OF DERIVATIVES:
1. Hedging risk exposure: Derivatives are popular for hedging. Individuals can enter into a
derivative contract where asset value moves in the opposite direction to the asset value, they
already own. Since the value of the derivatives is linked to the value of the underlying asset, the
contracts are primarily used for hedging risks. For example, an investor may purchase a derivative
contract whose value moves in the opposite direction to the value of the asset. In addition, it can
be utilized to reallocate risk from risk-averse players to risk-seeking players.
2. Enable Price Discovery: In the first place, derivatives encourage more and more people with
objectives of hedging, speculation, arbitrage to take part in the market and hence increase
competition. The increased no. of participants, more trades, more volumes, and greater sensitivity
to smallest of price changes facilitates correct and efficient price discovery of assets.
3. Lock in Prices: With derivatives, investors can lock in the prices of the assets. If they expect the
asset prices to go down in the future, through derivative contracts, they can lock in the present
prices.
4. Facilitates Transfer of Risk: By their very nature, the derivatives instruments do not involve
risk. Instead, they redistribute risk between the various market participants. In this sense,
derivatives can be compared to insurance: provides means to hedge against unfavourable market
movements in return for a premium, and provides opportunities to those who are willing to take
risks and make profits in the process.
5. Leverage: Derivatives are leveraged products. Investors can get access to higher capital through
leverage, i.e., they can get access to more money than actual cash in hand.
6. Completion of Market/Efficient Market: A market is efficient or said to be complete market
(theoretically possible) when the available instruments can by itself or jointly provide cover
against any possible adverse outcomes. It is considered that derivatives increase the efficiency of
financial markets. By using derivative contracts, one can replicate the payoff of the assets.
Therefore, the prices of the underlying asset and the associated derivative tend to be in
equilibrium to avoid arbitrage opportunities.
7. Lower Transaction costs: It translates into low transaction costs due to the high no. of
participants that take part in the market.
8. Access to unavailable assets or markets
Derivatives can help organizations get access to unavailable assets or markets. By employing
interest rate swaps, a company may obtain a more favorable interest rate relative to interest rates
available from direct borrowing.

DISADVANTAGES OF DERIVATIVES:
Derivatives behave like a two-edged sword. If put to use wisely they work very effectively but
when used recklessly can cause you severe agonies. Sadly, there is no realistic way in which one
could demarcate between the two. There is a very thin line that distinguishes gambling with a
calculated taken risk.
Below mentioned are disadvantages/ demerits of Derivatives:
 1. Raises Volatility: As a large no. of market participants can take part in derivatives with a small
initial capital due to leveraging derivatives provide, it leads to speculation and raises volatility in
the markets.
2. Higher no. of Bankruptcies: Due to leveraged nature of derivatives, participants assume
positions which do not match their financial capabilities and eventually lead to bankruptcies.
3. Increased need of regulation: large no. of participants takes positions in derivatives and take
speculative positions. It is necessary to stop these activities and prevent people from getting
bankrupt and to stop the chain of defaults.
4. Counter-party risk: Although derivatives traded on the exchanges generally go through a
thorough due diligence process, some of the contracts traded over-the-counter do not include a
benchmark for due diligence. Thus, there is a high probability of counter-party default.
5. Cost of holding underlying assets: Derivatives can be difficult to value, especially those that
are based on multiple underlying assets. This can make them a tool for gambling rather than
effective investor speculation.
6. Riskier to trade in due to anticipation of the price of the security: In derivatives, money is
made out of price changes, and not knowing how to price an asset accordingly could expose an
investor to higher-than-normal risks. Some derivatives, such as options, are time-restricted. This
adds another layer of risk when trading financial assets. It is realistic for an investor to predict that
prices of an underlying asset can rise or fall, but it is far more challenging to predict when exactly
such a price change will occur.
7. Changes in the amount of time to expiration.
8. Vulnerable to the market sentiment which causes the derivative to have no intrinsic value
9. Sensitive to demand and supply

WHY DO INVESTORS CHOOSE FINANCIAL DERIVATIVES?

Apart from making profits, there are various other reasons behind the use of derivative contracts.
Some of them are as follows:
 Protection against market volatility: Financial assets are highly volatile. The price fluctuations
can often lead to heavy losses. You can use the financial derivatives to minimise your losses. You
can look for products in the derivatives market which will help you to shield yourself against a
reduction in the price of stocks that you own. Additionally, you may buy products to safeguard
against a price rise in the case of stocks that you are planning to buy.
 Arbitrage opportunities: Derivative contracts have good arbitrage
opportunities. Arbitrage involves buying an asset at a low price in one market and selling it at a
high price in another market. The difference between the prices is the profit that you will make.
 Access to different assets and markets: Derivatives can help businesses gain access to assets or
markets that might otherwise be unavailable. For example, interest rate swaps allow a corporation
to get a better interest rate than it could get from direct borrowing.
 Park surplus funds: Some individuals use derivatives as a means of transferring risk. However,
others use it for speculation and making profits. Here, you can take advantage of the price
fluctuations without actually selling the underlying shares.

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES

Factors contributing to the explosive growth of derivatives are price volatility, globalization of the
markets, technological developments and advances in the financial theories.
1. Price Volatility
 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 person’s 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 are 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 breakdown of the BRETTON WOODS agreement brought an end to the
stabilizing role of fixed exchange rates and the gold convertibility of the dollars. The globalization
of the markets and rapid industrialization 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 has 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.

This 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.

2. Globalization of the Markets

Earlier, managers had to deal with domestic economic concerns; what happened in other part of
the world was mostly irrelevant. Now globalization 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-à-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 globalization of
industrial and financial activities necessitates use of derivatives to guard against future losses. This
factor alone has contributed to the growth of derivatives to a significant extent.
3. Technological Advances
A significant growth of derivative instruments has been driven by technological breakthrough.
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 worldwide
conferencing, Data transmission by satellite. At the same time there were significant advances in
software programmed 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.

4. Advances in Financial Theories

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.

EXCHANGE TRADED DERIVATIVES

An exchange traded derivative is a financial instrument that trades on a regulated exchange and
whose value is based on the value of another asset. Simply put, these are derivatives that are traded
in a regulated fashion. Exchange traded derivatives have become increasingly popular because of
the advantages they have over over-the-counter (OTC) derivatives, such as standardization,
liquidity and elimination of default risk. Futures and options are two of the most popular exchange
traded derivatives. These derivatives can be used to hedge exposure or speculate on a wide range
of financial assets like commodities, equities, currencies and even interest rates.

Over the Counter (OTC) derivatives are traded between two parties (bilateral negotiation) without
going through an exchange or any other intermediaries. OTC is the term used to refer stocks that
trade via dealer network and not any centralized exchange. These are also known as unlisted
stocks where the securities are traded by broker-dealers through direct negotiations.

EXCHANGE TRADED VERSUS OTC DERIVATIVES

Difference between Exchange Trading & OTC Trading:
1. Centralization of Market: In a market that operates with exchange trading, transactions are
completed through a centralized source. In other words, one party acts as the mediator connecting
buyers and sellers. There are a specified number of traders who will trade on that single centralized
system. On the other hand, over-the counter markets are generally decentralized. Here, there are
many mediators who compete to link buyers to sellers. The advantage to this is that it ensures that
costs for intermediary services are as low as possible.
2. Standardization: An Exchange Trade is a standard contract wherein Stock exchange acts as a
guarantor for all the trades. But OTC contracts are customized as there is no specified guarantor
and hence the risk increases a lot.
 3. Counterparty Risk: When you buy or sell something OTC in a private transaction, there is
always the risk of not getting what you bargained for. The other party might not be able to deliver
the stock, bond or other security within the agreed upon time frame. It might also deliver a
different kind of stock or bond than promised. These risks are broadly referred to as counterparty
risk. In an exchange, however, counterpart risk is not an issue. The trading occurs through brokers
who are closely monitored by both the exchange and the Securities and Exchange Commission.
Investors buy exchange traded securities with greater confidence and therefore pay more for such
stocks. Because of this, businesses are better off selling shares through an exchange rather than in
a private transaction.
4. Visibility: As Exchange market is an open market wherein there is a clear visibility for prices,
start date, expiration dates & counterparties involved in a deal etc. But, this is not the case with
OTC market as all the terms & conditions associated with any deal are between the counterparties
only.
5. Parties Involved: In exchange traded markets, the exchange is the counterparty to all of the
trades. Additionally, there is price standardization and execution. One negative these exchanges
involves less price competition. OTC, or over the counter markets, have no centralized trading
facility. This promotes heavy competition between counterparties and lower transaction costs. The
lack of regulation can introduce fraudulent firms and transaction execution quality may decrease.

Conclusion:
In exchange markets, there is a regulator (exchange) through which transactions are completed,
while in OTC market’s there is no regulator. Exchange markets have less chances of price
manipulation, while the many competing traders in OTC markets can manipulate prices.
Exchange markets ensure transaction security, while OTC markets are prone to fraud and dishonest
traders.

TRADERS IN DERIVATIVES MARKETS

There are four types of traders in the derivatives market:
1. Dealer
2. Hedger
3. Speculator
4. Arbitrageur
Dealers: Derivative contracts are bought and sold by dealers who work for banks and other security
houses. Some contracts are traded on exchanges while others are OTC Transactions.
In a large investment bank, the derivatives function is now a highly skilled
affair. Marketing and sales staff speak to clients about what they want. Experts help to create
solutions to those customer requirements using a combination of forwards, swaps and options.
Any risk the bank assumes as a result of providing such tailor-made products is managed by the
traders who run the banks derivatives books. In the meantime, risk managers keep an eye on the
overall level of the risk the bank is running. Mathematicians, also known as “Quants” devise the
tools required to price the new products created by the experts.
 Initially large banks tended to operate solely as intermediaries in the derivatives
market, matching the buyers and the sellers. Over time, however, they have assumed more and
more risk themselves.
Hedger: A hedge is a position taken in order to offset the risk associated with some other position. A
hedger is someone who faces risk associated with price movement of an asset and who uses
derivatives as a means of reducing that risk. A hedger is a trader who enters the futures market to
reduce a pre-existing risk.
Speculators: While hedgers are interested in reducing or eliminating risk, speculators buy and sell
derivatives to make profit and not to reduce risk. Speculators willingly take increased risks.
Speculators wish to take a position in the market by betting on the future price movements of an
asset. Futures and options contracts can increase both the potential gains and losses in a
speculative venture. Speculators are important to derivatives markets as they facilitate hedging
provide liquidity ensure accurate pricing, and help to maintain price stability. It is the speculators
who keep the market going because they bear risks which no one else is willing to bear.
Arbitrageur: An arbitrageur is a person who simultaneously enters into transactions in two or more
markets to take advantage of discrepancy between prices in these markets For example, if the
futures price of an asset is very high relative to the cash price, an arbitrageur will make profit by
buying the asset and simultaneously selling futures. Hence, arbitrage involves making profits from
relative mispricing. Arbitrageurs also help to make markets liquid, ensure accurate and uniform
pricing, and enhance price stability.
All types of trades and investors are required for a healthy
functioning of the derivatives market. Hedgers and investors provide economic substance to this
market, and without them the markets would become mere tools of gambling. Speculators provide
liquidity and depth to the market. Arbitrageurs help in bringing about price uniformity and price
discovery. The presence of Hedgers, speculators and arbitrageurs, not only enables the smooth
functioning of the derivatives market but also helps in increasing the liquidity of the market.

CRITIQUES OF DERIVATIVES
Besides from the important services provided by the derivatives, some experts have raised doubts and
have become critique on the growth of derivatives. They have warned against them and believe that
the derivatives will cause to destabilization, volatility, financial excesses and oscillations in financial
markets. It is alleged that they assist the speculators in the market to earn lots of money, and hence,
these are exotic instruments. A few important arguments of the critiques against derivatives have
been discussed below:
 Speculative and Gambling Motives
One of most important arguments against the derivatives is that they promote speculative
activities in the market. It is witnessed from the financial markets throughout the world that
 the trading volume in derivatives have increased in multiples of the value of the underlying
assets and hardly one to two percent derivatives are settled by the actual delivery of the
underlying assets. As such speculation has become the primary purpose of the birth, existence
and growth of derivatives. Sometimes, these speculative buying and selling by professionals
and amateurs adversely affect the genuine producers and distributors.
Some financial experts and economists believe that speculation brings about a better
allocation of supplies overtime, reduces the fluctuations in prices, make adjustment between
demand and supply, removes periodic gluts and shortages, and thus, brings efficiency to the
market. However, in actual practice, above such agreements are not visible. Most of the
speculative activities are ‘professional speculation’ or ‘movement trading’ which lead to
destabilization in the market. Sudden and sharp variations in prices have been caused due to
common, frequent and widespread consequence of speculation.
 Increase in Risk
The derivatives are supposed to be efficient tool of risk management in the market. In fact, this
is also one-sided argument. It has been observed that the derivatives market— especially OTC
markets, as particularly customized, privately managed and negotiated, and thus, they are
highly risky. Empirical studies in this respect have shown that derivatives used by the banks
have not resulted in the reduction in risk, and rather these have raised new types of risk. They
are powerful leveraged mechanism used to create risk. It is further argued that if derivatives are
risk management tool, then why ‘government securities,’ a riskless security, are used for trading
interest rate futures which is one of the most popular financial derivatives in the world.
 Instability of the Financial System
It is argued that derivatives have increased risk not only for their users but also for the whole
financial system. The fears of micro and macro financial crisis have caused to the unchecked
growth of derivatives which have turned many market players into big losers. The malpractices,
desperate behaviour and fraud by the users of derivatives have threatened the stability of the
financial markets and the financial system.
 Price Instability
Some experts argue in favour of the derivatives that their major contribution is toward price
stability and price discovery in the market whereas some others have doubt about this. Rather
they argue that derivatives have caused wild fluctuations in asset prices, and moreover, they
have widened the range of such fluctuations in the prices. The derivatives may be helpful in
price stabilization only if there exist a properly organized, competitive and well-regulated
market. Further, the traders behave and function in professional manner and follow standard
code of conduct. Unfortunately, all these are not so frequently practiced in the market, and
hence, the derivatives sometimes cause to price instability rather than stability.
 Displacement Effect
There is another doubt about the growth of the derivatives that they will reduce the volume of
the business in the primary or new issue market specifically for the new and small corporate
units. It is apprehension that most of investors will divert to the derivatives markets, raising
fresh capital by such units will be difficult, and hence, this will create displacement effect in the
financial market. However, it is not so strong argument because there is no such rigid
segmentation of investors, and investors behave rationally in the market.
 Increased Regulatory Burden
As pointed earlier that the derivatives create instability in the financial system as a result, there
will be more burden on the government or regulatory authorities to control the activities of the
 traders in financial derivatives. As we see various financial crises and scams in the market from
time to time, most of time and energy of the regulatory authorities just spent on to find out new
regulatory, supervisory and monitoring tools so that the derivatives do not lead to the fall of the
financial system.

DERIVATIVES MARKET IN INDIA:

In India, commodity futures date back to 1875. The government banned futures trading in many of
the commodities in the sixties and seventies. Forward trading was banned in the 1960s by the
government despite the fact that India had a long tradition of forward markets. Derivatives were not
referred to as options and futures but as “tezi-mandi.”

In exercise of the power conferred on it under section 16 of the Securities Contracts (Regulation) Act,
the government by its notification issued in 1969 prohibited all forward trading in securities.
However, the forward contracts in the rupee dollar exchange rates (foreign exchange market) are
allowed by the Reserve Bank and used on a fairly large scale. Futures trading are permitted in 41
commodities. There are 18 commodity exchanges in India. The Forward Markets Commission under
the Ministry of Food and Consumer Affairs acts as a regulator.

In the case of capital markets, the indigenous 125-year-old badla system was very popular among the
broking and investor community. The advent of foreign institutional investors in the nineties and a
large number of scams led to a ban on badla. The foreign institutional investors (FIIs) were not
comfortable with this system and they insisted on adequate risk-management tools. Hence, the
Securities and Exchange Board of India (SEBI) decided to introduce financial derivatives in India.
However, there were many legal hurdles which had to be overcome before introducing financial
derivatives. The preamble of the Securities Contract (Regulation) Act, states that the Act was to
prevent undesirable transactions in Securities by regulating business of dealing therein, by prohibiting
options, and by providing for certain other matters connected therewith. Section 20 of the Act
explicitly prohibits all options in securities. The first step therefore was to withdraw all these
prohibitions and make necessary amendments in the Act. The Securities Laws (Amendment)
Ordinance, 1995 promulgated on January 25, 1995 withdrew the prohibitions by repealing section 20
of the SC(R) A, and amending its preamble.

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. Liberalized 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.
A. EQUITY DERIVATIVES IN INDIA
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.

Many mutual funds have now adopted the NIFTY as the benchmark for their performance evaluation
efforts. If the stock derivatives have to come about, they should be 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
inIndia.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.

B. COMMODITY DERIVATIVES TRADING IN INDIA

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,
Barnalaand Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras,Gaziaba
d, 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 Rs1, 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
thecommodities 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.

PARTICIPANTS IN THE DERIVATIVES MARKET:

1. BROKERS
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.

2. MARKET MAKERS AND JOBBERS

Even in organized 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 onscreen,
so the role of jobber to some extent. In any case, jobbers provide liquidity and volume to any futures
and option market.
3. EXCHANGE
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 provides access to
members and makes available real time information online and also allows 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.
4. CLEARING HOUSE
A clearing house performs clearing of transactions executed in futures and optionexchanges. 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
involatile market. This provides confidence of people in futures and option exchange. Therefore, it is
an important institution for futures and option market.
5. CUSTODIAN / WARE HOUSE
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.
6. BANK FOR FUND MOVEMENTS
Futures and options contracts are daily settled for which large fund movement frommembers 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.

7. REGULATORY FRAMEWORK
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, SEBI is regulating the Commodity Exchanges.

REGULATORY FRAMEWORK OF DERIVATIVES MARKET IN INDIA

With the amendment in the definition of ''securities'' under SC(R)A (to include derivative contracts in
the definition of securities), derivatives trading takes place under the provisions of the Securities
Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. Dr. L.C
Gupta Committee constituted by SEBI had laid down the regulatory framework for derivative trading
in India. SEBI has also framed suggestive bye-law for Derivative Exchanges/Segments and their
Clearing Corporation/House which lays down the provisions for trading and settlement of derivative
contracts. The Rules, Bye-laws & Regulations of the Derivative Segment of the Exchanges and their
Clearing Corporation/House have to be framed in line with the suggestive bye-laws. SEBI has also
laid the eligibility conditions for Derivative Exchange/Segment and its Clearing Corporation/House.

The eligibility conditions have been framed to ensure that Derivative Exchange/Segment & Clearing
Corporation/House provide a transparent trading environment, safety & integrity and provide
facilities for redressal of investor grievances. Some of the important eligibility conditions are –
1. Derivative trading to take place through an online screen-based Trading System.
2. The Derivatives Exchange/Segment shall have online surveillance capability to monitor positions,
prices, and volumes on a real time basis to deter market manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for dissemination of information
about trades, quantities and quotes on a real time basis through at least two information vending
networks, which are easily accessible to investors across the country.
4. The Derivatives Exchange/Segment should have arbitration and investor grievances redressal
mechanism operative from all the four areas / regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of monitoring investor
complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor Protection Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the Clearing Corporation/House
shall interpose itself between both legs of every trade, becoming the legal counterparty to both or
alternatively should provide an unconditional guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the overall position of
Members across both derivatives market and the underlying securities market for those Members who
are participating in both.
9. The level of initial margin on Index Futures Contracts shall be related to the risk of loss on the
position. The concept of value-at-risk shall be used in calculating required level of initial margins.
The initial margins should be large enough to cover the one-day loss that can be encountered on the
position on 99% of the days.
10. The Clearing Corporation/House shall establish facilities for electronic funds transfer (EFT) for
swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing Corporation/House
shall transfer client positions and assets to another solvent Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial margins deposited
by Clearing Members for trades on their own account and on account of his client. The Clearing
Corporation/House shall hold the clients' margin money in trust for the client purposes only and
should not allow its diversion for any other purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the trades
executed on Derivative Exchange / Segment. Presently, SEBI has permitted Derivative Trading on
the Derivative Segment of BSE and the F&O Segment of NSE.

DIFFERENCE BETWEEN FORWARD AND FUTURES CONTRACT

CHARACTERIS FUTURES CONTRACT FORWARDS CONTRACT
TICS
Meaning Forward Contract is an agreement A contract in which the parties agree to
between parties to buy and sell the exchange the asset for cash at a fixed
underlying asset at a specified date price and at a future specified date, is
and agreed rate in future. known as future contract.
Structure Standardized contract Customized contract
Market Primary Primary & Secondary
Counterparty Risk Low High
Contract size Standardized/Fixed Customized/depends on the contract term
Regulation Stock exchange Self-regulated
Guarantees Both parties must deposit an initial No guarantee of settlement until the date
guarantee (margin). The value of the of maturity only the forward price, based
operation is marked to market rates on the spot price of the underlying asset
 with daily settlement of profits and is paid.
losses.
Collateral Initial margin required Not required
Settlement On daily basis On maturity date
Institutional Clearing House The contracting parties
guarantee
Default No such probability. As they are private agreement, the
chances of default are relatively high.
Traded on Organized stock exchange. Over the counter, i.e. there is no
secondary market.
Method of pre- Opposite contract on the exchange. Opposite contract with same or different
termination counterparty. Counterparty risk remains
while terminating with different
counterparty.
Purpose The purpose of forward contract is to The Purpose of futures contracts is
prevent loss through hedging. mainly to have speculative gain.