Unit 1: Introduction

Derivatives are those assets whose value is determined from the value of some
underlying assets. The underlying asset may be equity, commodity, or currency. In
other words, financial derivatives are those financial assets which do not have their
own value that means the value of such assets are derived from the other original or
underlying assets. It generally involves the contract or agreement between two parties
to exchange the standard quantity of an assets or cash flow at a predetermined price and
at a specified date in future. So, they are also called financial contracts. Prices for
derivatives derive from fluctuations in the underlying asset. Derivatives are usually
leveraged instruments, which increases their potential risks and rewards. Common
derivatives include futures contracts, forwards, options, and swaps. Most derivatives
are traded over-the-counter (OTC). However, some of the contracts, including options
and futures, are traded on specialized exchanges.

Features of Financial derivatives:

1. Two parties or Counter parties: Financial derivatives are the financial contract
between two parties to buy or sell certain assets on certain future date at price
agreed today. No financial derivatives can be created without the agreement between
two parties.
2. Underlying assets: The value of financial derivatives depends upon the value of
other assets. Such assets are called underlying assets. In other words, value of
derivatives will go or down according to the value of original assets.
3. Future transaction: Financial derivatives are the agreement for future transaction.
The actual transaction (delivery of assets and cash payment) takes place in future date.
This date is called exercise date.
4. Right and obligation: Derivatives are obligatory for both parties. Both parties
should meet their promises according to the contract. However, there are some
derivatives which give right to one party and obligation to another party. Futures,
forwards, and swap contracts are obligatory for both buyer and seller. The buyer must
buy, and seller must sell the underlying assets. But option is a derivative security which
gives the right to the holder or buyer of the contract to forgo the promise.
5. Zero sum game: Zero sum game is the game in which one party’s gain always equal
to the loss of other party. Neither both parties can gain nor have to bear loss
simultaneously. If payoffs (profit) of both are summed up, the result is always zero.
6. Financial derivatives as an asset: Real Assets includes Land and buildings, plant
and machinery, patents, and trademarks etc. Real assets are the assets which has no
corresponding liability. Financial assets are also called paper assets. They are the assets
of their buyers and liability of their issuer or seller. Derivative securities created through
contract between two parties. They do not have corresponding liabilities. Options,
forwards, futures swap are some examples of derivatives.

7. Predetermined life: The derivatives will expire after certain period in future means
that they should have pre-determined life.

8. Position in financial derivatives: In financial derivatives there are two parties in

trading. The parties who are buying the contract or derivatives are entering into long
position and who are selling the contract for others are considered as taking short
positions.
Advantages of Derivatives:

1. Hedging risk exposure: Since the value of the derivatives is linked to the value of
the underlying asset, the contracts are primarily used for hedging risks. For example,
an investor may purchase a derivative contract whose value moves in the opposite
direction to the value of an asset the investor owns. In this way, profits in the derivative
contract may offset losses in the underlying asset.

2. Underlying asset price determination: Derivatives are frequently used to determine

the price of the underlying asset. For example, the spot prices of the futures can serve
as an approximation of a commodity price.

3. Market efficiency: It is considered that derivatives increase the efficiency of

financial markets. By using derivative contracts, one can replicate the payoff of the
assets. Therefore, the prices of the underlying asset and the associated derivative tend
to be in equilibrium to avoid arbitrage opportunities.

4. Access to unavailable assets or markets: Derivatives can help organizations get

access to otherwise unavailable assets or markets. By employing interest rate swaps, a
company may obtain a more favorable interest rate relative to interest rates available
from direct borrowing.

Disadvantages of Derivatives:
1. High risk: The high volatility of derivatives exposes them to potentially huge losses.
The sophisticated design of the contracts makes the valuation extremely complicated
or even impossible. Thus, they bear a high inherent risk.
2. Speculative features: Derivatives are widely regarded as a tool of speculation. Due
to the extremely risky nature of derivatives and their unpredictable behavior,
unreasonable speculation may lead to huge losses.
3. Counter-party risk: Although derivatives traded on the exchanges generally go
through a thorough due diligence process, some of the contracts traded over the counter
do not include a benchmark for due diligence. Thus, there is a possibility of counter-
party default.
Purpose of derivatives
In financial market derivatives are very important for trading due to the following
purposes:
1. To hedge the risk: It is the process of managing or reducing the risk by taking the
inverse position is trading.
2. To gain from the speculation: By estimating the behavior of future price the
investor can get the huge profit through the small investment which is called
speculation. Derivatives create the high leverage (high risk) in investment.
3. To get the arbitrage profit: Generally, market is not perfect so the market it is not
in equilibrium then investor can get arbitrage profit. Arbitrage can be defined as the
process of getting positive expected return through zero investment and without
incremental risk from the inefficient market i.e., from overvalued and undervalued
securities.
4. For financial engineering or to create the new investment opportunities: By
using the different derivatives securities market player can create various hybrid and
synthetic instruments.
5. Change the nature of assets and liabilities: Using financial derivatives, investor
can change his outflow to inflow and assets to liabilities through various swap and
forwards. Or by taking the various derivative portfolios the investor can change his
assets and liabilities.
Importance of derivatives:
1. To explore the new investment opportunities: Primary securities like shares and
bonds are not sufficient to meet the growing needs of present-day investors. Financial
derivatives are the alternative investment opportunities available to the investors to
earn profit.
2. To minimize the risk (hedging): The main purpose of developing financial
derivatives is to hedge against the risk. Hedging is the process of reducing the financial
risk. Hedging is done by way of a transaction made to diminish the risk of price
fluctuation of financial assets/ commodities. Parities involving in hedging are called
hedgers. With hedging activities, the investor attempts to modify risk by undertaking
investment positions such that the gain on one investment counterbalances the loss on
another.
3. To increase risk and return (Speculation): Derivatives are the contracts that
require small amount of margin. Such assets provide high leverage. Therefore, there is
possibility of getting high profit with small investment. If traders could forecast the
future trend of market, they are able to get large profit. Hence derivatives are attractive
investment alternatives. The investor can gain in both bull and bear market by using
derivative instruments. Long position gives benefit in bull market and short position
gives benefit in bear market.
4. Lock in an arbitrage profit: Arbitrage is the process of making riskless profit from
the mispriced assets in the market. Over price and under price of futures, options etc.
provide the arbitrage opportunity. Hence derivatives are used to capture the profit from
disequilibrium.
5. To change the nature of liabilities and assets: Derivatives assets can be used to
change the nature of assets or liabilities as way to manage interest rate risk. Financial
institution pays interest on deposit and charge interest on lending. Some loan/ deposit
carries fixed interest rate, and some carry floating interest rate. Financial institutions
use swaps to hedge against the risk of change in market interest rates.

Derivative markets and instruments

Generally, market refers to the mechanism which is established for the trading of goods
and services, or it is the composition of buyer and seller. So, derivatives market refers
to the financial market for financial instruments such as options, futures, forwards, and
swaps that are based on the values of their underlying assets. It is new, developing, and
colorful market for trading of financial derivatives. The derivative markets may be the
organized market or over the counter market. As we know the established market make
the transaction easier, cover the transaction cost, provides information to trader to
determine the price.

1. Exchange traded derivative market: Exchange traded derivative market is the

market where standardized derivative assets like futures contracts and options are
traded. Exchange-traded derivatives are standardized, highly regulated, and transparent
transactions that are guaranteed against default through the clearinghouse of the
derivatives exchange.
2. Over the counter market: Over the counter (OTC) market is a market where non-
standardized and unregulated financial contract are traded. OTC markets do not have
any norms, rules, and regulations. There is an absence of a formal exchange or an
exchange regulator who can supervise its functioning. OTC market may not have a
physical location at all, and may just operate online through brokers, dealers, and their
networks. In this market, forward contract, and swap contract are traded. Over-the-
counter derivatives are customized, flexible, and more private and less regulated than
exchange-traded derivatives but are subject to a greater risk of default.

(TYPES OF DERIVATIVES Derivative contracts can be differentiated into several

types. All the derivative contracts are created and traded in two distinct financial
markets, and hence are categorized as following based on the markets:

 EXCHANGE TRADED CONTRACT: Exchange traded contracts trade on a

derivatives facility that is organized and referred to as an exchange. These contracts
have standard features and terms, with no customization allowed and are backed by a
clearinghouse.

 OVER THE COUNTER CONTRACT: Over the counter (OTC) contracts are
those transactions that are created by both buyers and sellers anywhere else. Such
contracts are unregulated and may carry the default risk for the contract owner.)

Traders in derivative market (Participants in the Derivatives Market):

1. Hedgers: Hedging is the process of reducing the financial risk. Hedging is done by
way of a transaction made to diminish the risk of price fluctuation of financial assets/
commodities. Parities involving in hedging are called hedgers. With hedging activities,
the investor attempts to modify risk by undertaking investment positions such that the
gain on one investment counterbalances the loss on another.
2. Speculators: Speculators are defined as investors who take positions that increase
their exposure to certain risks in the hope of increasing their wealth. Hedgers are the
traders who wish to avoid the risk; speculators are those who are willing to take such
risk. They believe that they have some specialized knowledge about the market, and
they can predict the direction of the market’s movement. Speculation is the betting in
the price of financial assets/ commodities. Speculation therefore is a bet on future
movement in the price of assets.
3. Arbitrageur: An arbitrageur is a trader who makes riskless profit at zero investment.
Arbitrageur involves looking in a riskless profit by simultaneously engaging into
transactions into two or more markets. An arbitrageur transaction involves buying
assets at lower price and selling it at higher price. They seek to get benefit from market
inefficiencies/imperfections. In derivative market, arbitrageur opportunities can be
captured by combining position in spot and derivative assets.
4. Margin traders: A margin refers to the minimum amount that you need to deposit
with the broker to participate in the derivative market. It is used to reflect your losses
and gains daily as per market movements. It enables to get leverage in derivative trades
and maintain a large outstanding position. A slight price change will lead to bigger
gains/losses in the derivative market as compared to the stock market.
Types of Derivative Contracts (Derivative instruments):
1. Options: Options are financial derivative contracts that give the buyer the right, but
not the obligation, to buy or sell an underlying asset at a specific price (referred to as
the strike price) during a specific period of time. Based on the option type, the buyer
can exercise the option on the maturity date (European options) or on any date before
the maturity (American options). There are two types of options.
Call option – A call option gives the holder right to buy the underlying assets.
Put option – A put option gives the holder right to sell the underlying assets.
The price of the assets fixed by the contract is known as exercise price/ strike price and
the date fixed in the contract is known as the exercise date.

2. Forwards: It is a specific and private contract between two counter parties to buy or
sell an asset at a certain future date at a stated price. It creates right and obligation for
both parties for payment and delivery of asset. However, forwards contracts are over-
the-counter products, which means they are not regulated and are not bound by specific
trading rules and regulations. Forward is non-standardized, having high default risk, no
price and cash flow settlement and only the over-the-counter market instruments.
3. Futures: Futures contracts are standardized contracts that allow the holder of the
contract to buy or sell the respective underlying asset at an agreed price on a specific
date. The parties involved in a futures contract not only possess the right but also are
under the obligation, to carry out the contract as agreed. It creates right and duties for
each counter parties for the transaction i.e., payment and delivery. The contracts are
standardized, meaning they are traded on the exchange market. Futures are
standardized, low default risk, traded in future exchange and these is the price
settlement.
4. Swaps: Swaps are derivative contracts that allow the exchange of cash flows between
two parties. In simple word swap is the exchange of payment to each other. The swaps
usually involve the exchange of a fixed cash flow for a floating cash flow. The most
popular types of swaps are interest rate swaps, commodity swaps, and currency swaps.
Swaps are not traded on the exchange market. They are traded over the counter, because
of the need for swaps contracts to be customizable to suit the needs and requirements
of both parties involved.
Core concepts in financial and derivative market
Risk preference
Risk is the uncertainty about future outcomes. If the future return can be predicted
accurately, the investment becomes risk free. Risk preference is the intention of
investors of taking risks. Usually, higher returns are associated with higher risk-taking
capability, while lower risks yield lower returns. There are three types of investors
regarding their attitude towards risk.
Risk Seeker: A risk seeker investor is one who prefers risk. Given a choice between
more and less risky investment with identical expected returns, this type of investor
prefers the riskier investment. A risk-loving person prefers an uncertain outcome to a
certain outcome, even if the expected utility of the uncertain outcome is less than that
of the certain outcome.
Risk Neutral: A risk neutral investor does not care about risk while selecting
investment alternatives. He/she just compare is expected return. A risk-neutral person
is indifferent between a certain outcome and an uncertain outcome with the same
expected utility.
Risk averter: A risk averse investor is an investor who prefer less risk to more for a
given return. A risk-averse person prefers a certain outcome to an uncertain outcome
with the same expected utility. The difference between expected return and risk-free
rate of return is known as risk premium. A high-risk averse investor requires a large
increase in risk premium to compensation even a small increase in risk.
Short selling
When an investor anticipates falling in price, a short position is undertaken. In this case,
the objective would be to sell security at high price and buy at low price. Selling the
stock short an investor borrows the stocks from a broker and sells them. Later, the short
seller purchases the stock of the same company from the market to replace the stock
that was borrowed. The investor earns a profit from a price decline in the short position.
Risk and return
The risk and return theory provide fundamental ideas about making optimal investment
decision under the environment of uncertainty to maximize the value of an investment.
Therefore, it is important to understand the nature of risk and return. Return is the
numerical measure of investment performance. It represents the increase in the
investors’ wealth that results from making the investments. One fundamental
characteristic of investors is their desire to increase their return, but the higher return is
accompanied by higher risk. If risk is increased, return should also be increased.
Normally, the relationship between the risk and return is positive.
Market efficiency and theoretical fair value
Market efficiency implies that all known information is immediately evaluated by all
investors and reflected in financial assets prices in financial market. As such no one has
an information lack. In the ideal efficient market, everyone knows all possible
information, interprets it similarly and behave rationally. However human being what
they are, this is rare to happen in market.
Market efficiency is the characteristics of a market in which the prices of instruments
trading reflect their true value to the investors. True economic value is also called the
theoretical fair value. Spot and derivative markets are normally quite efficient and
efficient market is a consequence of rational and knowledgeable investors behavior.
Linkage between spot and derivative market
Spot market is a market for immediate transaction. Delivery of goods and payment for
purchase take place now. But derivative market is the market for trading in future at
price agreed today. Delivery of goods and payment for purchase takes place in future
date.
Derivative instruments such as options, forwards and futures are available for the
purchase and sell of spot market assets like stocks and bonds in future. The prices of
derivatives are related to those of the underlying spot market instruments through
several important mechanisms. General overview is presented below-
Arbitrage and the law of one price
Arbitrage means the earning of riskless profit by taking advantage of differential pricing
for the same physical asset or security. It is a type of transaction in which an investor
seeks to profit when the same assets sell for two different prices. If a stock sells on one
exchange at one price and on another exchange at different price, arbitrageur will buy
it at lower price from one exchange and sell at higher price at another exchange.
It is based on the law of one price. It suggests that two or more identical goods should
not sell for two different prices. If these assets do sell at different prices this creates an
arbitrage opportunity of selling goods relatively high price and simultaneously purchase
of the same goods at a relatively low price. By so doing, an arbitrager will earn profits
at zero investment and zero risk. The arbitrager will continue this activity until the
prices for the goods are equal.
Storage mechanism
We purchase and store different types of assets today. Holding a security is a form of
storage. One can also buy a commodity such as wheat, corn and store it. Storage is a
type of investment in which we postpone selling the assets today in expectation of
selling it at later date. Storage of goods entails risk like opportunity cost, rent of
warehouse, obsolescence, and risk of price fluctuations. However, such type of risk can
be minimized by using derivatives such as forward or future contracts. By entering a
forward, one can contract to buy assets at future date. Thus he/she need not to buy and
store assets today. So, he/she can avoid costs related to the storage. The forward seller
will not enter the contract unless the forward price compensates his/her storage cost.
Thus, the forward price is determined by the spot price, storage cost, opportunity cost
and estimated risk of price fluctuations. Therefore, there is link between derivative and
spot market.
Delivery and settlement
One more important linkage between spot and derivative markets is delivery and
settlement. At expiration, a forward or future contract calls for either immediate
delivery of the items or a cash payment of the same value. Therefore, an expiring
forward or futures contract is equivalent to a spot transaction. The price of the
expiration contract, therefore, must equal the spot price.
Role of derivative markets:
1. Risk management: Primary use of derivatives is to manage the financial risk.
Investors use derivatives to reduce risk are called hedgers and investors who seek to
increase their risk in derivative market are called speculators. Derivative markets enable
those wishing to reduce their risk to transfer it to those wishing to increase it. (i.e., from
hedgers to speculators). Investors have different risk preference. Some are more tolerant
of risk than others. All investors, however, wants to keep their investment at acceptable
risk level. A wheat farmer may be anxious about the uncertain sale and low price of his
crops at the time of harvest. So, he can use future agreement to reduce uncertainty about
the prices they will receive for their product.
2. Price discovery: Forward and future markets are important source of information
about prices of assets in future date. Derivative markets are considered a primary means
of determining the spot price of assets in future date. Prices in derivative market contain
information about what people expect future spot price to be.
3. Operational advantages: Derivative markets offer three important operational
advantages-
- It involves lower transaction costs (commission and other trading costs).
- Derivative markets have greater liquidity than spot market.
- Derivative markets allow investors to sell short securities easily. Securities markets
impose several restrictions designed to limit or discourage the short selling that are not
applied to derivative transactions.
4. Market efficiency: Arbitrage trading is quite common in derivative market. Due to
such trading, the price of mispriced security is rapidly adjusted, and market becomes
efficient. Society benefits because the price of underlying goods more accurately
reflects the goods true economic value.
Criticisms of the Derivatives Market
Derivatives are the versatile financial instrument in the financial world. However,
derivatives have been criticized for having been the source of large losses by some
investors. Derivatives are also criticized as a form of legalized gambling which involves
social cost. But derivative market intended to provide benefit across the society by
making financial markets function in a more organized way. Despite these all, some
important arguments of the critiques against derivatives as are follows.
1. Risk: The derivatives market is often criticized and looked down on, owing to the
high risk associated with trading in financial instruments.
2. Sensitivity and volatility of the market: Many investors and traders avoid the
derivatives market because of its high volatility. Most financial instruments are very
sensitive to small changes such as a change in the expiration period, interest rates, etc.,
which makes the market highly volatile in nature.
3. Complexity: Owing to the high-risk nature and sensitivity of the derivatives market,
it is often a very complex subject matter. Because derivatives trading is so complex to
understand, it is most often avoided by the public, and they often employ brokers and
trading agents to invest in financial instruments.
4. Legalized gambling: Owing to the nature of trading in financial markets, derivatives
are often criticized for being a form of legalized gambling, as it is very similar to the
nature of gambling activities.

Misuse of derivative
Derivatives contain a high degree of leverage, meaning that small price changes can
lead large gain or losses. This is the most undesirable feature of derivatives. Due to
versatile features of derivatives, they can cause problem as well. Having excessive
confidence in one’s ability to forecast price or interest rate or exchange rate and then
acting on those forecasts by using derivatives can be extremely risky. For example, the
person who is assigned the job to hedge risk or follow an arbitrageur strategy, become
speculator.
Derivatives and Ethics
Ethics is a set of morally and legally accepted principles that must be accepted and
followed while doing a task. They are something that have to be followed on the basis
of one's conscience and legal grounds. That is also the case within the derivative market
or derivative sector. There are various ethics to be knowledge and followed which are
as followed.
1. Derivatives professionals and businesses should not Scam or cheat the
investors.
2. Services provided should not be biased towards an individual, a group of
individuals or part of the market. They shouldn't favor someone based on family
relationship or power.
3. A buisness should act with integrity, competence, diligence, respect and ethics
with public, clients, prospective clients etc.
Career in derivative market
The primary use of derivatives is to manage the risk. No matter whether we involve in
small or big business, government, or non-government organization, we must use
derivatives to manage the financial risk. If we choose our career in the field of
investment management, we surely need derivatives tools. Derivative market is the part
of investment industry. Career of the derivative market is increasing day by day. The
career of the derivative market is explained by the following points.
Financial Management in a buisness: A buisness must face various risks which can
be either acceptable or unacceptable. Not managing such risks may lead to huge loss
and destruction of one's career. So, in derivative market, our career can be great if we
learn to manage risks.
Small Buisness ownership: Using derivatives, we can manage foreign exchange risk
or interest rate and manage a small buisness as well.
Investment Management: In our career, if we get into investment management, we
will surely encounter derivatives. While investing into commodities and energy, we
will see many situations where derivatives can be used. If we make good use of such
situations, our career will be bright.
Public Service: In Public Service assets of government must be managed. For such
purpose, various applications of derivatives are necessary.