FINACIAL DERIVATIVE

Introduction
The word derivative indicates that it has no independent value but its value is derived
from the value of the cash asset. A cash asset represents an asset that is bought /sold in
the cash market on normal delivery terms. Derivatives are future contracts i.e. contracts
for delivery and payment on a specified future date. Derivatives are used as risk
management tools. The underlying idea of derivative trading is hedging against risks.
Derivatives are “risk shifting devices”. There are some people who want to avoid risk or
minimize it, derivative serve their purpose.
Derivative is an instrument or contract whose value is derived from the value of one or
more basic variables, technically called underlyings, i.e. it doesn’t have any independent
value. Since its value is essentially derived out of an underlying, it is financial abstraction
whose value is derived mathematically from the changes in the value of the underlying.
The underlyings may vary, for example, it may be commodities (e.g. rice, potato, etc.),
financial instruments (e.g. currency, interest rate, securities, stock index, etc.), real assets
(e.g. gold, bullion, etc.), live stocks, weather, energy or anything else. Accordingly,
derivatives are classified as commodity derivatives, financial derivatives, and so on.

Types of Derivatives
Broadly there are four techniques in each class of these derivatives.

a) Forward - A forward is a customized agreement between two parties to buy or sell a specified
quantity of an asset on a specific date in future at a certain price agreed today.
b) Futures- Futures are standardized exchange-traded contracts between two parties to buy or
sell underlying asset within a future date at today’s future price.
c) Option- An option is a contract which gives the holder / buyer of the contract the right but not
the obligation to buy or sell the underlying asset at a predetermined price within or at a specified
time period.
d) Swaps- A swap is a contract whereby two parties exchange streams of cash flows over a
defined period of time, usually through an intermediary like a financial institution and the nature
of the cash flows to be exchanged is defined in the contract.
The concepts regarding forward, futures, option and swaps do not change with the change
in the underlyings. Alternatively, the underlyings are immaterial for understanding these
concepts. When any one of these techniques is applied to a particular underlying, it
becomes a derivative product, like interest rate forward, index futures, stock put option
etc. In this article, emphasis is given only on features of financial derivatives, its
historical development and uses.

Development of exchange-traded derivatives

Derivatives have probably been around for as long as people have been trading with one
another. Forward contracting dates back at least to the 12th century, and may well have
been around before then. Merchants entered into contracts with one another for future
delivery of specified amount of commodities at specified price. A primary motivation for
pre-arranging a buyer or seller for a stock of commodities in early forward contracts was
to lessen the possibility that large swings would inhibit marketing the commodity after a
harvest.

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The need for a derivatives market
The derivatives market performs a number of economic functions:
1. They help in transferring risks from risk averse people to risk oriented people
2. They help in the discovery of future as well as current prices
3. They catalyze entrepreneurial activity
4. They increase the volume traded in markets because of participation of risk averse
people in greater numbers
5. They increase savings and investment in the long run
The participants in a derivatives market
• Hedgers use futures or options markets to reduce or eliminate the risk associated with
price of an asset.
• Speculators use futures and options contracts to get extra leverage in betting on future
movements in the price of an asset. They can increase both the potential gains and
potential losses by usage of derivatives in a speculative venture.
• Arbitrageurs are in business to take advantage of a discrepancy between prices in two
different markets. If, for example, they see the futures price of an asset getting out of line
with the cash price, they will take offsetting positions in the two markets to lock in a
profit.

Legal Definition
As observed earlier, a financial derivative is a financial instrument whose value is derived
from the value of another financial instrument(s). Derivatives have been included in the
definition of securities in Securities Laws (Second Amendment) Act, 1999 in India and
Securities Contracts (Regulation) Act, [SC(R)A] defines “derivative” to include –
(a) a security derived from a debt instrument, share, loan, whether secured or unsecured,
risk instrument or contract for differences or any other form of security;
(b) a contract which derives its value from the prices, or index of prices, of underlying
securities”. Accordingly, derivatives are securities under the SC (R) A and the trading of
derivatives is governed by the regulatory framework under the SC(R)A.

The Financial Accounting Standards Board also issued FASB Statement No 133, leading
to Account for Derivative Instruments and Hedging Activities (FAS 133) in which
derivative has been defined as, a financial derivative or other contract with all three of the
following characteristics:
a. It has one or more underlyings and one or more notional amount or payments
provisions or both. These terms determine the amount of the settlement or settlements.
b. It requires no initial net investment or an initial net investment that is smaller than that
of other types of contract that would be expected to have a similar response to changes in
market factors.
c. Its terms require or permit net settlement .It can be readily settled net by a means
outside the contract or it provides for delivery of an asset that puts the recipients in a
position not substantially different from net settlement.

Features of Financial Derivatives

Financial derivative products are of different types, e.g., currency forwards, interest rate
swaps, index futures, index option, stock put option etc. and each of them has its own
unique features .However, the basic features of a financial derivative instrument may be
stated as follows:
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(i) A financial derivative instrument relates to the future contract between two
counter parties and the value of such instrument is derived from the value of another
financial instrument. Since the pay-offs of financial derivative depend on the value of
underlying instrument, value of derivatives changes as per the changes in the value of
underlying assets, and some times, it may be nil or zero. Hence, they are closely related.

(ii) The financial derivative contracts can be undertaken either as over the counter
(OTC) products or as Exchange traded products. OTC products are tailor-made or
customized products, which are written across the counter with the help of telephone, fax,
e-mail or any other mode of communication usually between two financial institutions.
Exchange traded products are standardised products in terms of various characteristics,
like quantity and quality of the underlying, expiry dates of the contract, settlement
mechanisms etc. and these products are traded on the floor of physical exchange. The
exchange traded products are quite liquid and have low transaction costs in comparison to
OTC products .Example of OTC products are forwards and FRAs on currency and
interest rates while futures on different financial instruments are the principal form of
exchange traded products. However, swaps and options on various financial instruments
are available both as OTC and exchange traded products.

(iii) Financial derivatives may be price fixing products like forwards, futures, FRAs
and swaps on different financial instruments and price insurance products like options on
various financial instruments. Price fixing products fix the price of the underlying to the
buyer irrespective of the market price on the date of exercise. The rights and duties of the
buyer and seller are symmetric, i.e., they have the equal rights and obligations.
Accordingly, no compensation paid to the seller by the buyer. The pay-offs to the buyer
and seller are a linear function of the price of the underlying. In case of price insurance
products, the price of the underlying is fixed for the buyer, thereby insuring his worst
case scenario. For example, the buyer of the option has the right but not the obligation to
exercise the option and the buyer will exercise the option only in cases where the market
price is unfavorable to him on the date of the exercise. Consequently, the seller/writer of
the option has only an obligation and no right, to compensate for which he is paid a
premium .The pay-offs to the buyer and seller are non-linear in options as the rights and
obligations are skewed in favour of the buyer and seller is compensated by way of a
option premium.

(iv) The financial derivatives are also known as off-balance sheet items as their value
is not directly ascertainable, which in turn is based on the value of the underlying and no
asset or liability underlying the contract is put on the balance sheet as such. Since the
value of such derivatives depends upon the movements of the market prices of the
underlying assets, hence, they are treated as contingent asset or liabilities and such
transactions and positions in derivatives are not recorded in the balance sheet.

(v) All financial derivative instruments have a pre-determined finite life at the end of
which they expire and generally involve small payments in comparison with the notional
principal amount of the transactions. But, the underlyings from which the financial
derivatives are derived are generally perpetual in nature.
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(vi) The financial derivatives are usually operated in a highly unstructured information
environment and accordingly, independent judgment takes predominant role over
objective rules in handling derivatives.

(vii) All financial derivatives are the classic examples of zero-sum game. Whenever
one party gains, the other party must lose i.e., if it has a positive value for one party, it
must have the same negative value for the counterparty.

(viii) The financial derivative products may be ‘plain vanilla’ type or ‘exotic’ type. A
plain vanilla derivative product is a standard instrument with no usual features and is
created by following anyone for the four basic techniques, namely forward, futures,
options and swaps. The exotic derivative product is a non-standard instrument with usual
pay-off mechanisms. The basis of the structure of these products is not unique and is
formed by combining two or more plain vanilla call and put options whereas some others
are far more complex. In fact, there is no boundary for designing the non-standard
financial derivatives, and hence, they are termed as exotics.

(ix) The financial derivatives are very sophisticated as well as risky instruments as
their prices are subject to substantial fluctuations and accordingly, it requires investment
techniques and risk analyses. The use of financial derivatives requires an understanding
not only of the underlying instrument but also of the derivative techniques itself.
Understanding the various risks that are associated with the financial derivatives is
necessary in order to apply control over the risk.

The structure of Derivative Markets in India:

Derivative trading in India takes place either on a separate and independent Derivative
Exchange or on a separate segment of an existing Stock Exchange. Derivative
Exchange/Segment function as a Self-Regulatory Organization (SRO) and SEBI acts as
the oversight regulator. The clearing & settlement of all trades on the Derivative
Exchange/Segment would have to be through a Clearing Corporation/House, which is
independent in governance and membership from the Derivative Exchange/Segment.