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Derivatives are the contracts which are written between two parties (Counter parties) and whose

value is derived from the value of underlying assets.It has no independent value. Its value is entirelyderived from the value of underlying assets i.e. stock,commodity, bullion, currency and livestock etc.

Financial Derivatives are financial instrument

whose value is derived from underlying assets.

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It is a future contract between two parties. It has no independent value. Its value is entirely derived from

the value of underlying assets.

The counter parties have specified obligation under thederivative contract.

It can be traded on OTC or through Stock Exchange. It is Off-balance sheet item. Usually in derivative trading, the taking or making of delivery

of underlying assets is not involved. Derivatives are known as deferred delivery/deferred Payment

instrument. It is secondary market instrument and have little useful in

mobilizing fresh capital except warrants and convertibles.

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There are 2 types of derivatives

1. Financial derivatives

2. Commodity Derivatives

Commodity derivatives: the underlying instruments are a commodity

which may be agricultural products, metals, gold, silver, gas, oil etc.Financial Derivatives: the underlying instruments are stock, bond,foreign exchange, index, bills cost of living index.

Financial Derivatives further divided into 2 types

1.Basic

2.Complex.

Basics 1. Forward 2. Future 3.Option 4. Warrants & Convertibles

Complex 1.Swap 2.Exotics (non-standard)

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A forward contract is an agreement between two parties to

buy (long position) or sell (short position) an assets/security

at a certain future time for a certain future price, settlement

happens at the end of period. It is usually traded on OTCmarket..

The party that agrees to buy the asset in the future is said to

have the long position.

The party that agrees to sell the asset in the future is said to

have the short position.

The specified future date for the exchange is known as the

delivery (maturity) date.

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A futures contract is similar to a forward contract in that itis an agreement between two parties to buy or sell an assetat a certain time for a certain price, in future, it followsdaily settlements. Futures, however, are usually exchangetraded and are usually standardized contracts.

` Note: The long and short party usually do not deal with each other directly or

even know each other for that matter. The exchange acts as a clearinghouse.As far as the two sides are concerned they are entering into contracts with theexchange. In fact, the exchange guarantees performance of the contractregardless of whether the other party fails.

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Traded on OTC

Not-Standardized

Specified delivery date Settle at end of maturity

No margin money required

Traded on Stock Exchange

Standardized

Range of delivery date Daily settled

Margin money required

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Option is a contract that gives the holder the right butnot obligation to buy/sell an assets/security.

There are two basic types of options:

ACalloption istheright,butnottheobligation,tobuytheunderlyingassetbyacertaindateforacertainprice.

A Putoption istheright,butnottheobligation,toselltheunderlyingassetbyacertaindatefora certain price.

Note: unlike a forward or futures contract, the holder of theoptions contract have the option to do it or not.

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OptionSeller- Onewhogives/writestheoption.Hehasanobligationtoperform,

incaseoptionbuyerdesirestoexercisehisoption.

Option Buyer- Onewhobuystheoption.Hehastherighttoexercisetheoptionbut

noobligation.

AmericanOption-Anoptionwhichcanbeexercisedanytimeonorbeforetheexpirydate.

EuropeanOption- Anoptionwhichcanbeexercisedonlyonexpirydate.

StrikePrice/ExercisePrice- Priceatwhichtheoptionistobeexercised.

ExpirationDate- Dateonwhichtheoptionexpires.

ExerciseDate- Dateonwhichtheoptiongetsexercisedbytheoptionholder/buyer.

OptionPremium- Thepricepaidbytheoptionbuyertotheoptionsellerfor

grantingtheoption.

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Warrants is a contract/option entered into by the issuingcompany giving the holder the right to purchase or subscribeto the stated no. of equity shares of that company within a predetermined specified period of time at a predetermined

price.

Convertible bond/debenture/preference share are the othertypes of equity derivatives securities. They can befully/partially converted into equity of the issuing company

on specified terms with regard to the timing, the price and theratio of conversion.

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Swaps are agreement between two parties toexchange sets of financial obligations of cash flowsfor a specified period of time at predetermined

intervals. Three major types of financial Swaps are;x Interest Rate Swaps

x Currency Swaps

x Debt-Equity Swaps

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These are non-standard derivatives formed bycombining two or more standard derivatives andthere is no boundary for designing these derivatives.

These are usually traded on OTC market. Variousexamples are ;

Packages, forward option, compound options,choose options, barrier options, Asian options,

Basket options, Barrier option, Binary options, indexcurrency option notes, Interest Rate Options, InterestRate Caps, Interest Rate Floor, Swaptions, AmericanOption, Shout Options, Rainbow Options and so on.

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To control, avoid, shift and manage different type of risk

To serve as barometers of the future trends in prices

To enhance liquidity and reduce transaction cost Helpful in proper assets allocation result in increase in earning

To control over price fluctuations and integrate price structure

at different points of time

To act as catalysts to the growth of financial market byattracting expert investors & professional resulting in inrease

in trading volume in the country.

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Speculative and gambling motives

Increase in Risk

Instability of the financial system Price instability

Displacement effect

Increased Regulatory burden

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