uerlvaLlve

WhaL uoes uerlvaLlve Mean?

A securlLy whose prlce ls dependenL upon or derlved from one or more underlylng asseLs ( equlLy
derlvaLlves forelgn exchange derlvaLlves lnLeresL raLe derlvaLlves commodlLy derlvaLlves or credlL
derlvaLlves) 1he derlvaLlve lLself ls merely a conLracL beLween Lwo or more parLles lLs value ls
deLermlned by flucLuaLlons ln Lhe underlylng asseL 1he mosL common underlylng asseLs lnclude sLocks
bonds commodlLles currencles lnLeresL raLes and markeL lndexes MosL derlvaLlves are characLerlzed
by hlgh leverage
luLures conLracLs forward conLracLs opLlons and swaps are Lhe mosL common Lypes of derlvaLlves
uerlvaLlves are conLracLs and can be used as an underlylng asseL 1here are even derlvaLlves based on
weaLher daLa such as Lhe amounL of raln or Lhe number of sunny days ln a parLlcular reglon
uerlvaLlves are generally used as an lnsLrumenL Lo hedge rlsk buL can also be used for speculaLlve
purposes lor example a Luropean lnvesLor purchaslng shares of an Amerlcan company off of an
Amerlcan exchange (uslng uS dollars Lo do so) would be exposed Lo exchangeraLe rlsk whlle holdlng
LhaL sLock 1o hedge Lhls rlsk Lhe lnvesLor could purchase currency fuLures Lo lock ln a speclfled
exchange raLe for Lhe fuLure sLock sale and currency converslon back lnLo Luros
A flnanclal lnsLrumenL whose characLerlsLlcs and value depend upon Lhe characLerlsLlcs and value of an
underlle Lyplcally a commodlLy bond equlLy or currency Lxamples of derlvaLlves lnclude fuLures and
opLlons Advanced lnvesLors someLlmes purchase or sell derlvaLlves Lo manage Lhe rlsk assoclaLed wlLh
Lhe underlylng securlLy Lo proLecL agalnsL flucLuaLlons ln value or Lo proflL from perlods of lnacLlvlLy or
decllne 1hese Lechnlques can be qulLe compllcaLed and qulLe rlsky












C8!LC1lvLS Cl S1uu?
1o sLudy varlous Lrends ln derlvaLlve markeL
Comparlson of Lhe proflLs/losses ln cash markeL and derlvaLlve markeL
1o flnd ouL proflL/losses poslLlon of Lhe opLlon wrlLer and opLlon holder
1o sLudy ln deLall Lhe role of Lhe fuLure and opLlons
1o sLudy Lhe role of derlvaLlves ln lndlan flnanclal markeL
rovlde leverage (or gearlng) such LhaL a small movemenL ln Lhe underlylng value can cause a large
dlfference ln Lhe value of Lhe derlvaLlve
SpeculaLe and make a proflL lf Lhe value of Lhe underlylng asseL moves Lhe way Lhey expecL (eg moves
ln a glven dlrecLlon sLays ln or ouL of a speclfled range reaches a cerLaln level)
Pedge or mlLlgaLe rlsk ln Lhe underlylng by enLerlng lnLo a derlvaLlve conLracL whose value moves ln Lhe
opposlLe dlrecLlon Lo Lhelr underlylng poslLlon and cancels parL or all of lL ouL
CbLaln exposure Lo Lhe underlylng where lL ls noL posslble Lo Lrade ln Lhe underlylng (eg weaLher
derlvaLlves)
CreaLe opLlon ablllLy where Lhe value of Lhe derlvaLlve ls llnked Lo a speclflc condlLlon or evenL (eg Lhe
underlylng reachlng a speclflc prlce level)









-LLu Cl 1PL S1uu?
ulfferenL lnvesLmenL avenues are avallable lnvesLors SLock markeL also offers good lnvesLmenL
opporLunlLles Lo Lhe lnvesLor allke all lnvesLmenLs Lhey also carry cerLaln rlsks 1he lnvesLor should
compare Lhe rlsk and expecLed ylelds afLer ad[usLmenL off Lax on varlous lnsLrumenLs whlle Lalklng
lnvesLmenL declslon Lhe lnvesLor may seek advlce from experLly and consulLancy lnclude sLock brokers
and analysLs whlle maklng lnvesLmenL declslons 1he ob[ecLlve here ls Lo make Lhe lnvesLor aware of Lhe
funcLlonlng of Lhe derlvaLlves
uerlvaLlves acL as a rlsk hedglng Lool for Lhe lnvesLors 1he ob[ecLlve lf Lo help Lhe lnvesLor ln selecLlng
Lhe approprlaLe derlvaLes lnsLrumenL Lo Lhe aLLaln maxlmum rlsk and Lo consLrucL Lhe porLfollo ln such a
manner Lo meeL Lhe lnvesLor should declde how besL Lo reach Lhe goals from Lhe securlLles avallable
1o ldenLlLy lnvesLor ob[ecLlve consLralnLs and performance whlch help formulaLe Lhe lnvesLmenL pollcy?
1he develop and lmprovemenL sLraLegles ln Lhe wlLh lnvesLmenL pollcy formulaLed 1hey wlll help Lhe
selecLlon of asseL classes and securlLles ln each class dependlng up on Lhelr rlsk reLurn aLLrlbuLes
















SCCL Cl 1PL S1uu?
1he sLudy ls llmlLed Lo uerlvaLlves" wlLh speclal reference Lo fuLures and opLlons ln Lhe lndlan conLexL
Lhe sLudy ls noL based on Lhe lnLernaLlonal perspecLlve of derlvaLlve markeLs
1he sLudy ls llmlLed Lo Lhe analysls made for Lypes of lnsLrumenLs of derlvaLes each sLraLegy ls analyzed
accordlng Lo lLs rlsk and reLurn characLerlsLlcs and derlvaLlves performance agalnsL Lhe proflL and
pollcles of Lhe company
Company proflle




















evlew of llLeraLure
Demyst|fy|ng Der|vat|ves

1he flnanclal servlces lndusLry ls one whereln changes happen fasL and Lhere ls need for coerclve
regulaLlons Lo keep up wlLh flnanclal lnnovaLlon Cne such area ln Lhe flnanclal arena ls LhaL of
derlvaLlves flnanclally englneered producLs 1he lndlan markeLs have [usL been exposed Lo Lhls arena
wlLh Lhe Lradlng of lndex fuLures aL Lhe 8SL and Lhe -SL 1he bureaucraLlc levlaLhan responslble for
reforms and regulaLlons musL face Lhe facL LhaL fears abouL derlvaLlves have proved unfounded lsk
managemenL has assumed a loL of lmporLance however Lhere has also been a loL of apprehenslon
abouL rlskmanagemenL lnsLrumenLs 1he alm of Lhls wrlLlng ls Lo reveal Lhe myLh abouL derlvaLlves and
Lo emphaslze Lhe facL LhaL derlvaLlves and oLher rlsk managemenL lnsLrumenLs should noL be feared buL
embraced wlLh cauLlon Lo help flrms manage Lhe vlclsslLudes of Lhe markeL 1he mosL common myLhs of
derlvaLlves are

MyLh#1 says uerlvaLlves are new complex hlghLech flnanclal producLs creaLed by Wall SLreeLs rockeL
sclenLlsLs 1he LruLh ls uerlvaLlves are conLracLs LhaL are based on or derlved from some underlylng
asseL reference raLe or lndex Wall SLreeLs rockeL sclenLlsLs are conLlnually creaLlng new complex
sophlsLlcaLed flnanclal derlvaLlve producLs Powever Lhose producLs are all bullL on a foundaLlon of Lhe
four baslc Lypes of derlvaLlves opLlons fuLures forwards and swaps uerlvaLlves ls baslcally a rlsk
hedglng mechanlsm whlch by deflnlLlon ls as old as man hlmself

MyLh#2 says uerlvaLlves are purely speculaLlve hlghly leveraged lnsLrumenLs and are akln Lo
gambllng
1he LruLh ls LhaL Lhe exploslve use of flnanclal derlvaLlve producLs ln recenL years was broughL abouL
by Lhree prlmary forces more volaLlle markeLs deregulaLlon and new Lechnologles 8anks and oLher
flnanclal lnLermedlarles responded Lo Lhe new envlronmenL by developlng flnanclal rlskmanagemenL
producLs deslgned Lo beLLer conLrol rlsk

MyLh#3 says 1he enormous slze of Lhe flnanclal derlvaLlves markeL dwarfs bank caplLal Lhereby maklng
derlvaLlves Lradlng an unsafe and unsound banklng pracLlce 1he LruLh ls LhaL Lhe flnanclal derlvaLlves
markeLs worLh ls regularly reporLed as more Lhan $20 Lrllllon Powever for derlvaLlves noLlonal
prlnclpal ls Lhe amounL on whlch lnLeresL and oLher paymenLs are based -oLlonal prlnclpal Lyplcally
does noL change hands lL ls slmply a quanLlLy used Lo calculaLe paymenLs

MyLh#4 says Cnly large mulLlnaLlonal corporaLlons and large banks have a purpose for uslng
derlvaLlves
1he LruLh ls llnanclal derlvaLlves are lmporLanL Lools LhaL can help organlzaLlons Lo meeL Lhelr speclflc
rlskmanagemenL ob[ecLlves and lL ls lmporLanL LhaL Lhe user undersLand Lhe Lools lnLended funcLlon
and LhaL Lhe necessary safeLy precauLlons be Laken before Lhe Lool ls puL Lo use

llnanclal derlvaLlves have changed Lhe face of flnance by creaLlng new ways Lo undersLand measure
and manage rlsks ulLlmaLely flnanclal derlvaLlves should be consldered parL of any flrms rlsk
managemenL sLraLegy Lo ensure LhaL valueenhanclng lnvesLmenL opporLunlLles are pursued 1he
freedom Lo manage rlsk effecLlvely musL noL be Laken away















Why Der|vat|ves?
1he laLesL buzzword ready Lo hlL lndlan flnanclal markeLs ls uerlvaLlve uerlvaLlves are wasLlng asseLs
whlch derlve Lhelr values from an underlylng asseL 1hese underlylng asseLs are of varlous caLegorles llke
equlLy bonds commodlLles eLc lor example a dollar lorward ls a derlvaLlve conLracL whlch glves Lhe
buyer a rlghL an obllgaLlon Lo buy dollars aL some fuLure daLe 1he prlces of Lhe derlvaLlves are drlven
by Lhe spoL prlces of Lhese underlylng asseLs
1here ls a debaLe golng on ln Lhe lndlan flnanclal clrcles on Lhe lssue of lnLroducLlon of derlvaLlves
World over ln developed flnanclal markeLs Lhese lnsLrumenLs have been ln vogue for qulLe someLlme
now 1he argumenLs ln favor are as follows
A Lool for hedglng uerlvaLlves provldes an excellenL mechanlsm Lo hedge Lhe fuLure prlce rlsk 1hlnk of
a farmer who doesn'L know whaL prlce he ls golng Lo geL for hls crop aL Lhe Llme of harvesL Pe can sell
hls crop ln Lhe fuLures' markeL lock ln Lhe prlce lf Lhe fuLure spoL prlce ls more Lhan Lhe fuLures prlce
he can Lake Lhe off seLLlng poslLlon can geL ouL of Lhe markeL (wlLh a marglnal loss) CLherwlse he wlll
geL Lhe locked ln prlce
lsk managemenL uerlvaLlves provlde an excellenL mechanlsm Lo orLfollo Managers for managlng Lhe
porLfollo rlsk and Lo 1reasury Managers for managlng lnLeresL raLe rlsk 1he lmporLance of lndex fuLures
lorward aLe AgreemenL (lA) ln Lhls process can'L be oversLaLed
8eLLer avenues for ralslng money WlLh Lhe lnLroducLlon of currency lnLeresL raLe swaps lndlan
corporaLe wlll be able Lo ralse flnance from global markeLs aL beLLer Lerms
rlce dlscovery 1hese derlvaLlve lnsLrumenLs make Lhe spoL prlce dlscovery more rellable uslng
dlfferenL models llke -ormal 8ackwardaLlon hypoLhesls 1hese lnsLrumenLs wlll cause any arblLrage
opporLunlLles Lo dlsappear wlll lead Lo beLLer prlce dlscovery
lncreaslng Lhe depLh of flnanclal markeLs When a flnanclal markeL geLs such sorL of rlskmanagemenL
Lools lLs depLh lncreases slnce Lhe lnsLlLuLlonal lnvesLors geL beLLer ways of hedglng Lhelr rlsks agalnsL
unfavorable markeL movemenLs
uerlvaLlves markeL on lndlan underlylng elsewhere 1hese days wlLh Lhe advenL of Lechnology lndlan
prlces are avallable globally on euLers knlghLrlder -oLhlng prevenLs any forelgn markeL from
launchlng derlvaLlves on Lhese lndlan underlylng 1hls wlll puL lndlans ln a dlsadvanLageous poslLlon as
Lhey can'L Lake Lhe advanLages of derlvaLlves of securlLles or commodlLles Lraded ln lndla buL someone
lese can Lake So we wlll have Lo move fasL ln Lhls dlrecLlon
Lmplrlcal evldence 1here ls sLrong emplrlcal evldence from oLher counLrles LhaL afLer derlvaLlve
markeLs have come abouL Lhe llquldlLy and markeL efflclency of Lhe underlylng markeL has lmproved



-ow Laklng a look aL argumenLs agalnsL
SpeculaLlon Many people fear LhaL Lhese lnsLrumenLs wlll unnecessarlly lncrease Lhe speculaLlon ln Lhe
flnanclal markeLs whlch can have far reachlng consequences 1he recenL 8arrlngs 8ank lncldenL ls Lhe
classlc case ln polnL
MarkeL efflclency Many people fear LhaL Lhe lndlan markeLs are noL maLure efflclenL enough Lo
lnLroduce Lhese lnsLrumenLs 1hese lnsLrumenLs requlre a well funcLlonlng maLure spoL markeL Llke
recenLly 1he Lconomlc 1lmes reporLed Lhe sLrong correlaLlon of lndlan equlLy markeLs Lo Lhe -ASuAC
Such Lype of markeL lmperfecLlons makes Lhe funcLlonlng of derlvaLlves markeL all Lhe more dlfflculL
volaLlllLy 1he lncreased speculaLlon lnefflclenL markeL wlll make Lhe spoL markeL more volaLlle wlLh
Lhe lnLroducLlon of derlvaLlves
CounLer parLy rlsk MosL of Lhe derlvaLlve lnLrumenLs are noL exchange Lraded So Lhere ls a counLer
parLy defaulL rlsk ln Lhese lnLrumenLs Agaln Lhe same 8arrlngs case 8arrlngs declared lLself bankrupL
when lL faced huge losses ln Lhese lnsLrumenLs
LlquldlLy rlsk LlquldlLy of a markeL means Lhe ease wlLh whlch one can enLer or geL ouL of Lhe markeL
1here ls a conLlnued debaLe abouL Lhe lndlan markeL's capablllLy Lo provlde enough llquldlLy Lo
derlvaLlve Lrader

So one can see LhaL Lhe pros of derlvaLlves far ouLwelgh Lhe cons And moreover by lmposlng margln
requlremenLs by llmlLlng Lhe exposure one can Lake and oLher measures llke LhaL Lhese vlces of
derlvaLlves can be conLrolled 1he lmporLance of derlvaLlves for any flnanclal markeL can'L be
oversLaLed

WhaL wlll happen Lo lndlan llnanclal markeL when Lhe derlvaLlves wlll be launched ls yeL Lo be sen buL
for Lhe markeL Lhe lnsLlLuLlonal lnvesLors lL's a welcome sLep