WORK SHEET – Financial Derivatives

Instruction: Write answers of the questions given in this word file & send the completed worksheet when done.

Q1) Enumerate the basic differences between cash and derivative markets.

7 Differences between cash market and derivatives market

Two of the most popular places to trade and invest in the capital markets is the cash segment or the
futures segment also called the derivatives segment. There are plenty of differences between the
cash segment of the capital market and the futures segment. Here are few of the easy to understand
differences

1) Ownership:- When you buy shares in the cash market and take delivery, you are the owner of
these shares or you are a shareholder, until you sell the shares. You can never be a shareholder
when you trade in the derivatives segment of the capital market. This is because you just hold
positional stocks, which you have to square-off at the end of the settlement.  

2) Holding:- Period When you buy shares in the cash segment, you can hold the shares for life. This
is not true in the case of the futures market, where you have to settle the contract within three months
at the very maximum. In fact, when you buy shares in the cash segment they can also be trans
generational, that is they can be transferred from one generation to the other.

3) Dividends:- When you buy shares in the cash segment, you normally take delivery and are a
owner. Hence, you are entitled to dividends that companies pay. No such luck when you buy any
derivatives contract. This is not only true in the case of dividends, but, also other corporate benefits
like rights shares, bonus shares etc.

4) Risk:- Both, cash and futures markets pose risk, but the risk in the case of futures can be higher,
because you have to settle the contract within a specified period and book losses. In the case of
shares bought in the cash market, you can hold onto them for an indefinite period and can hence sell
when prices are higher.

5) Investment Objective Differs:- You buy a contract in the derivatives market to hedge risk or to
speculate. Individuals buying shares in the cash market are investors.

6) Lots v/s shares:- In the derivatives segment you buy a lot, while in the cash segment you buy
shares.

7) Margin money:- In the derivatives segment you pay only margin money for example, if you buy 1
lot of Punjab National Bank (4000 shares) you just pay 15 to 20 per cent of the cost of the 4,000
shares and not the entire amount. That is not true in the case of cash segment, where you have to
pay the entire amount and not only margin.
Q2) Who are the users and what are the purposes of use of derivatives?

Users/Participants In A Derivative Market

The derivatives market is similar to any other financial market and has following three broad
categories of participants:

HEDGERS:

These are investors with a present or anticipated exposure to the underlying asset which is subject to
price risks. Hedgers use the derivatives markets primarily for price risk management of assets and
portfolios.

SPECULATORS:

These are individuals who take a view on the future direction of the markets. They take a view
whether prices would rise or fall in future and accordingly buy or sell futures and options to try and
make a profit from the future price movements of the underlying asset.

ARBITRAGEURS:

They take positions in financial markets to earn riskless profits. The arbitrageurs take short and long
positions in the same or different contracts at the same time to create a position which can generate a
riskless profit.

Users of Derivatives:
Hedgers, Traders and Speculators use derivatives for different purposes. Hedgers use derivatives to
protect their assets/positions from erosion in value due to market volatility. Traders look for enhancing
their income by making a two-way price for other market participants. Speculators set their eyes on
making quick money by taking advantage of the volatile price movements.

Hedging is a mechanism by which an investor seeks to protect his asset from erosion in value due to
adverse market price movements. A Hedger is usually interested in streamlining his future cash flows.
He is most concerned when the market prices are very volatile. He is not concerned with future
positive potential of the value of underlying asset.

A speculator has, normally, no asset in his possession to protect. He is not concerned with stabilising
his future cash flows. He is interested only in making quick money by taking advantage of the price
movements in the market. He is quite happy with volatility. In fact, volatility is his daily bread and
butter.

Arbitrageurs also form a segment of the financial markets. They make riskless profit by exploiting the
price differentials in different markets. For example, if a company’s shares were trading at Rs. 3500 in
Mumbai market and Rs.3498 in Delhi market, an arbitrageur will buy it in Delhi and sell it in Mumbai
to make a riskless profit of Rs. 2 (transaction cost is ignored for the purpose of this example).

Successive such transactions will iron out the difference in prices and bring equilibrium in the market.
However, arbitraging is not a very safe way of making money as was proved in the case of Barings
Bank where unscrupulous arbitraging between Osaka and Tokyo exchanges in Nikkei Stock index
futures drove the Bank to bankruptcy.
Q3) What is the significance of an underlying in relation to a derivative instrument?

Underlying Instrument:- An underlying instrument is an asset that gives derivatives their value, and
the term is commonly used in derivatives trading. Derivatives contracts are financial instruments with
a price that is derived from the underlying instrument they track.

Simply put, an underlying instrument is an asset on which a derivative contract’s price is based. The
underlying instrument provides value to the derivative, supports the agreement, and the parties
involved agreed to exchange the underlying instrument at the derivative’s maturity date.

Example of an Underlying Instrument

Options and shares can be used to describe what an underlying instrument is. Let’s say you buy a put
option on stock ABC, which gives you the right – but not the obligation – to sell the stock ABC at the
strike price up until the option’s expiration.

In this example, the common stock of ABC is the underlying instrument of the option which gives the
contract its value. The option’s price is based on the price of the underlying stock ABC. If the stock’s
price changes, the option’s price will also be directly affected, providing investors with the information
whether the option is worth executing or not.

The underlying instrument can be any tradable asset class, such as stocks, currencies, commodities,
or even real estate. If an investor buys a futures contract on the Canadian dollar to lock the exchange
rate at a future date, the Canadian dollar would be the underlying instrument of the futures contract
which gives the contract its intrinsic value.

However, unlike option contracts, futures contracts are an obligation for both the buyer and the seller.
The buyer of a futures contract agrees to buy the underlying asset at the contract’s expiry, while the
seller agrees to provide the underlying asset at expiry. Derivative products and contracts are a
significant innovation which has enhanced modern financial markets and shaped them as we know
them today.
Q4) What are the reasons for an index futures becoming more popular financial derivatives over stock futures
segment in India?

9 Reasons for Popularity of Stock Index Futures:

The Stock Index Futures is the most preferred derivatives in India owing to the undernoted reasons:

1. The portfolio hedging is given priority by the institutional and other enormous equity-holders.

2. The most cost-efficient hedging is the Stock Index Futures.

3. Stock index is almost beyond the scope of manipulation whereas it is very easy to manipulate the
individual stock price.

4. The most liquidity featured Stock Index Futures are the most popular in India and abroad.

5. The remote possibility of bankruptcy in Stock Index Futures has been guaranteed by the clearing
house effects.

6. The Stock Index Futures are cash settled all over the world and its value is derived independently
from the cash market and safely accepted as the settlement price, where as in the case of individual
stock the outstanding positions remaining on expiration date have to be settled by physical delivery.
But these settlements by means of physical delivery in case of Stock Index Futures are not practically
accepted globally as it is cash settled.

7. The volatility of Stock Index Futures is much lower than the individual stock price.

8. The Individual Stock Futures are always used for manipulating their prices in cash market.

9. The less volatility featured Stock Index Futures has lowered the requirement of capital adequacy
and margin in comparison to Individual Stock Futures.

10. The well regulatory framework for Stock Index Futures ensures less complexity and thereby
growing popularity for equity derivatives.

Stock Index Futures offer implementation advantages and incremental returns to portfolios only
because of the fact that some useful strategies are available for institutions using Stock Index
Futures.