Derivatives Capital Market

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PROJECT REPORT

ON

AN OVERVIEW OFAN OVERVIEW OF

DERIVATIVES- A CAPITALDERIVATIVES- A CAPITAL

MARKET FINANCIALMARKET FINANCIAL

INSTRUMENTINSTRUMENT

For:

DEGREE OFE-MASTER OF BUSINESS ADMINISTRATION

Submitted by: Abhishek Srivastava

Roll No 03110128Year 2005

INSTITUTE OF MANAGEMENT TECHNOLOGY

GHAZIABAD.

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ACKNOWLEDGEMENT

First I would like to express my heartfelt thanks to the professor

Shri Sudhir Bajaj who guided me in this project. Though this topic

looks to be a bit new in Indian context, but this is a sincere effort

towards attaining new heights of knowledge.

Further, I would like to thank all my friends who extended their

cooperation in completing this project.

No project can be said to be free from the limitations. The

limitations which I faced during the completion of this project are

as follows:

Limitation of time.

Inherent limitation in getting the secondary data.

Reluctance by persons responsible to give primary

informations.

Even then I tried my level best to complete this project with my

full and sincere efforts.

In the end I would like to thank my parents who encouraged me

and extended their cooperation in completion of this project.

Abhishek

Srivastava.

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PREFACE

Derivatives are a type of financial instrument that few of us

understand and fewer still fully appreciate, although many of us

have invested indirectly in derivatives by purchasing mutual

funds or participating in a pension plan whose underlying assets

include derivative products.

In a way, derivatives are like electricity. Properly used, they can

provide great benefit. If they are mishandled or misunderstood,

the results can be catastrophic. Derivatives are not inherently

"bad". When there is full understanding of these instruments and

responsible management of the risks, financial derivatives can be

useful tools in pursuing an investment strategy.

This project attempts to familiarize with financial derivatives,

their use and the need to appreciate and manage risk. It is not a

substitute, however, for seeking competent professional advice

the knowledge of financial derivative will lead to the right

direction for investment proposals.

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CONTENTS

Topics Page No.

Introduction 5

What is a derivative 7

History of Derivatives 10

Characteristics of derivatives 16

Type of derivatives 18-40

Forward contract 19

Future contract 22

Swaps 29

Options 35

Function of derivatives 41

Advantages of Derivatives 46

Disadvantages of derivatives 52

Risks associated with derivatives 62

Derivatives in Indian Market 65-78

Trading Mechanism of Derivatives 69

Trading Mechanism of Derivative in IndianCapital market 73

Recommendations 79-86

Annexures 87-90

References 91

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INTRODUCTION

Over the past two decades, the financial markets have

experienced an impressive expansion in terms of securities

issued and traded on the secondary markets. In addition,

financial markets have becomes more and more

interconnected allowing almost continuous trading in some

precious metals, currencies and stocks traded on several

exchanges.

Financial innovation that led to the issuance and trading of

derivative products has been perhaps one of the most

important boost to the changes and development of

financial market.

In the financial marketplace, some securities and some

instruments are regarded as fundamental, while others are

regarded as derivative. In a corporation, for example, the

stock and bonds issued by the firm are fundamental

securities and form the bedrock of financial geology. Every

corporation must have stock and stock ownership gives

rights of ownership to the firm. In contrast with

fundamental securities such as stocks and bonds, there is

an entirely distinct class of financial instruments called

derivatives,. In finance, a derivative is financial instrument

or security whose payoffs depend on a more primitive or

fundamental good. For example a gold futures contract is a

derivative instrument, because the value of the futures

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contract depends upon the value of the gold that underlies

the futures contract. The value of the gold is the key since

the value of a gold futures contract derives its value from

the value of the underlying gold.

Derivative products such as options, futures or swap

contracts have become a standard risk management tool

that enables risk sharing and thus facilitates the efficient

allocation of capital to productive investment opportunities.

The word derivative has only been in common usage for

about the last few years or so. Many practitioners in this

markets will remember the terms, off-balance sheet

instruments, f inancial products risk management

instruments and financial engineering all meaning much

the same thing and now all covered by the expression

derivative. Unfortunately some market participants, not

only the banks who provide a service in these instruments,

but also some end users, have used these derivative

products to speculate widely.

Derivatives have been likened to aspirin: Taken as

prescribed for a headache they will make the pain go away.

If you take the whole bottle at once, you may kill yourself.

The expression derivative covers any transaction where

the is no movement of principal, and where the price

performance of derivatives is driven by an underlying

commodity.

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What is a Derivative?

A derivative is a contractual relationship established by two

(or more) parties where payment is based on (or derived

from) some agreed-upon benchmark. Since individuals can

create a derivative product by means of an agreement, the

types of derivative products that can be developed are

limited only by the human imagination. Therefore, there is

list of derivative products.

When one enters into a derivative product arrangement, the

medium and rate of repayment are specified in detail. For

instance, repayment may be in currency, securities or a

physical commodity such as gold or silver. Similarly the

amount of repayment may be tied to movement of interest

rates, stock indexes or foreign currency.

Derivatives, as the basic definition of the word implies, are

a synthetic by-product created or derived from the value of

the underlying asset, be it a real asset, such as gold wheat

or oil, or a financial asset, such as a stock, stock index,

bond or foreign currency.

Exchange traded derivatives- Derivatives which trade on

an exchange are called exchange traded derivatives. Trades

on an exchange generally take place with anonymity.

Trades at an exchange generally go through the clearing

corporation.

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OTC Derivative- A derivative contract which is privately

negotiated is called an OTC derivative. OTC trades have no

anonymity, and they generally do not go through a clearing

corporation. Every derivative product can either trade OTC

(i.e., through private negotiation), or on an exchange.

The most important derivatives are-

Forwards

A forward contract, as it occurs in both forward and futures

markets, always involves a contract initiated at one time;

performance in accordance with the terms of the contract

occurs at one time; performance in accordance with the

terms of the contract occurs at a subsequent time. further,

the type of forward contracting to be considered here

always involves an exchange of one asset for another. The

price at which the exchange occurs is set at the time of the

initial contracting. Actual payment and delivery of the good

occur later. So defined, almost everyone has engaged in

some kind of forward contract.

Futures

A futures contract is a type of forward contract with highly

standardized and closely specified contract terms. As in all

forward contracts, a futures contract calls for the exchange

of some good at a future date for cash, with the payment

for the good to occur at that future date. The purchaser of a

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futures contract undertakes to receive delivery of the good

and pay for it while the seller of a futures promises to

deliver the good and receive payment. The price of the

good is determined at the initial time of contracting.

Option

Option contracts confer the right but not the obligation to

buy in the case of a call or sell, in the case of a put a

specified quantity of an asset at a predetermined price on

or before a specified future date option contract would

expire if it is not in the best interest of the option owner to

exercise.

Swaps

Swaps generally trade in the OTC market but there is

monitoring of this market segment, which is now the largest

segment of the derivatives market as provided by the

international swap dealers associations (ISDA) and the

Bank of international settlements (BIS) Swaps which are

agreement between two parties to exchange cash flows in

the future according to a prearranged formula. In case of

popular interest rate swap, one party agrees to pay a series

of fixed cash flows in exchange for a sequence of variable

cost.

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HISTORY OF DERIVATIVES

Financial derivatives are not new; they have been around

for years. A description of the first known options contract

can be found in Aristotle a writings. He tells the story of

Thales, a poor Philosopher from Miletus who developed a

financial device which Thales said that his lack of wealth

was proof that philosophy was useless occupation and of no

practical value. But Thales knew what he was doing and

made plans to prove to others his wisdom and intellect.

Thales had great skill in forecasting and predicted that the

olive harvest would be exceptionally good the next autumn.

Confident in his prediction, he made agreements with Area

Olives Press owners to deposit what little money he had

with them to guarantee his exclusive use of their olive

presses when the harvest was ready. Thales successfully

negotiated low prices because the harvest was in the future

and no one know whether the harvest would be plentiful or

pathetic and because the olive-press owners ware willing to

hedge against the possibility of a poor yield.

Aristotle 1s story about Thales ends as one might guess:

When the harvest time came and many presses were

wanted all at once and of a sudden he let them out at any

rate which he pleased and made a quantity of money. Thus

he showed the world that philosophers can sort. So Thales

exercised the first known options contracts some 25,000

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years ago. He was not obliged to exercise the options. If

the olive harvest had not been good, Thales could have let

the option contracts expire unused and limited his loss to

the original price paid for the options. But as it turned out,

bumper crop came in, so Thales exercised the options and

sold his claims on these olive presses at a high profit.

Options are just one type of derivative instrument,

Derivatives as their name implies are contracts that are

based on or derived from some underlying asset, reference

rate, or index Most common financial derivatives, described

later, can be classified as one or a combination of four

types swaps, forwards, futures and options that are based

on interest rates or currencies.

Most financial derivatives traded today are the plain

vanilla variety the simplest form of a financial instrument.

But variants on the basic structures have given way to more

sophisticated and complex financial derivatives that are

much more difficult to measure manage and understand for

those instruments, the measurement and control of risks

can be far more complicated creating the increased

possibility of unforeseen losses.

Wall Streets stock-scientists are continually creating new

complex sophisticated financial derivative products.

However those products are all built on the foundation of

the four basic types of derivatives. Most of the newest

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innovations are designed to hedge complex risks in an

effort to reduce future uncertainties and manage risks more

effectively. But the newest innovations require a firm

understanding of the trade off of risks and rewards. To what

and derivatives users should establish a guiding set of

principles to provide a framework for effectively managing

and controlling financial derivative activit ies. Those

principles should focus on the role of senior management

valuation and market risk management credit risk

measurement and management enforceability operating

systems and controls and accounting and disclosure of risk

management positions.

Banks have long been involved in the purchase and sale of

derivatives products such as futures options and swaps.

Before the 1980s such activities were only of moderate

interest to bank regulators. Generally speaking the use of

derivatives by banks was expected to be limited to the

management of interest rate and exchange rate risks

associated with banking operations the derivatives were

limited to instruments for which the underlying asset was

an asset that was permissible for direct purchase by a bank.

But the 1980s saw a dramatic change in the nature and

extent of bank participation in the derivatives market.

Banks became increasingly involved in:

i. Trading activities that were not necessari ly related to

the management of risk and

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i i. Dealing in derivative instruments where the underlying

asset was not necessarily one that banks could buy or

sell.

Furthermore, banks became active participants in the OTC

derivatives market during the explosive growth of the

swaps market during this period. It seems that commercial

banks have suddenly become the primary (if not the

principal) participants in both domestic and international

swaps, futures, options and other derivatives markets.

The following table shows the instruments traded in the

global derivatives industry and outstanding contracts in

$billion.

1986 1990 1993 1994

Exchange

Traded

583 2292 7839 8838

Interest rate

futures

370 1454 4960 5757

Interest rate

options

146 600 2362 2623

Currency

futures

10 16 30 33

Currency

options

39 56 81 55

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Stock index

futures

15 70 119 128

Stock index

options

3 96 286 242

Some of the

OTC industry

500 3450 7777 11200

Interest rate

swaps

400 2312 6177 8815

Currency swaps 100 578 900 915

Caps, collars,

floors,Swaptions

- 561 700 1470

Total 1083 5742 16616 20038

Development of financial derivatives

1972 Foreign Currency Futures

1973 Equity Futures: Futures on Mortgage-backed

Bonds

1973 Equity Futures

1975 Treasury bill Futures on Mortage backed Bonds

1977 Treasury bond future

1979 Over the Counter Currency Options

1980 Currency Swaps

1981 Equity Index Futures; Options on T bond

Futures Bank CD Futures, T-note futures,

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Eurodollar Futures; interest-rate Swaps.

1983 Interest-rate Caps and Floor; Options on: T

note, future; Currency Futures; Equity Index

Futures.

1985 Eurodollar Options: Swaptions: Futures on US

Dollar and Municipal Bond Indices

1987 Average options Commodity Swaps Bond

Futures and Options Compound Options

1989 Three-month Euro-DM Futures Captions ECU

Interest-rate futures on interest rate Swaps

1990 Equity Index Swaps

1991 Portfolio Swaps

1992 Differential Swaps

Source: Phillips, K. Arrogant Capital (Boston: Mass, 1994)

CHARACTERISTICS OF DERIVATIVES:

Derivatives have increased in popularity because they offer

four distinct characteristics, which are not readily found

in any one asset or a combination of assets.

The most important is the close relationship between

the value of the derivative and its underlying assets,

which can be readily used to speculate or hedge. In a

speculative transaction the investor can lever his

investment through the purchase of the derivative asset

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exhibits almost identical profit potential in absolute

dollar value with greater percentage gains.

Secondly the existence of derivatives allows an investor

to readily acquire a short position in an asset. For

example, assume that an investor holds a bond

dominated in a foreign currency and will be obliged to

take position of that currency when the bond matures

(long position). Assume further that he is concerned that

the foreign currency may depreciate against his own

prior to maturity. In order to offset this risk he

undertakes to short himself by entering into a forward

agreement wherein he sells the currency at

predetermined rate guaranteed by the bank, thereby

eliminating the risk inherent in currency movements. It

is generally easier to take short position in derivative

assets than in the underlying asset.

Thirdly, exchange-traded derivatives can readily he

more liquid and exhibit lower transactions costs than a

variety of other assets. They exhibit increased liquidity

owing to their standardized terms and low credit risk. As

well, transactions costs and margin requirements tend to

be low.

Lastly, the investor can use derivatives through financial

engineering to construct portfolios which are highly

specific to the needs of the portfolio objectives, such as

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portfolio insurance techniques (e.g., purchasing

protective puts on individual stocks or stock indices) to

limit downside risk.

TYPES OF DERIVATIVES

One of the most misunderstood and maligned investment,

today is the derivative. A Derivative is a security or

contract whose market value is derived from an underlying

index, interest rate or asset including other securities.

There are several kind of derivatives of which the following

are the most important :

1. Forward Contracts

2. Future Contracts

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3. Swaps

4. Options

FORWARD CONTRACTS

In the forward market currencies are brought and sold at

prices agreed now but for future delivery at an agreed date.

Not only is delivery made in the future, but payment is also

made at the future date.

The main participants in the market are companies and

individuals, commercial banks, central banks and brokers.

Companies and individuals need foreign currency for

business or travel reasons. Commercial banks are the

source for which companies and individuals obtain their

foreign currency.

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There are also foreign exchange brokers who bring buyers,

sellers and banks together and receive commissions on

deals arranged. The other main player operating in the

market is the central bank, the main part of whose foreign

exchange activities involves the buying and selling of the

home currency or foreign currencies with a view to ensuring

that the exchange rate moves in line with established

targets set for it by the government.

Not only are there numerous foreign exchange market

centres around the world, but dealers in different locations

can communicate with one another via the telephone, telex

and computers. The overlapping of time zones means that

apart from weekends, there is always one centre that is

open.

A foreign exchange rate is the price of one currency in

terms of another. Foreign exchange dealers quote two

prices, one for selling, one for buying. The first area of

mystique in foreign exchange quotations arises from the

fact that there are two ways of quoting rates: the direct

quote and the indirect quote. The former gives the

quotation in terms of the number of units of home currency

to buy one unit of foreign currency. The latter gives the

quotation in terms of the number to buy one unit of foreign

currency. The latter gives the quotation in terms of the

number of units of foreign currency bought with one unit of

home currency.

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The rate at which the exchange is to be made the delivery

date and the amounts involved are fixed at the time of the

agreement.

Premium or discount on the forward trade

One of the major problems that newcomers to foreign

exchange markets have is understanding how the forward

premium and discount works and how foreign exchange

dealers quote for forward delivery. Assume that a quoted

currency is more expensive in the future than it is now in

terms of the base currency. The quoted currency is then

said to stand at a premium in the forward market relative

to the base currency. Conversely, the base currency is said

to stand at a discount relative to the quoted currency.

If a foreign currency stands at premium in the forward

market it shows that the currency is 'stronger' than the

home currency in that forward market. By contrast, if a

foreign currency stands at discount in the forward market,

it shows that the currency is 'weaker' than the home

currency in that forward market. The forward premium or

discount is always calculated as the annualized percentage

difference between the spot and forward rates as a

proportion of the spot rate - that is :

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Non - deliverable forward contracts

A new type of forward contract called non-deliverable

forward contracts (NDFs) is frequently used for currencies

in emerging markets. Like a regular forward contract, an

NDF represents an agreement regarding a position in aspecified amount of a specified currency a specified

exchange rate and a specified future settlement date.

However, an NDF does not result in an actual exchange of

the currencies at the future date. That is there is no

delivery. Instead a payment is made by one party in the

agreement to the other party based on the exchange rate atthe future date.

FUTURE CONTRACT

A futures contract is a type of forward contract with highly

standardized and closely specified contract terms. As in all

forward contracts, a future contract calls for the exchange

of some good at a future date for cash, with the payment

for the good to occur at that future date. The purchaser of a

future contract undertakes to receive delivery of the good

and pay for it while the seller of a futures promises to

deliver the good and receive payment. The price of the

good is determined at the initial time of contracting.

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It is important to understand how futures contracts differ

from other forms of forward contracts.

Comparison of the forward and future market.

Forward Futures

Size of contract Tailored to

individual needs

Standardized

Delivery date Tailored to

individual needs

Standardized

Participants Banks, brokers

and multinational

companies. Public

speculation not

encouraged

Banks, brokers

and multinational

companies.

Qualified public

speculation

encouraged

Security deposit None as such, but

compensating

bank balances or

lines of credit

required

Small security

deposit required.

Clearing operation Handling

contingent on

individual banks

and brokers.

No separate

clearinghouse

Handled by

exchange

clearinghouse.

Daily settlements

to the market

price.

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function

Marketplace Over the telephone

worldwide.

Central exchange

floor with

worldwide

communications

Regulation Self-regulating Commodity futures

trading

commission;

National futures

association

Liquidation Most settled by

actual delivery.

Some by offset at

a cost

Most by offset,

very few by

delivery.

Transaction costs Set by "spread"

between bank's

buy and sell prices

Negotiated

brokerage free

Source : Reprinted with the permission of the Chicago

Mercantile Exchange

Note : Clearing House

Future contracts trade in a smoothly functioning market,

each futures exchange has an associated clearinghouse. The

clearinghouse may be constituted as a separate corporation

or it may be part of the futures exchange, but each

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exchange is closely associated with a particular

clearinghouse.

In addition the clearinghouse, there are other safeguards

for the futures market. Chief among these are the

requirements for margin and daily settlement. Before

trading a futures contract the prospective trade must

deposit funds with a broker. These funds serve as a good

faith deposit by the trader and are referred to as margin.

The main purpose of margin is to provide a financial

safeguard to ensure that traders will perform on their

contract obligations.

The function of the clearinghouse in future market

Obligations without a clearinghouse

Goods

FundsBuyer Seller

Obligations with a Clearinghouse

Goods Goods

BuyerFunds

Clearinghouse Funds Seller

Types of Future contracts

The types of futures contracts that are traded fall into four

fundamentally different categories. The underlying good

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traded may be a physical commodity, a foreign currency, an

interest earning asset or an index, usually a stock index.

Agricultural and metallurgical contracts : In the

agricultural area, contracts are traded in grains (corn, oats,

and wheat), oil and meal (soybeans, soyameal, and soyaoil,

and sunflower seed and oil), live-stock (live hogs, cattle,

and pork bellies), forest products (lumber and plywood),

textiles (cotton), and foodstuffs (coca, coffee, orange juice,

rice and sugar). For many of these commodities, several

different contracts are available for different grades or

types of the commodity. For most of the goods, there are

also a number of months for delivery. The months chosen

for delivery of the seasonal crops generally fit their harvest

patterns. The number of contract months available for each

commodity also depends on the level of trading activity.

Interest - Earning Assets: Futures trading on interest-

bearing assets started only in 1975, but the growth of this

market has been tremendous. Contracts are traded now on

Treasury bills notes, and bonds, on Eurodollar deposits, and

on municipal bonds. The existing contracts span almost the

entire yield curve, so it is possible to trade instruments

with virtually every maturity.

Foreign Currencies : Active futures trading of foreign

currencies dates back to the inception of freely floating

exchange rates in the early 1970s. contracts trade on the

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British pound, the Canadian dollar, the Japanese yen, the

franc, and the German mark. Contracts are also listed on

French francs, Dutch guilders, and the Mexican peso, but

these have met with only limited success and are no longer

traded.

Indexes : The last major group of futures contracts is for

indexes. Most but not all of these contracts are for stock

indexes. Beginning only in 1982, these contracts have been

quite successful, with trading on market indexes in full

swing.

One of the most striking things about these stock index

contracts is that they do not admit the possibility of actual

delivery. A trader's obligation must be fulf il led by a

reversing trade or a cash settlement at the end of trading.

Closing a future position

There are three ways to get out of a futures position once

you take it.

You can satisfy the contract by delivering the goods. This is

called delivery. Depending on the wording of the contract,

delivery may be made by physically delivering the goods to

the designated location or by making a cash settlement of

any gain or losses.

You may make a reverse, or offsetting, trade in the future

market. Since the other side of your position is held by the

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clearinghouse, i f you make an exact opposite trade

(maturity, quantity and good) to your current position the

clearinghouse will net your positions out, leaving you with a

zero balance.

A position may also be settled through an exchange for

physicals (EFP). Here, you find a trade with an opposite

position to your own and deliver the goods and settle up

between yourselves off the floor of the exchange (Called an

ex-pit transaction.

Purpose of future market

Futures market have been recognized as meeting the need of

three groups of futures market users: those who wish to discover

information about future price of commodities those who wish to

speculate and those who wish to hedge. Thus, there are two main

social functions of futures markets - price discovery and hedging.

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SWAPS

A swap is an agreement between two or more parties to

exchange a sequence of cash flows over a period in the

future. For example, Party A might agree to pay a fixed rate

of interest on $1 million each year for five year to Party B.

In return, Party B might pay a floating rate of interest on

$1 million each year for five years. The parties that agreeto the swap are known as counterparties. The cash flows

that the counterparties make are generally tied to the value

of debt instruments or to the value of foreign currencies.

Therefore, the two basic kinds of swaps are interest rate

swaps and currency swaps.

The swaps market

For purposes of comparison, we begin by summarizing some

of the key features of futures and options markets. Against

this background, we focus on the most important features

of the swap product. On futures and options exchange

major financial institutions are readily identifiable. Forexample in a futures pit, traders can discern the activity of

particularly firms, because traders know who represents

which firm. Therefore exchange trading necessarily involves

a certain loss of privacy. In the swaps market, by contrast

only the counterparties know that the swap takes place.

Thus the swaps market affords a privacy that cannot beobtained in exchange trading.

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We have noted that futures and options exchanges are

subject to considerable government regulation. By contrast,

the swaps market has virtually no government regulation.

As we will see later swaps are similar to futures. The swaps

market feared that the commodity futures trading

commission might attempt to assert regulatory authority

over the swaps market on the grounds that swaps are really

futures. However the commodity futures trading

commission has formally announced that it will not seek

jurisdiction over the swaps market. This means that the

swaps market is likely to remain free of deferral regulation

for the foreseeable future. For the most part, participants in

the swaps market are thankful to avoid regulation. The

international swaps and derivatives association inc. (ISDA)

is an industry organization that provides standard

documentation for swap agreements and keeps records of

swap activity.

Bankers are in the business of taking deposits in various

currencies on the basis of a fixed or floating interest rate.

At the same time banks offer to make loans in various

currencies on a fixed or on a floating interest rate basis.

The fact that banks are prepared to take deposits on a

floating basis and to lend on a fixed basis-and vice versa -

in a particular currency gives the essential rationale for the

interest rate swap market. The fact that banks will take

deposits in one currency on a fixed or floating basis and

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also make loans to customers in a different currency on a

fixed or floating basis provides an underpinning to the

currency swap market.

Interest rate swaps

A swap- whether an interest rate swap or a currency swap -

can simply be described as the transformation of one

stream of future cash flows into another stream of future

cash flows with different features. An interest rate swap is

an exchange between two counterparties of interest

obligations (payments of interest) or receipts (investment

income) in the same currency on an agreed amount of

notional principal for an agreed period of time. the agreed

amount is called notional principal because, since it is not a

loan or investment the principal amount is not initially

exchanged or repaid at maturity. An exchange of interest

obligations is called a liability swap; an exchange of interest

receipts is called an asset swap. Interest streams are

exchanged according to predetermined rules and are based

upon the underlying notional principal amount.

There are two main types of interest rate swap - the coupon

swap and the basis swap. Coupon swaps convert interest

flows from a fixed rate to a floating rate basis or the

reverse, in the same currency. A simple example is shown

in figure 1. In the figure the arrows refer to interest

payment flows.

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Basis swaps convert interest flows from a floating rate

calculated according to one formula to a floating rate

calculated according to another. For example, one set of

interest flows might be set against six-month dollar LIBOR,

while the other set of flows might be based upon another

floating rate such as US commercial paper, US Treasure Bill

Rate or LIBOR based upon one-or three-month maturities.

Figure 2, givens an example of a basis swap.

Figure 1 Coupon Swap

Company

X

Fixed rate 12%

Floating rate based upon 6-monthLIBOR?

Bank

Figure 2 Basis Swap

Company

X

Floating rate -6month $ LIBOR

Floating rate - US Commercial paper

Bank

Currency swaps

Fixed rate currency swap involves counterparty A

exchanging fixed rate interest in one currency with

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counterparty B in return for fixed rate interest in another

currency. Currency swaps usually involve three basic steps:

Initial exchange of principal

Ongoing exchange of interest

Re-exchange of principal amounts on maturity.

The initial exchange of principal works as follows. At the

outset, the counterparties exchange the principal amounts

of the swap at an agreed rate of exchange. This rate is

usually based on the spot exchange rate, but a forward rate

set in advance of the swap commencement date may also

be used. This initial exchange can be on a notional basis -

that is, with no physical exchange of principal amounts - or

alternatively on a physical exchange basis. Whether the

initial exchange is on a physical or notional basis, its

importance is solely to establish the reference point of the

principal amounts for the purpose of calculating first, the

ongoing payments of interest and, secondly the re-

exchange of principal amounts under the swap. The ongoing

exchange of interest is the second key step in the currency

swap. Having established the principal amounts, the

counterparties exchange interest payments on agreed dates

based on the outstanding principal amounts at fixed interest

rates agreed at the outset of the transaction. The third step

in the currency swap involves the ultimate re-exchange of

principal amounts at maturity.

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Currency coupon swap

Essentially this is a combination of interest rate swap and

fixed rate currency swap. The transaction follows the three

basic steps described for the fixed rate currency swap. The

transaction follows the three basic steps described for the

fixed rate currency swap except that fixed rate interest in

one currency is exchanged for floating rate interest in

another currency.

Imagine a borrower which is in a relatively favourable

position, for example to raise long-term fixed rate US dollar

funding but in fact wants floating rate yen. The currency

swap market enables it to marry its requirements with

another borrower of relatively high standing in the yen

market but which does not have similar access to long-term

fixed rate dollars. The gain accrues by each corporation

swapping liabilities raised in those markets which each can

readily access; the effect is to broaden the access of

borrowers to international lending markets Clearly, the

currency swap enables the treasurer to alter the

denomination of his or her liabilities and assets.

Swap transactions may be set up with great speed, and

their documentation and formalities are generally much less

detailed than in other large financial deals - swap

documentation is normally shorter and simpler than that

relating to term loan agreements. Transaction costs are

relatively low too. And swaps can be unwound easily.

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OPTIONS

Everyone has options. When buying a car, we can add more

equipment to the automobile that is "optional at extra

cost." In this sense an option is a choice. This book

examines options in financial markets. These are a very

specific types of option - an option created through a

financial contract.

Options have played a role in security markets for many

years, although no one can be certain how long. Initially,

options were created by individualized contracts between

two parties. However, until recently there was no organized

exchange for trading options. The development of option

exchanges stimulated greater interest and more active

trading of options. The development of option exchanges

stimulated greater interest and more active trading of

options. In many respects the recent history of option

trading can be regarded as an option revolution.

Every option is either a call option or a put option. The

owner of a call option has the right to purchase the

underlying good at a specific price, and this right lasts until

a specific date. In short the owner of a call option can call

the underlying good away from someone else.

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Likewise, the owner of a put option can put the good to

someone else by making the opposite party buy the

good.To acquire these rights, owners of options buy them

from other traders by paying the price, or premium, to

seller.

Options are created only by buying and selling. Therefore

for every owner of an option, there is a seller. The seller of

an option is also known as an option writer. The seller

receives payment for an option from the purchaser. In

exchange for the payment received, the seller confers rights

to the option owner. The seller of a call option receives

payment and in exchange, gives the owner of a call option

the right to purchase the underlying good at a specific

price, with this right lasting for a specific time. the seller of

a put option receives payment from the purchaser and

promises to buy the underlying good at a specific price for a

specific time, it the owner of the put option chooses.

In these agreements all rights lie with the owner of the

option. In purchasing an option the buyer makes payments

and receives rights to buy or sell the underlying good on

specific terms. In selling an option the seller receives

payment and receives rights to buy or sell the underlying

good on specific terms. In selling an option the seller

receives payment and promises to sell or purchase the

underlying good on specific terms - at the discretion of the

option owner. With put and call options and buyers and

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sellers, four basic positions are possible. Notice that the

owner of an option has all the rights. After all that is what

the owner purchases. The seller of an option has all the

obligations, because the seller undertakes obligations in

exchange for payment.

Let us now see some of the commonly adopted strategies

using hybrid options combinations:-

Strategies-

Straddle- Straddle is a strategy which involves buying

or selling (writing) both a call and a put on the same

stock with both the options having the same exercise

price.

Strip- Buying two put options and one call options of

the same stock at the same exercise price and for the

same period, such a strategy is called a Strip. This

strategy may be used when there is a strong

possibility of declining value of stock.

Strap- A Strap is buying two calls and one put when

the buyer feels that the stock is more likely to rise

steeply than to fall, i.e. a possibility skewed in the

direction opposite to the one assumed in the case of a

strip.

Spreads- A spread involves the purchase of one option

and sale of another (i.e.), writing) on the same sock.

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It is important to note that spreads comprise either all

calls or all puts and not a combination of the two, as

in a straddle, strip or a strap.

Option spreads having different exercise prices but the

same expiration date are called vertical spreads and are

listed in a separate block in the quotation lists.

On the other hand if the exercise prices are the same and

the expiration dates are different such combinations are

called horizontal spreads. These are listed in horizontal

rows in the quotation lists. Time spreads and calendar

spreads are forms of horizontal spreads.

Mixtures of vertical and horizontal spreads comprising

options with different expiration dates and exercise prices

are called diagonal spreads.

Price of an Option

Options are generally traded on different types of strike

prices. At the money, in the money and out of money.e.g.

If the call option is traded at a strike price equal to that of

underlying spot price of the equity, then it is called At the

money. If the strike price is lesser than the underlying spot

price, it is called In the money and similarly if the strike

price is greater than the underlying spot price it is called

Out of Money.

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Thus, if the buyer of an option is making a profit/loss than

the option is In the money/Out of money respectively.

An option writer charges an upfront premium from the

buyer for selling a right. The premium charged consists of

two parts 1) the intrinsic value and 2) time value. The

intrinsic value of a put option is the difference between the

strike price and the spot price, whereas the intrinsic value

of a call option is the difference between the spot price and

the strike price. Time value of an option is the price the

buyer of an option has to pay to the writer of an option

because of the risk the writer of the option takes. This is

over and above the intrinsic value of that an option holder

pays. Generally, the premium charged by the writer of an

option is equal to the sum of both the intrinsic value and

the time value.

The factors affecting the price of an option

The various factors affecting the price of an option include

the price of the underlying asset, the strike price of the

option, the volatility of the underlying stock, the expiration

time and interest rate in the country. Factors like the rate

of interest at which the writer is investing the money and

the type of option whether American or European also

effects the price of an option.

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Why trade options?

1. Options can be used to speculate on price movements

Call option are always cheaper than the underlying stock.

Put options are almost always cheaper than the

underlying stocks price.

Options prices are more volatile than the underlying

stock's price

2. Option can be used to reduce risk exposure

Options can be used to adjust the risk return

characteristics of a portfolio.

Options can be used to eliminate risk altogether Options can be combined with stocks to a perform like

risk free bonds.

3. Options can be used to reduce transaction costs.

4. Options can be used to avoid tax exposure

5. Options can be used to avoid market restrictions. There

are restrictions on short selling that can be avoided bybuying puts.

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FUNCTIONS OF DERIVATIVES

The three basic functions of financial institutions and

financial markets naturally also apply to the wide area

of derivatives. Three functions are discussed in more

detail:

Risk sharing and market completion;

Implementation of asset allocation decisions;

Information gathering.

Trivially derivative transactions appear to be zero-sum

games (transaction costs and other costs neglected). Why

should zero-sum games be economically beneficial? As amatter of fact, derivatives are at best monetary zero-sum

games, i.e., with respect to the involved cash flow. But the

economic nature of derivatives cannot be understood by an

isolated analysis of the resulting cash flows stemming from

derivative transactions. If instead, derivatives are analyzed

in an economic setting where for example, risk allocationand imperfect information are relevant structural

characteristics of the financial system and the economy,

derivatives turn out to have strong welfare effects. As such

they are not zero-sum games in allocative terms.

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Risk Sharing

The major economic function of derivatives is typically seen

in risk sharing derivatives provide a more eff icient

allocation of economic risks. Examples of risk management,

which have already been mentioned are illustrative but they

do not address the question why derivatives are necessary

to attain a better social allocation of risks. A systematic

analysis of this question is provided by the state-preference

to attain a better social allocation of risk. A systematic

analysis of this question is provided by the state-preference

model developed by Arrow (1953, 1964) and Debreu

(1959). Within this framework, it can be shown that options

have a tremendous power to complete the capital markets.

The principal characteristic of a complete market is that the

entire set of state securit ies can be constructed with

portfolios of existing assets. The economic implication of

complete markets is straightforward. If there is

unconstrained trading in the state securities then

individuals are able to achieve any desired risk allocation

pattern in terms of payoff distributions across states. This

implies an unconstrained Pareto efficient allocation of risk.

This approach was taken by Ross (1976) and Hakansson

(1978) to demonstrate the welfare effects of options in

incomplete markets.

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Implementation of strategies

Portfolio strategies can be classified as either static or

dynamic. One of the most attractive features of options is

that they enable a static strategy to achieve the same

payoffs as dynamic strategies relying on stocks and bonds.

Static strategies represent buy-and-hold investments in

stocks, bonds options, futures, and other securities. In

order to enhance the full risk-return investment spectrum,

static strategies require cheap diversification and leverage

opportunities. Derivatives significantly reduce the cost of

diversification and provides for heavy leverage

opportunities.

Derivatives are available on many aggregate economic risk

factors such as global bond and stock portfolios. With many

futures contacts, global risk positions and portfolios can be

traded as a s ingle financial product. While for example, it is

difficult to trade baskets of securities at stock exchanges

stock index options and futures offer opportunities to trade

aggregate stock market risks for as much as 1/10 or 1/20

of the costs of an equivalent cash market transactional.

Derivatives also facilitate diversification because, given

amount of capital across several assets. Finally, if more risk

can be diversified the systematic risk exposure of the

economy decreases which lowers the overall cost of risk

capital for firms. Further leverage opportunities are often

expensive and complicated to implement for many investors

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in the cash market or are simply not feasible. However,

options and futures represent (highly) levered investment

in the underlying cash instruments and require only a small

fraction of the investment in the underlying securities. The

availabi li ty of a specific, highly levered instrument

facilitates to take a risk exposure which exactly matches

the risk preference of the investor, and which exactly

matches the risk preference of the investor and which

cannot be achieved through (static) positions in stocks and

cash.

Information gathering

In a perfect market with no transactions costs no

frictions and no informational asymmetries, there

would be no benefit stemming from the use of

derivative instruments. However, in the presence of

trading costs and market illiquidity, portfolio

strategies are often implemented or supplemented

with derivatives at substantial lower costs compared

to cash market transactions. In this respect the

welfare effect of derivative instruments results from a

reduction in transaction costs. But this is only a part

of the real economic benefit of derivatives. If risk

allocation is the major function of these instruments,

and because risk is also related to information,

derivative markets also affect the information

structure of the financial system. The information

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structure of the financial system. The information

structure is a major determinant of the dynamics and

the stability of the economic system. The information

on aggregate economic factors (interest rates stock

indices oil price, etc.) is more efficiently processed

and reflected in futures (and options) markets and

supports their price discovery role. Thus with respect

to the information flow, it is the cash market, which

should be regarded as the derivative with respect to

the futures (and options) market! Empirical evidence

often demonstrates that mature futures markets

systematically lead the underlying cash market.

Investors use derivatives for four basic purposes :

To hedge risk;

To speculate and profit from anticipated market

movements;

To adjust portfolios quickly and cheaply;

To arbitrage price discrepancies in financial markets.

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ADVANTAGES AND DISADVANTAGES

Financial innovation that led to the issuance and trading of

derivative products has been an important boost to the

development of financial markets. Derivative product such

as options, futures or swap contracts have become a

standard risk management tool that enables risk sharing

and thus facilitates the efficient allocation of capital to

productive investment opportunities. While the benefits

stemming from the economic functions performed by

derivative securities have been discussed and proven by

academics, there is increasing concern within the financial

community that the growth of the derivatives markets-

whether standardized or not-destabilizes the economy. In

particular, one often hears that the widespread use of

derivatives has reduced long term investments since it

concentrates capital in short term speculative transaction.

In this study, we have tried to look at the various pros and

cons that the derivative trading pose.

BENEFITS OF DERIVATIVES

The recent studies of derivatives activity have led to a

broad consensus, both in the private and public sectors,

that derivatives provide numerous and substantial benefits

to end-users.

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Derivatives as means of hedging

Derivatives provide a low-cost, effective method for end

users to hedge and manage their exposures to interest

rates commodity prices or exchange rates. Interest rate

futures and swaps, for example, help banks of all sizes

better manager the re-pricing mismatches in funding long

term assets, such as mortgages, with short term liabilities

such as the certificates of deposit. Agricultural futures and

options help farmers and processors hedge against

commodity price risk. Similarly, airlines and oil refiners can

use commodity derivatives to hedge their exposures to

fluctuating fuel and oil prices. Final ly multinational

corporations can hedge against currency risk using foreign

exchange forwards, futures or options.

Derivatives also allow corporations, and institutional

investors to more effectively manage their portfolios of

assets and liabilities. An equity fund for example, can

reduce its exposure to the stock market quickly and at a

relatively low cost without selling off part of its equity

assets by using stock index futures or index options.

Corporate borrowers and governmental entities can

effectively manage their liability structure the ratio of fixed

to floating rate debt and the currency composition of that

debt using interest rate and currency futures and swaps.

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Improves market efficiency and liquidity

Well functioning derivatives improves the market efficiency

and liquidity of the cash market. The launch of derivatives

has been associated with substantial improvement in the

market qualify on the underlying equity market. This

happens because of the low transaction costs involved and

arbitrageurs will face low costs when they are eliminating

the mispricings. Traders in individual stocks who supply

liquidity to these stocks use index futures to offset their

index exposure and hence able to function at lower levels of

risk.

Allows institutions to raise capital at lower costs

Corporations, governmental entities and financial

institutions also benefit from derivatives through lower

funding costs and more diversified funding sources.

Currency and interest rate derivatives provide the ability to

borrow in the cheapest capital market, domestic or foreign,

without regard to the currency in which the debt is

denominated or the form in which interest is paid.

Derivatives can convert the foreign borrowing into a

synthetic domestic currency financing with either fixed-or

floating-rate interest institutional investors and portfolio

managers may enhance asset, yields, diversify their

portfolios, and protect the value of illiquid securities by

using derivatives.

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Allows exchanges to offer differentiated products

In spot market, the ability for the exchanges to

differentiate their products is limited by the fact that they

are trading the same paper. In contrast, in the case of

derivatives there are numerous avenues for product

differentiation. Each exchange trading index option has to

take major decisions like choice of index choice of contract

size, choice of expiration dates, American Vs European

options, rules governing strike price etc. Thus in derivatives

area, it is easier for exchanges to differentiate themselves

and find subsets of the user population which require

different features in the product thus making the market

place competitive.

Participating in derivatives activity benefits derivatives

dealers by increasing both the average credit quality and

the diversity of credit risk to which they are exposed. This

activity provides a profitable and stable earnings stream

that helps to build capital and diversify sources of earnings.

Finally as banking supervisors have rightly emphasized,

improvements in risk management techniques that were

first applied to derivatives are now spilling over into and

improving the management of risks in other more

traditional business banks taking deposits and making

loans, securities firms purchasing and financing securities

positions. Or corporations managing their treasury function.

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These improvements in risk management, in turn enhance

the safety and profitability of these institutions.

Assists in Capital formation in the economy

By providing investors and issuers with a wider array of

tools for managing risks and raising capital, derivatives

improve the allocation of credit and the sharing of risk in

the global economy, lowering the cost of capital formation

and stimulating economic growth. It improves the markets

ability to carefully direct resources towards the projects and

industries where the rate of return is the highest. This

improves the allocative efficiency of the market and thus a

given stock of inevitable funds wil l be better used in

procuring the highest possible GDP growth for the country.

By providing domestic firms with new and more effective

tools to manage their inherent risk exposures, derivatives

reduce the likelihood that these firms will face financial

distress, helping to stabilize employment. Moreover with

these incidental risk exposures under control, management

can focus on its core business strategy-improving the

quality and lowering the cost of its product.

The growth in derivatives activities yields substantial

benefits to the economy and by facilitating the access of

the domestic companies to international capital markets

and enabling them to lower their cost of funds and diversify

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their funding sources, derivatives improve the position of

domestic firms in an expanding competitive global

economy.

Improved ROI (IN the books) for institutions

Derivatives are basically off-balance trading in that no

transfer of principal sum occurs and no posting in the

balance sheet will be required. Consequently a fund that

corresponds to the principal sum in traditional financial

transactions (on -alance trading) is unnecessary, thus

substantially improving the return on investment. Looking

at the restriction on the ratio of net worth, on the other

hand, the risk ratio of assets that form the basis for

calculating the net worth in off-balance trading is assumed

to be lower than that in the traditional on balance trading.

In practice calculated by multiplying the assumed amount

of principal of an off-balance trading by a risk-to-value ratio

is to be weighted by the creditworthiness of the other

party. Eventually the impact of the restriction on the ratio

of net worth in derivative transactions is relatively lower

than in the case of traditional financial transactions. This is

a quite important aspect when utilizing a limited amount of

available capital to the best of its advantage.

Derivatives have strengthened the important linkages

between global markets, increasing market liquidity and

efficiency and facilitating the flow of trade and finance.

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DISADVANTAGES OF DERIVATIVES

Many stories have invaded the non-academic financial press

with attention generating headlines which may actually

mislead many readers. To be fair to the popular press,

many of the stories written present a more balanced picture

than the images conjured up by the attention glabbing

headlines. For example in The Devils in the Derivatives.

It is revealed that one investor, who had suffered derivative

losses through an investment fund, had not closely

examined that fund prior to investing when he did examine

its structure but only after incurring the loses he discovered

that it was a hedge fund, intended to protect against falling

interest rates.This unfortunate investor , however, had

been lured to the fund by impressive past performance and

was not looking to hedge another position. As a result this

investor became an unwitting speculator.

Still the reporting of the workings of derivatives markets

has been slanted, and several unproven or misleading

claims have been promoted. These range from the simple

claim that they are risky investment, to the charge that

speculation in derivatives has superseded traditional

investing, and the arguments are:

Derivative securities are risky

Derivative securities create risk.

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Derivative securities generate volatility

Derivative securities are speculative investments

Derivative securit ies have caused speculation to

displace investment.

Derivative Securities are Risky

This is the most common claim made against derivatives

apparently based on the magnitude of the losses which the

popular press has reported .Several; important points must

be considered in this regard. The first is that risk is often a

relative (as opposed to absolute) measure in the same way

that hot and cold are relative. It is improper to

categorically state that any particular security is risky, as

all securities even the risk free government bonds have

some level or form of risk associated with them . The level

of risk must be referenced to that of another security: for

example, a stock entails more risk than a government bond.

This relative risk is also dependent upon the perception of

the individual, as each person has differing level of risk

tolerance. That is, two people many examine the same

situation and while one may assess the risk as excessive

the other could view the associated risk as minimal This

difference is highly dependent upon the level of knowledge

and experience of the individual. To most people, walking

on a high wire would be viewed as very risky. For the

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trained and practiced tightrope artist who might perform

such a feat daily , the level of risk is not perceived to be

significantly different than the average person views going

to work each day. Thus a financial manager charged with

dealings in foreign currencies would not likely view currency

derivative contracts to be as risky as a casual investor

would.

Risky level is also situation specific . Generally the more

significant the loss resulting from an unfavorable outcome,

the greater the risk one associates with the venture. If a

person while hiking the woods, came upon a small stream

where the only way across was a narrow log suspended

between the banks. The hiker would probably use it to

cross the stream. The unfavorable out come facing the

hiker is losing his or her balance and falling off the log, But,

the associated loss is likely to be only a very wet pair of

feet. The situation changes if that same log is suspended

across a deep gorge. The unfavorable outcome is the same

loosing balance and falling off the log. But now the fallout

from that event could be the loss of life and the hiker

would not likely attempt the crossing. For the investor,

more risk is associated with an investment where total loss

would have a greater effect (such as bankruptcy than one

which would represent an insignificant fraction of total

wealth.

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Any investor must analyze the level of risk he is willing to

accept, and invest accordingly. For Procter & Gamble which

lost U.S.$ 157 million in derivatives, the investments made

were not part of its investment strategy and were in fact in

violation of corporate policy. Once invested, the investor

must also watch the situation because it can change

(markets are dynamic) and the strategy must be adjusted

accordingly. This may have been the trap that caught

Orange Country Treasurer Robert Citron. He had

successfully pursued a strategy (which had been agreed to)

for several years but when interest rates initially began to

rise that strategy should have been reassessed It does not

appear that it was instead of cutting the loses short, they

kept mounting Within a relatively short period(about nine

months from the first rate increase) losses mounted to

approximately U S $ 1.5 billion.

Derivative Securities Create Risk

Which came first the chicken or the egg.? There are many

seemingly simple question which have frustrated great

minds, since the beginning of time . Derivatives were

created as a means of reducing risks experienced with

traditional securities through hedging . But does their

existence create or increase financial risk. As derivative

securities and skills in risk management have evolved. It

has become apparent that many businesses are actually

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exposed to form of risk that in a superficial examination

one would not expect to encounter. The principles of risk

management quickly became relatively complex as did the

derivatives used to manage the risks. It may be that as

these risks have been identified as the risk management

techniques evolve one could get the impression that they

are new risks hence, the creation of risk. These risks have

always existed however they just were not considered to

be there or were inadequately measured or understood.

One argument against the creation of risk is that the

hedging function of derivatives is achieved through risk

transference. This means that through the derivative a risk

that one person, the hedger, it is not willing to take is

transferred to someone, the speculator who is No new or

additional risk is created in this scenario Just the bearer of

the risk changes. The investment risk that arises with a

derivative contract(in a non-hedging role) is the result of

future unpredictability. At the point in time that the

contract is derived a spot price exists in the market. The

contract specifies a price (or rate) that the agreed

transaction will be performed at in the future. That future

price is therefore , an estimate or prediction of the spot

price at the future point in time. The future price set each

day and the spot price must converge as the contract

expiry date approaches becoming equal on the final day or

settlement of the contract. The risk to the non hedging

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investor is that the spot price in the future does not equal

the estimated price made now.

Derivative Securities Generate Volatility

This claim is linked to the assertion that derivatives create

risk, as volati li ty is the most accepted measure for

assessing relative risk. To understand how volatility is used

to measure risk one must full appreciate a basic tenet of

market price movement know as the Random Walk theory.

The hypothesis states that market prices of a security will

fluctuate randomly about its intrinsic value and that its

basic intrinsic value will not change without new input(s)

This means that any specific price movement it completely

unrelated to the previous move which further means that

subsequent price moves are unrelated Volatil ity is

insensitive to direction and only reflects the magnitude of

problem movements. Following any price movement the

subsequent price move has equal probability of being

either upwards or down wards.

Volatility is linked to risk in this manner. A security with a

higher volatility than another has a higher probability of a

large, random price movement. Since it is just as likely that

the price move would be down as up there is a greater

probability of large drop in price for this security than for

the one with lower volatil ity: hence the more volatile

security carries grater risk.

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The popular perception is that volatility is undesirable and

this is not unreasonable given the way it is used to quantify

risk However, volatility which is more specifically a measure

of how quickly a security price may change is necessary for

one to profit. If a security completely stable with volatility

of zero its price would be unchanging an no profit would be

possible. When markets advance steadily as they did

through 1993, they are considered to be stable when,in

fact, they change continually, they must be volatile. There

is no link which shows that the use of derivatives has

increased market volatilities .

Derivative Securities are Speculative Investments

In describing derivatives, the press has continually referred

to them as bets on a movement in one direction or the

other The connotation that this terms implies is decidedly

unfair To address this clam. Consider a California lettuce

farmer and a Canadian Supermarket chain while keeping in

mind the idea of risk transference. In the spring when the

farmer plants his crop the risk that arises is that at harvest

time the price for the crop may be so low that the value of

the crop will be less than what it cost of plant, care for

harvest and deliver it If the farmer finds that in his view

that the risk is exceedingly high he will want to hedge the

position. To do so the farmer can enter into a forward sale

contract ( a commodity derivative) to insure that the price

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received at harvest wil l provide a profit Commodity

derivatives have long been accepted and used to manage

such risks.

The forward sale contract could be arranged between the

farmer and the eventual purchaser. While the farmer faces

the risk of a low price. the purchaser faces the risk of a

high price One might assume that if the risk of a low price

is high, then the risk of a high price would be low and the

purchaser should not worry. However if the market price

has been rising and falling sharply and inconsistently both

may view their risk as too great, and each can address

their risk by arranging the forward commodity contract

with each other fixing the future price of their transaction

with certainty:

Financial derivatives are used in exactly the same manner.

If it is assumed that the forward commodity contract is

denominated in U.S dollars the Canadian market will need

to exchange Canadian for American currency at some point

in time to pay for the crop becoming a seller of Canadian

Funds. The risk to the purchaser is that between now and

the commodity sale the Canadian dollar may weaken

relative to the U.S. dollar making the transaction more

costly . To manage this risk, the supermarket can use a

financial derivative such as a currency option or futures

contract to ascertain the cost of acquiring U.S. funds just

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as the commodity derivative was used to fix the cost of

acquiring the commodity crop.

Who is a speculator? Is a speculator someone who is willing

to accept higher level of risk than the average person or is

it someone who enters a situation without any consideration

of the risk involved? If it is the former one encounters a

problem since risk is a relative measure. How does one

position a cross over point between an investor and a

speculator on a sliding pace? If it is the latter type of

person, it is very difficult to imagine someone who would

not have some preconceived notion of possible out comes.

Who one person may think of as speculator, another may

consider to be a very well informed investor. In general

when speaking of speculators in the markets one is

referring to a person who has no desire or need to hedge a

position in the underlying security but only wishes to profit

in changes in its price.

But also consider an investor in stock which has a clam on a

company s assets. Most investors would have no desire to

acquire those assets but only wish to profit from changes

in the stock . Speculator used only in differentiate one

from a hedger on a bi polar scale, may just be a rather

unfortunate choice of label. The hedger is trying to protect

an existing position from incurring losses, while the

speculator is establishing a position to potentially earn a

profit.

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The financial press has claimed that the use of derivatives

has led to speculation surpassing investment as the prime

motive for transactions in the financial markets. That is,

the majority of transactions are gambles, rather than

rationally assessed investment strategies. The logic in

arriving at this assertion seems to go as follows

derivatives are speculative Derivative markets have grown

faster than traditional markets and derivative volumes now

exceed traditional volumes: Therefore speculation has

displaced investment.

If one believes that derivatives do indeed open certain

financial markets to a green population segment than it is

logical that market volumes would be high. The growth

should not be surprising either considering that while

derivatives have been around much longer than most

people believe formal organized markets for financial

derivatives are relatively new. With new derivative products

constantly being devised and the understanding of risk

management increasing the industry could be as one would

naturally expect in a growth phase of its life cycle. The

growth rates may be impressive as present but one would

expect moderation of the growth in the future.

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RISKS ASSOCIATED WITH DERIVATIVES

The following seven categories of risk have been defined in

the USA by the Senate Banking Committee, Federal Reserve

Board, Federal Deposit Insurance Corporation, and Office of

Comptroller of the Currency:

CREDIT RISK

For derivatives where there is a firm commitment by the

parties, credit exposure is measured not by the national

amount of the contract, but by the cost to replace it in the

market. Since most such contracts are made free or for a

nominal fee, there is no immediate credit risk. The potential

risk arises from movement of the underlying security that

results in a positive value to the contract. The possibility of

the counterpart reneging on the deal creates the credit

exposure. Conversely, contracts that contain options have

an immediate value to the seller due to the premium paid

by the buyer. The buyer of these types of contracts carries

the credit risk unless the value of the option is reduced to

zero as a result of market movements. The seller has no

credit risk.

MARKET RISK

As with all financial instruments, derivatives are subject to

various price risks. The market risk of derivatives is

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generally a function of the same risks facing the underlying

security, although the extent varies considerably depending

on the nature of the derivatives contract. Most institutions

dealing in derivatives break market risk into its components

(e.g., exchange rate risk, interest rate risk, raw material

prices risk, etc.)

OPERATING RISK

When venturing into the derivatives market, organizations

need sophisticated, high-tech dealing systems in order to

maintain internal control. Without such systems.

Organizations are vulnerable to errors (both accidental and

deliberate) that can result in substantial losses. Included in

this type of risk is the need for senior management to

understand the various method employed by their

treasurers. Similarly, treasurers need to be aware of the

principles underlying senior managements risk-

management strategy. It was the lack of protection from

this type of risk that resulted in the Sterling Pounds 860

million loss to barring PLC.

SETTLEMENT RISK

This risk is a function of the timing of payments. If one

party of a contract del ivers money or assets before

receiving retribution from the other party, they subject

themselves to potential default by the other party.

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LEGAL RISK

This type of risk arises when there is doubt as to the

validity of a contract. This risk is greater if the contract

involves international parties and is further complicated if

one of the parties declares bankruptcy. Despite the work of

the International Swap Dealers Association on this type of

risk, there remains an unsettling degree of uncertainty.

LIQUIDITY RISK

The replacement value of most derivatives contracts is

based on a liquid market. However, much larger losses

than anticipated can occur from a counterparty default if

the markets become viscous or dry up. This can be

especially true in over-the-counter (OTC) markets.

AGGREGATION RISK

This is also known as interconnection or systematic risk. It

results from derivatives contracts that involve several

markets and institutions. A default by one institution may

lead to a domino effect that places the entire financial

system in jeopardy. This type of risk is the basis for the

world-wide financial collapse concerns of some analysts.

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DERIVATIVES IN THE INDIAN MARKET

As the mankind progressed and business and markets grew,

the art of risk management grew from primitive stages to

the modern day rocket science. While derivatives markets

flourished in the developed world Indian markets remain

deprived of financial derivatives to this day.

The phase of waiting seems to be over. The statutory

hassles have been cleared. Regulatory issues are being

sorted out. Bourses are gearing up for derivatives trading.

One the internet business portals are providing simulated

trading games in index futures. Indian securities market is

all set to the see derivatives trading in a few months from

now. Derivatives are finally making their way to the Indian

securit ies market. It has indeed been a long awaited

development. It took a decade of post-reform period to set

the stage for the launch of derivatives trading. During the

initial phases of financial sector reforms it appeared as if

derivatives would foray into the Indian market just as easily

as other things did. But it took a fairly long time for

derivatives dream turn into reality.

While the rest of the world progressed by leaps and bounds

on the derivatives front. Indian market lagged behind.

Emerged in the 1970s, derivatives market grew from

strength to strength. The trading volumes nearly doubled in

every three years making it a trillion-dollar business. They

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became so ubiquitous that now one cannot think of the

existence of financial markets without derivatives.

While the Indian equity market is totally devoid of

derivatives, some varieties of them have been in existence

in the money market. Last year derivatives based on

interest rates have also been allowed. As for the debt

market, less said the better. It offers a very narrow range

of securities. Inspite of the efforts made by the NSE to

-/create an exchange driven market the efforts have been

in vain. Derivatives like options and futures do not exist.

The existing debt market is small and inactive. It does not

provide a wide range of investment choices to investors, to

enabled them to design portfolios that match their risk-

return preferences.

The reforms process began as a reactive rather than

proactive measure. Precarious economic conditions, which

existed at that point of time, compelled India to reform

itself. The improvements in the securities markets like

capital ization, margining, establishment of clearing

corporations etc. reduced market and credit risks. Other

major improvements are introduction of screen-based

trading systems, commendable progress on the demat from.

While the reforms transformed the face of Indian securities

market drastically, the absence of derivatives trading has

been a lacuna in the Indian market. There have been

statutory roadblocks to derivatives trading. Securities

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contracts act banned option type of transactions. Moreover,

regulatory framework for derivatives trading did not exist in

India. The constitution of LC Gupta Committee by SEBI was

intended to fill this gap. Another roadblock was the non-

recognition of derivatives as securities under securities

contracts regulations act.

It was in May 1998 that SEBI has accepted the

reco

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Derivatives Capital Market

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