WORK SHEET – Financial Derivatives

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

Q1) Define the term ‘derivatives’. What is the need of derivatives?

____________________________________________________________________________Derivative
s:- It is a product whose value is to be derived from the vale of one or more basic variables called bases
(underlying assets, index or reference). The underlying assets can be equity, forex and commodity.

A derivative is a financial security with a value that is reliant upon or derived from, an underlying
asset or group of assets—a benchmark. The derivative itself is a contract between two or more
parties, and the derivative derives its price from fluctuations in the underlying asset.

The most common underlying assets for derivatives are stocks, bonds, commodities, currencies,
interest rates, and market indexes. These assets are commonly purchased through brokerages.

Let us see the dictionary meaning of ‘derivative’. Webster’s Ninth New Collegiate Dictionary (1987)
states Derivatives as:

1. A word formed by derivation. It means, this word has been arisen by derivation.
2. Something derived; it means that something have to be derived or arisen out of the underlying
variables. For example, financial derivative is an instrument indeed derived from the financial
market.
3. The limit of the ratio of the change is a function to the corresponding change in its independent
variable. This explains that the value of financial derivative will change as per the change in the
value of the underlying financial instrument.
4. A chemical substance that can related structurally to another substance, and theoretically derivable
from it. In other words, derivatives are structurally related to other substance
5. A substance that can be made from another substance in one or more steps. In case of financial
derivatives, they are derived from a combination of cash market instruments or other derivative
instruments.

For example, you have purchased a gold futures on May 2020 for delivery in August 2020. The price
of gold on May 2020 in the spot market is Rs4500 per 10 grams and for futures delivery in August
2020 is Rs 4800 per 10 grams. Suppose in July 2003 the spot price of the gold changes and increased
to Rs 4800 per 10 grams. In the same line value of financial derivatives or gold futures will also
change.

From the above, the term derivatives may be termed as follows:

The term “Derivative” indicates that it has no independent value, i.e., its value is entirely derived from
the value of the underlying asset. The underlying asset can be securities, commodities, bullion,
currency, livestock or anything else.
In other words, derivative means forward, futures, option or any other hybrid contract of predetermined
fixed duration, linked for the purpose of contract fulfilment to the value of a specified real or financial or
to an index of securities.

The Need for Derivatives

The truth is that derivatives were created out of the need of financial markets. They can and do
serve a wide variety of purposes and that is the reason that they exist. Some of the purposes
that they serve are ethical whereas others are not. In this article we will list down the 4 most common
reasons behind the usage of derivatives.

Purpose #1: To Hedge

Derivatives were originally created as tools for hedging. Businesses face a lot of risks related to
commodity prices in their day to day operations.
  For instance, the operations of an airline firm are largely affected by the prices of jet fuel. The
prices of jet fuel fluctuate on a daily basis. Hence, businesses cannot earn a stable income.
Organizations usually prefer stability and hence there is a need for a financial instrument which
can ensure stable prices regardless of the rise and fall in commodity prices
 Exporters face a lot of risk related to foreign exchange. Their goods are invoiced in foreign
currency. However, they have to pay their expenses in local currency. The exchange rates
between the foreign and local currency change every second. Hence, the profitability of such
an export oriented firm is hit by these changes in the commodity prices. They too feel that
there is a need for a financial instrument which can provide them a stable exchange rate
regardless of the ups and downs in the market so that they can plan their operations based on
this stable platform.
 Lastly, a farmer faces the risk of the variability in the price of his produce. If there is excess
produce in a given year, then the prices are low or else the prices are high. The farmer wants
to get rid of this price variability and hence feels that there is a need for a financial instrument
that can help him fix the prices.

Hedging is the legitimate reason for the existence of derivatives. Hedging happens when the people
buying or selling derivatives contract use the underlying asset in the day to day operations of their
firm.

Purpose # 2: To Speculate

The second most common reason behind the usage of derivatives is speculation. Now, this may not
seem like a legitimate reason. However, speculators are necessary participants in any market as they
provide liquidity.

Hedging happens when the parties to a contract have genuine business interests in the underlying
asset. Speculation is the exact opposite. Speculators have no interest in the underlying asset and
take part in the contract because they believe that they can make a gain out of the price movements.
For instance if you believe that the US dollar will depreciate significantly against the Euro in the next
month, derivatives contracts enable you to take a position on this in the market. Since derivative
contracts are extremely leveraged, speculation in the derivative market is a highly risky business.
However, there are people who specialize in doing so.

Purpose # 3: Circumventing Regulations

The third reason why derivatives are used in the marketplace is to circumvent regulation. Certain
institutions like pension funds are prohibited from making investments in any kind of risky securities.
Hence, derivatives help in superficially de-risking the securities and making it legal for the pension
funds to purchase them.

Consider the case of mortgage backed securities. Pension funds were not allowed to invest money in
real estate since it was considered a risky bet. However, investment bankers created de-risked
mortgage backed securities which were backed by agencies like Freddie Mac and Fannie Mae.
These securities appeared to be risk free and hence pension funds could legally trade in them.

There are many such instances wherein derivatives have been used to circumvent regulations and
change the very nature of the investment being made.

Purpose # 4: Minimizing Trade Costs

Investors all over the world do not like transaction costs. Derivatives provide a great way to avoid and
evade them. This can be best explained with the help of an example.

Consider the case of a company that has taken a fixed rate loan from a bank. However, now they
believe that the interest rates will go down. Hence, they feel like they should take a floating rate loan.
However, closing the loan before its due date would attract prepayment penalty. Also, taking a new
loan would generally attract processing charges. Hence to avoid these transaction costs on both
sides, a firm can simply structure a swap wherein they can switch over to floating interest rates
without bearing any of the above mentioned transaction charges.

Hence, derivatives are extremely useful financial instruments. This usefulness adds tremendously to
their popularity and explains why ever Multinational Corporation, major bank or investment bank in
the world is highly involved in derivative trading.
Q2) “Derivatives are contracts which derive their values from the value of one or more of other assets.”
Comment.

Features of a Financial Derivative

A observed earlier, a financial derivative is a financial instrument whose value is derived from the value of an
underlying asset, hence, the name ‘derivative’ came into existence. There are a variety of such instruments
which are extensively traded in the financial markets all over the world, such as forward contracts, futures
contracts, call and put options, swaps, etc. A more detailed discussion of the properties of these contracts will be
given later part of this lesson. Since each financial derivative has its own unique features, in this section, we
will discuss some of the general features of a simple financial derivative instrument.

The basic features of the derivative instrument can be drawn from the general definition of a derivative
irrespective of its type. Derivatives or derivative securities are future contracts which are written between two
parties (counter parties) and whose value are derived from the value of underlying widely held and easiIy
marketabIe assets such as agricultural and other physical (tangible) commodities, or short term and long term
financial instruments, or intangible things like weather, commodities price index (inflation rate), equity price
index, bond price index, stock market index, etc. Usually, the counter parties to such contracts are those other
than the original issuer (holder) of the underlying asset. From this definition, the basic features of a derivative
may be stated as follows:

1. A derivative instrument relates to the future contract between two parties. It means there must be a
contract-binding on the underlying parties and the same to be fulfilled in future. The future period may
be short or long depending upon the nature of contract, for example, short term interest rate futures and
long term interest rate futures contract.
2. Normally, the derivative instruments have the value which derived from the values of other underlying
assets, such as agricultural commodities, metals, financial assets, intangible assets, etc. Value of
derivatives depends upon the value of underlying instrument and which changes as per the changes in
the underlying assets, and sometimes, it may be nil or zero. Hence, they are closely related.
3. In general, the counter parties have specified obligation under the derivative contract. Obviously, the
nature of the obligation would be different as per the type of the instrument of a derivative. For example,
the obligation of the counter parties, under the different derivatives, such as forward contract, future
contract, option contract and swap contract would be different.
4. The derivatives contracts can be undertaken directly between the two parties or through the particular
exchange like financial futures contracts. The exchange-traded derivatives are quite liquid and have low
transaction costs in comparison to tailor-made contracts. Example of exchange traded derivatives are
Dow Jons, S & P 500, Nikki 225, NIFTY option, S & P Junior that are Traded on New York Stock
Exchange, Tokyo Stock Exchange, National Stock Exchange, Bombay Stock Exchange and so on.
5. In general, the financial derivatives are carried off-balance sheet. The size of the derivative contract
depends upon its notional amount. The notional amount is the amount used to calculate the pay off. For
instance, in the option contract, the potential loss and potential payoff, both may be different from the
value of underlying shares, because the payoff of derivative products differ from the payoff that their
notional amount might suggest.
6. Usually, in derivatives trading, the taking or making of delivery of underlying assets is not involved,
rather underlying transactions are mostly settled by taking off setting positions in the derivatives
themselves. There is, therefore, no effective limit on the quantity of claims, which can be traded in
respect of underlying assets.
7. Derivatives are also known as deferred delivery or deferred payment instrument. It means that it is easier
to take short or long position in derivatives in comparison to other assets or securities. Further, it is
possible to combine them to match specific, i.e., they are more easily amenable to financial engineering.
8. Derivatives are mostly secondary market instruments and have little usefulness in mobilizing fresh
capital by the corporate world, however, war rants and convertibles are exception in this respect.
9. Although in the market, the standardized, general and exchange-traded derivatives are being
increasingly evolved, however, still there are so many privately negotiated customized, over the-counter
(OTC) traded derivatives are in existence. They expose the trading parties to operational risk, counter-
 party risk and legal risk. Further, there may also be uncertainty about the regulatory status of such
derivatives.
10. Finally, the derivative instrument, sometimes, because of their off- balance sheet nature, can be used to
clear up the balance sheet. For example, a fund manager who is restricted from taking particular
currency can buy a structured not whose coupon is tied to the performance of a particular currency
payer.
Q3) “The derivatives are used as tools of investment risk management.” Discuss this statement and outline
various uses of derivatives in investment management.

7 Uses of Derivatives

Derivatives are supposed to provide the following services:-

1. One of the most important services provided by the derivatives is to control, avoid, shift and manage
efficiently different types of risks through various strategies like hedging, arbitraging, spreading, etc.
Derivatives assist the holders to shift or modify suitably the risk characteristics of their portfolios. These are
specifically useful in highly volatile financial market conditions like erratic trading, highly flexible interest
rates, volatile exchange rates and monetary chaos.

2. Derivatives serve as barometers of the future trends in prices which result in the discovery of new prices both
on the spot and futures markets. Further, they help in disseminating different information regarding the futures
markets trading of various commodities and securities to the society which enable to discover or form suitable
or collect or true equilibrium prices in the markets. As a result, they assist in appropriate and superior allocation
of resources in the society.

3. As we see that in derivatives trading no immediate full amount of the transaction is required since most of
them are based on margin trading. As a result, large number of traders, speculators arbitrageurs operate in such
markets. So, derivatives trading enhance liquidity and reduce transaction costs in the markets for underlying
assets.

4. The derivatives assist the investors, traders and managers of large pools of funds to devise such strategies so
that they may make proper asset allocation increase their yields and achieve other investment goals.

5. It has been observed from the derivatives trading in the market that the derivatives have smoothen out price
fluctuations, squeeze the price spread, integrate price structure at different points of time and remove gluts and
shortages in the markets.

6. The derivatives trading encourage the competitive trading in the markets, different risk taking preference of
the market operators like speculators, hedgers, traders, arbitrageurs, etc. Resulting in increase in trading volume
in the country. They also attract young investors, professionals and other experts who will act as catalysts to the
growth of financial markets.

7. Lastly, it is observed that derivatives trading develop the market towards 'complete markets'. Complete
market concept refers to that situation where no particular investors be better of than others, or patterns of
returns of all additional securities are spanned by the already existing securities in it, or there is no further scope
of additional security.
Q4) What are the different kinds of financial derivatives? Also state their features.

Forward contracts

A forward contract is a simple customized contract between two parties to buy or sell an asset at a certain time
in the future for a certain price. Unlike future contracts, they are not traded on an exchange, rather traded in the
over-the-counter market, usually between two financial institutions or between a financial institution and one of
its client.

Example ◆ An Indian company buys Automobile parts from USA with payment of one million dollar
due in 90 days. The importer thus, is short of dollar that is, it owes dollars for future delivery. Suppose
present price of dollar is Rs 48. 0ver the next 90 days, however, dollar might rise against Rs 48. The
importer can hedge this exchange risk by negotiating a 90 days forward contract with a bank at a price Rs 50.
According to forward contract in 90 days the bank will give importer one million dollar and importer will give
the bank 50 million rupees hedging a future payment with forward contract. On the due date importer will make
a payment of Rs 50 million to bank and the bank will pay one million dollar to importer, whatever rate of the
dollar is after 90 days. So this is a typical example of forward contract on currency.

Futures contracts

Like a forward contract, a futures contract is an agreement between two parties to buy or sell a specified
quantity of an asset at a specified price and at a specified time and place. Futures contracts are normally traded
on an exchange which sets the certain standardized norms for trading in the futures contracts.

Example: A silver manufacturer is concerned about the price of silver, since he will not be able to
plan for profitability. Given the current level of production, he expects to have about 20,000 ounces of
silver ready in next two months. The current price of silver on May 10 is Rs 1052. 5 per ounce, and July futures
price at FMC is Rs 1068 per ounce, which he believes to be satisfied price. But he fears that prices in future
may go down. So he will enter into a futures contract. He will sell four contracts at MCX where each contract is
of 5000 ounces at Rs 1068 for delivery in July.

Options contracts
Options are the most important group of derivative securities. Option may be defined as a contract,
between two parties whereby one party obtains the right, but not the obligation, to buy or sell a particular asset,
at a specified price, on or before a specified date. The person who acquires the right is known as the option
buyer or option holder, while the other person (who confers the right) is known as option seller or option writer.
The seller of the option for giving such option to the buyer charges an amount which is known as the option
premium.

Options can be divided into two types: calls and puts. A call option gives the holder the right to buy
an asset at a specified date for a specified price whereas in put option, the holder gets the right to sell an asset at
the specified price and time. The specified price in such contract is known as the exercise price or the strike
price and the date in the contract is known as the expiration date or the exercise date or the maturity date. The
asset or security instrument or commodity covered under the contract is called as the underlying asset. They
include shares, stocks, stock indices, foreign currencies, bonds, commodities, futures contracts, etc. Further
options can be American or European. A European option can be exercised on the expiration date only whereas
an American option can be exercised at any time before the
maturity date.

Example: Suppose the current price of CIPLA share is Rs 750 per share. X owns 1000 shares of CIPLA Ltd.
and apprehends in the decline in price of share. The option (put) contract available at BSE is of Rs 800, in next
two-month delivery. Premium cost is Rs 10 per share. X will buy a put option at 10 per share at a strike price of
Rs 800. In this way X has hedged his risk of price fall of stock. X will exercise the put option if the price of
stock goes down below Rs 790 and will not exercise the option if price is more than Rs 800, on the exercise
date. In case of options, buyer has a limited loss and unlimited profit potential unlike in case of forward and
futures.

Warrants and convertibles

Warrants and convertibles are another important categories financial derivatives, which are frequently
traded in the market. Warrant is just like an option contract where the holder has the right to buy shares of a
specified company at a certain price during the given time period. In other words, the holder of a warrant
instrument has the right to purchase a specific number of shares at a fixed price in a fixed period from a issuing
company. If the holder exercised the right, it increases the number of shares of the issuing company, and thus,
dilutes the equities of its shareholders. Warrants are usually issued as sweeteners attached to senior securities
like bond and debenture so that they are successful in their equity issues in terms of volume and price. Warrants
can be detached and traded separately. Warrants are highly speculative and leverage instruments, so trading in
them must be done cautiously.

Swap contracts

Swaps have become popular derivative instruments in recent years all over the world. A swap is an agreement
between two counter parties to exchange cash flows in the future. Under the swap agreement, various terms like
the dates when the cash flows are to be paid, the currency in which to be paid and the mode of payment are
determined and finalized by the parties. Usually the calculation of cash flows involves the future values of one
or more market variables.

There are two most popular forms of swap contracts, i.e., interest rate swaps and currency swaps. In the interest
rate swap one party agrees to pay the other party interest at a fixed rate on a notional principal amount, and in
return, it receives interest at a floating rate on the same principal notional amount for a specified period. The
currencies of the two sets of cash flows are the same. In case of currency swap, it involves in exchanging of
interest flows, in one currency for interest flows in other currency. In other words, it requires the exchange of
cash flows in two currencies. There are various forms of swaps based upon these two, but having different
features in general.

Features of Financial Derivatives

 A derivative instrument relates to the future contract between two parties.

 Value derived from the vales of the other underlying assets.
 Counter parties have specific obligation under the derivative contract.
 Derivative contract can either be direct or through exchange like options & futures.
 Usually settled by offsetting rather than delivery of asset.
 Known as deferred delivery or deferred payment instrument, easier to take long & short positions.
 Mostly secondary market instruments except warrants & convertibles.